Fed in Massive Denial of Bubble Creation with No Plan to Deal with Aftershocks

by the Curmudgeon and Victor Sperandeo  



We learned this week that the Fed is (only now) looking for asset bubbles, yet they don't see one yet.  Nor do they have any plan to either pop the bubble(s) or manage the negative aftershocks when the bubble ultimately bursts (as they always do).  In the minutes of the December 2013 Federal Open Market Committee meeting (released January 8, 2014), some FMOC members expressed concern that QE3 -- which they decided to trim back by $10 billion a month, to $75 billion, starting this month -- was beginning to inflate asset prices.  But that's it!  No discussion of what steps to take from potential bubble trouble. 


What the FOMC said at their December 2013 meeting:

Here's the applicable text (emphasis added via bold font):

"Participants also reviewed indicators of financial vulnerabilities that could pose risks to financial stability and the broader economy. These indicators generally suggested that such risks were moderate, in part because of the reduction in leverage and maturity transformation that has occurred in the financial sector since the onset of the financial crisis. In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.


A couple of participants offered views on the role of financial stability in monetary policy decision-making more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy.


Another suggested that the importance of financial stability considerations in the Committee’s deliberations would likely increase over time as progress is made toward the Committee’s objectives, and that such considerations should be incorporated into forward guidance for the federal funds rate and asset purchases."


Other Views:

1.  Fed Governor Jeremy Stein had previously said that the Fed's policies have induced investors to reach for higher returns while the Fed has pushed down Treasury yields, with potentially destabilizing effects.  Really?

2.   John Williams, President of the Federal Reserve Bank of San Francisco, said in an interview with the WSJ:  "Right now the situation is not one where we are seeing broad indicators of a lot of excesses in financial markets that pose a lot of dangers to the financial system or the economy," Mr. Williams said. Still, he said he was watching warily.   Whoopi!

3.  "The minutes conveyed little sense of contentiousness, as apparently the game plan was easily agreed upon to ratchet down asset purchases," said Michael Feroli, chief U.S. economist for J.P. Morgan Chase Bank NA, in an email to clients. But nothing was discussed to guarantee financial stability resulting from Fed distorted asset prices.

4.  Zerohedge  reports that Richmond Fed President Jeffrey Lacker responded to a question following a speech by saying the Fed was reluctant to "prick" asset-price bubbles. 

Tyler Durden wrote: "Lacker - who has been anti-QE to some extent - knows that if the Fed moves to actually do anything about it (other than jawbone), it's all over. Perhaps as more realize the transition from a Bernanke Put to a Yellen Collar has occurred, there will be no need to jawbone any longer.  But jawbone on they will as open-mouth operations try to persuade investors that strong forward guidance is just as effective as printing 100s of billions of USDs...."


Comment and Analysis:

We find it astonishing that only now has the FOMC started to consider the distorting effects on financial markets of their QE and ZIRP policies. The irony is that Bernanke indicated back in 2010, that was the monetary authorities' intent. But nothing has been done to stop that distortion and soaring asset prices have become decoupled from the lackluster, real economy (which we've called "the great disconnect").  For example, stock prices (e.g. S&P 500) were up 30% from a year ago (the Russell 2000 was up close to 40%) and home prices have risen at double-digit rates. 

It's not clear from the FOMC minutes how many of the panel's members worry the Fed is blowing bubbles. But it is evident the Fed's bond purchases have been more successful in boosting asset prices than jobs. Let's examine the effect of QE3 on stock prices last year.

Using trailing earnings — those accrued over the preceding 12 months — bespoke analysts noted that the market's P/E ratio soared 23% - from 14.64 at the beginning of the 2013 - to 18.01 by the end of the year. That valuation shift accounted for almost of the market’s gains for the year since there was only a miniscule rise in earnings.  What’s more, the historical average P/E was only 15.3.  So at the beginning of the year, the market was cheaper than average, but by year-end it had become overvalued.

What is the Fed going to do?  No forward guidance was given in the December meeting minutes.  It isn't clear that the Fed will alter its presumed policy course of gradual reductions in its bond purchases, most likely with cuts of $10 billion per month announced at each FOMC meeting.  Nor do we know when ZIRP will end, even as the (reported) U.S. unemployment rate nears the targeted 6.5%.

Will the Fed recognize its actions feed into inflation of asset prices more than employment and wages?  How will the incoming Fed head Janet Yellen deal with this problem?

We believe the Fed is SEVERELY underestimating the financial bubbles caused by QE.  The last meeting minutes stated that threats to financial stability were moderate and that stock market valuations were "broadly in line with historical norms."  We think that statement is ridiculous.



In our view, the Fed is way too complacent and smug regarding downside risks (e.g. black swan events) to economic growth forecasts as depicted in the charts above.  They have not accurately or realistically assessed the negative effects and fallout of a the current stock and bond market bubbles bursting. And that benign neglect comes in spite of the reductions in consumer spending and corporate investment/capital spending after the wealth destruction which occurred after the 2007 real estate bubble burst and is still ongoing!

Victor's Closing Comments:

1.  It cannot be emphasized enough that listening to the words of government officials is quite naive. They have proven time and time again to almost never tell the truth, but to instead say what they think the public should hear to accomplish their goals.  So the Fed does not want to tell the public that they've caused financial asset bubbles.

Another example of the U.S. government not being forthright is the reported inflation rate as measured by the CPI, which is said to average 2.1% over the last five years of "economic recovery."  Yet, the UK has been in recession for almost all of that time and their reported inflation rate is higher at 2.47%? Who is telling the truth? You can decide.

2.  It does not take a study or logical proof that there are bubbles in stocks and bonds.  See point 4 below for additional evidence.

We have discussed elevated stock prices as being far removed from the real economy many times in previous Curmudgeon posts.  But let's now analyze some facts on bonds.

In the last 53 years, the average yield is 6.02%. The average yield today is 1.93% with TBills at 5 bps and the 30 year TBond yield at 3.80%.  Today's average yield is 68% less than the average modern history yield!

This means to trade at the average yield in the last 53 years, the long end of the bond market would have to drop 38%! The total value of the US debt market is $ 39.9 trillion according to the Securities Industry and Financial Markets Association (SIFMA)     

The U.S. debt market is composed of: Mortgage bonds, Corporates, Federal Agency, Municipals, Treasury Related, Debt Securities, Money Markets, and Asset-Backed.  A return to fair yield would imply a loss of $15 trillion in market value.

The equity markets can also decline $7.6 trillion with a bear market of 38%. Can you imagine the fallout on the real economy in that case? 

The Fed has imposed this Armageddon- like risk on the U.S. economy through QE which has increased its balance sheet by 400% during the last five years.  And the result?   The lowest GDP recovery growth (of 2%) since 1945. 

3.  The Fed represents the banking system. They will not allow a risk to losing their power and will do whatever it takes to create profits to itself under the pretense of helping the economy. If the Fed were truly "independent," cared about the economy and the American people, its members would tell the administration that they are the problem.  And that the administration needs to change its anti-business policies. 

4.  As to the objective evidence that financial asset bubbles have been created, I quote Larry Summers, Harvard Professor and former US Treasury Secretary.  In a recent FT editorial titled Washington Must not Settle for Secular Stagnation he wrote:

"But a strategy that relies on interest rates significantly below growth rates for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without the costs is a chimera. It is precisely the increases in asset values and increased ability to borrow that stimulates the economy and that is the proper concern of prudential regulation."

Shouldn't the Fed be more concerned with financial stability, especially after creating the last two bubbles that burst- the dot com boom/bust followed by the real estate bubble/mortgage meltdown? 

We'll let the readers think about that as the Fed surely isn't listening to us!


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies.  As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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