Bubbles & Schemes

Editor’s Note: Consistent with our ongoing determination to publish in-depth analysis along with the more digestible tidbits that should never be an exclusive source of political and economic analysis and commentary, here is a 2,400 word piece that exposes and dissects the sources of instability and speculative excess in global financial markets. Anyone who has a strong opinion on the sustainability of, for example, 7.75% projected average annual returns for the Los Angeles Fire and Police Pension system, or, for that matter, any other public employee pension system, needs to wade through material like this. Because global financial markets, as author Doug Noland states, are now driving the economy, instead of the other way around. The result are assets that are artificially inflated; to quote Noland, “Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.” Central banking policies, and the ecosystem of financial special interests that exploit them, are creating a global pricing bubble of dangerous proportions, across all classes of assets.

The “economic sphere” versus “financial sphere” analytical framework has in the past been a focal point, but over recent years I have not given this type of analysis the attention it deserves. Conventional analysis holds that the real economy drives the performance of the markets. During bull markets, pundits fixate on every little indicator supposedly corroborating the optimistic view. These days, the bulls trumpet strong underlying profit growth as supporting ever higher stock prices.

Especially in this Age of Unfettered Finance, I’m convinced that the “financial sphere” commands the “economic sphere.” Profits are generally a byproduct of strong underlying growth in finance – hence a lagging indicator. Corporate earnings will appear absolutely stellar at market peaks – as Credit flows freely and financial conditions remain ultra-loose. Profits will be lousy at market bottoms, when risk aversion and attendant tight financial conditions dominate.

Going back now more than twenty years, one of my primary analytical objectives has been to identify, study and monitor the underlying finance fueling booms in markets and economic activity. Fundamental analytical issues include: What is the nucleus of the underlying Credit expansion? Whose balance sheets/liabilities are growing? What is the nature of prevailing financial flows? How stable are the underlying Credit and flow dynamics? What is the role of policymaking and government market intervention? Are there major market misperceptions and resulting mispricings?

Today’s consensus view holds that the economy and markets are sound – robust even. The economy is finally emerging from a difficult post-Bubble period, with the markets appropriately valued based on improving fundamentals. Central bankers and pundits alike assure us that markets have not succumbed to yet another Bubble. Top officials at the Fed and ECB have both recently stated that underlying Credit growth and market leverage are inconsistent with a problematic Bubble backdrop.

I have repeatedly identified troubling parallels between the past twenty year cycle and the protracted boom that ended with the 1929 stock market crash. Having extensively studied the late-twenties period, I was repeatedly struck by how virtually everyone was caught unaware of acute underlying financial and economic fragilities. “How could they have not seen it coming?,” I often asked myself. It all makes clearer sense to me now.

Importantly, this has been a particularly prolonged Credit and speculative cycle (exceeding even the historic 1914-1929 boom). Similar to 1929, everyone has become numb to the scope of Credit excess, speculative leveraging and economic maladjustment. Back in the sixties, Alan Greenspan was said to have pointed responsibility for the financial collapse and resulting Great Depression on a misguided Federal Reserve that had repeatedly placed “coins in the fuse box” to sustain the Twenties boom.

Clearly, a protracted period of repeated central bank market interventions will solidify the notion that adroit policymakers have everything under control. And given enough time – and sufficient inflation in Credit and financial asset markets – price distortions will become deeply systemic – if not commonly appreciated. Importantly, protracted booms create cumulative deleterious effects that, by the nature of things, go completely unappreciated even in the face of precarious “terminal phase” Bubble excess.

I titled a presentation back in early-2000, “How Could Irving Fisher Have been so Wrong?” Only days before the great 1929 crash, the leading American economist at the time famously stated: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be if ever a 50 or 60 point break from present levels…”

Fisher and about everyone else at the time were oblivious to underlying financial and economic fragilities. With this in mind, I will touch upon what I believe are sources of potential vulnerability. In particular, my focus is on potentially unstable Credit and financial flows – the “financial sphere”.

First of all, Credit financing asset speculation is inherently unstable. Broker call loans and various leveraged structures proved catastrophic in the 1929 crash and subsequent financial meltdown. During booms, speculative leveraging engenders their own self-reinforcing liquidity abundance. But as we saw firsthand during the 2008/09 fiasco, the cycle’s vicious downside, with the forced unwind of speculative leverage, pressures market liquidity and asset prices in a self-reinforcing market crash. Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.

It is my view that the current amount of global speculative leverage across securities and asset markets is surely unprecedented – stocks, bonds, EM, real estate, collectables, etc. The global leveraged speculating community has grown significantly since the ’08 crisis, while there has been a proliferation of instruments, vehicles and funds that boost returns through the use of embedded leverage. Anecdotes suggest global “carry trade” speculative leverage has inflated to unprecedented extremes, certainly bolstered by central bank currency/liquidity manipulation (the U.S., Japan and China at the top of the list). And I worry that booming markets for ETFs and derivatives (of all stripes) ensure the utilization of massive amounts of leverage (along with trend-reinforcing “dynamic trading” hedging strategies).

At the same time, record margin debt and booming “repo” markets suggest speculative leverage from traditional sources remains as prominent as ever. What are the ramifications for system stability from record quantities of stocks and bonds at record high prices underpinned by record amounts of speculative leverage?

Sheila Bair penned an interesting op-ed in Friday’s Wall Street Journal: “The Federal Reserve’s Risky Reverse Repurchase Scheme.” I appreciate the analysis and particularly the notion of a “scheme.” I actually believe that there is a critically important evolution that occurs during protracted Credit and speculative cycles. In simple terms, over time runaway financial and economic booms transforms from a Bubble dynamic to one more akin to a sophisticated financial scheme.

Importantly, mounting financial and economic fragility fosters progressive government intrusion throughout the markets and real economy. Resulting market instability and poor economic performance then provoke only more meddlesome government “activism.” As we’ve witnessed over the past six years, massive fiscal spending has bolstered the economy and inflated corporate profits. Meanwhile, central bank interest-rate manipulation, market intervention and massive “money” printing incited risk-taking and incentivized speculative leveraging. If the great American economist Hyman Minky were alive today, he would undoubtedly label this one of history’s most outrageous episodes of “Ponzi Finance.”

It’s certainly no coincidence that we’ve been witnessing a proliferation of financial jerry-rigging. The loosest financial conditions imaginable have spurred record stock buybacks that have bolstered equities prices, while goosing earnings-per-share (EPS). Other popular methods of financial engineering include “tax inversions,” master limited partnership and various other tax avoidance schemes that work to inflate equity market valuation. Government and central bank largesse has also incited a historic M&A boom that will leave a legacy of problem debt.

It’s surprising that there has not been more concern regarding conspicuous excess throughout the corporate debt market. Corporate borrowings are notoriously cyclical and potentially disruptive. One can look back to the late-eighties corporate debt boom and resulting early-nineties bust. Then there were late-nineties excesses that left a legacy of problematic telecom debt, along with a severe tightening of Credit conditions. Yet those excesses were left in a trail of dust by the 2006/07 corporate lending fiasco that played prominently in the subsequent financial crisis.

So let’s take a brief look under the hood of today’s corporate debt boom (beyond record issuance of bonds – risky and otherwise). From the Fed’s Z.1 “flow of funds” report we see that non-financial corporate borrowings increased at a seasonally-adjusted and annualized rate (SAAR) $873bn during Q1, up sharply from 2013 Q4 and at a pace surpassing even 2007’s record $862 growth in corporate debt. It is worth noting that the two-year 2012-2013 corporate debt expansion of $1.45 TN surpassed the $1.42 Trillion gain from 2006-2007. And while we’re at it, the 1998-1999 lending boom saw corporate debt increase $801bn and the 1987-1988 Bubble posted growth of $395bn. Some would argue that the 9% (or so) pace of corporate debt growth over the past nine quarters remains below 2007’s 13.6%, 1998’s 10.8% and 1987’s 10.4%. I would counter that today’s record low corporate borrowing costs work to somewhat temper overall growth in corporate Credit. Excesses – including issuance and mispricing – are greater than ever.

The cyclical boom and bust dynamic saw Credit expansion slow rapidly during the early nineties, with corporate debt actually contracting 2.3% in 1991 (and growing only 0.8% in ’02). Booming corporate debt growth was cut in half by 2001, and then expanded only 1.3% in 2002 and 2.0% in 2003. Corporate borrowings were also cut in half in 2008, before contracting 3.1% in 2009 (expanding only 1.7% in 2010). Importantly, corporate debt is prone to cyclicality and instability.

Returning to “financial sphere” analysis, I discern latent fragility. Sure, Q1 total non-financial sector Credit expanded SAAR $2.113 TN (up from 2013’s $1.812 TN), surpassing my $2.0 TN bogey for Credit sufficient to drive a maladjusted economic structure. But the federal (SAAR $874bn) and corporate (SAAR $873bn) sectors accounted for the vast majority of system Credit expansion. And I believe both Credit booms have been heavily impacted by central bank QE liquidity injections. After all, Fed holdings expanded SAAR $911bn during Q1, after surging $1.086 TN in 2013. Importantly, we’re now only a few months away from the end of QE.

July 25 – Financial Times (Vivianne Rodrigues and Michael Mackenzie): “Junk bonds are on track for their worst monthly return in nearly a year, with investors fretting the era of easy US central bank money is at an end and calling time on a bull run for one of the market’s riskier asset classes. Years of quantitative easing by the Federal Reserve have driven investors into bonds, real estate and equities, sparking concerns of looming asset price bubbles. Junk-rated debt, in particular, has attracted record inflows and generated robust returns for investors prepared to bet on bonds sold by companies with the lowest credit ratings.”

July 25 – Wall Street Journal (Katy Burne and Chris Dieterich): “Investors are selling junk bonds at the fastest pace in more than a year, as fresh interest-rate fears and geopolitical turmoil amplify valuation concerns following a long rally. Prices on bonds issued by lower-rated U.S. companies tumbled to a three-month low this week… Investors yanked $2.38 billion from mutual funds and exchange-traded funds dedicated to junk bonds in the week ended Wednesday, the largest weekly withdrawal since June last year, said… Lipper. That came on the heels of $1.68 billion that poured out the week before. Companies have taken note, with some borrowers delaying scheduled debt sales and others canceling planned deals. New issuance is on track for its slowest month since February, according to… Dealogic.”

I suspect that the end of QE could very well send shudders throughout the corporate debt marketplace, and I would furthermore expect the initial tightening of financial conditions to manifest with the marginal “junk” borrowers. Especially after hundreds of billions have flooded into high-yielding vehicles (certainly including the ETF complex), an abrupt reversal of flows would spell Credit tightening trouble. Further, any meaningful deterioration in corporate Credit Availability would have negative ramifications for an overextended stock market Bubble. As I have written previously, with QE winding down the securities markets are increasingly vulnerable to a destabilizing bout of “risk off.” It wouldn’t require a major de-risking/de-leveraging episode to dramatically alter the marketplace liquidity backdrop.

There is another element of “financial sphere” analysis that I believe could play a major role in unappreciated latent fragilities: Integral to the “global government finance Bubble” thesis is that excesses today encompass the world and virtually all asset classes. While not readily apparent, I believe there are various international financial flows that today stoke asset inflation and Bubbles – flows that could prove especially destabilizing in the event of globalized financial tumult. Myriad flows originating from the likes Japan, China, overheated EM Credit systems and elsewhere unobtrusively inject liquidity and drive price gains throughout our stocks, bonds, real estate and the real U.S. economy more generally.

July 16 Wall Street Journal (Min Zeng) “China Plays a Big Role as U.S. Treasury Yields Fall – Record Chinese Purchases of Treasurys Help Explain U.S. Bond Rally.” “Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China. The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago… The purchases help explain Treasurys’ unexpectedly strong rally this year… The world’s most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014… “

July 9 – Los Angeles Times (Tim Logan): “A record amount of foreign money is flowing into the U.S. housing market… Overseas buyers and new immigrants accounted for $92 billion worth of home purchases in the U.S. in the 12 months ended in March… That’s up 35% from the year before, and the most ever. Nearly one-fourth of those purchases came from Chinese buyers. And the place they’re looking most is Southern California… The report highlights the growing effect of global capital on some local housing markets. The $92 billion amounts to 7% of all money spent on homes in the U.S. during those 12 months, and nearly half of it was concentrated in a handful of cities, including Los Angeles.”

Perhaps it’s coincidence that the ECB is commencing a major new liquidity operation just as the Fed’s QE winds down. Clearly, the “Draghi plan” to bolster fragile European peripheral debt markets should be viewed as a sophisticated financial scheme. Thus far, the Bank of Japan (BOJ) shows no indication that its “money” printing scheme is ending anytime soon. And despite all the talk that the Chinese were serious about financial and economic reform, they apparently took one alarming look at rapidly unfolding systemic fragilities and opted to let their historic Bubble run. The Chinese Bubble is a government-dictated financial scheme of epic proportions.

So it’s become an equally fascinating and alarming global dynamic: a multifaceted global scheme to support massive amounts of debt, inflated securities markets and a grossly maladjusted global economic structure. Worse yet, it’s a global scheme held together by various governments that are increasingly engaged in heated geopolitical strife. In the end, “Ponzi Finance” financial schemes boil down to games of confidence.

So I’ll attempt the briefest responses to the above noted key questions: What is the nucleus of the underlying Credit expansion? Answer: Non-productive government debt, speculative leverage and borrowings to support financial engineering. Whose balance sheets/liabilities are growing? Answer: The Fed’s and Treasury’s, along with corporate America. What is the nature of prevailing financial flows? Answer: Financial speculation – chasing yields and inflating securities prices. How stable are the underlying Credit and flow dynamics? Answer: I believe highly unstable and susceptible to changing market perceptions and faltering confidence. What is the role of policymaking and government market intervention? Answer: Profound impact on all markets and the real economy. Are there major market misperceptions and resulting mispricings? Answer: Confidence in both ongoing liquidity abundance and the power of central banks has fostered profound systemic mispricing throughout securities and asset markets on a global basis. Is the backdrop consistent with a momentous financial scheme? Absolutely.

About the Author:  Doug Noland has been the Senior Portfolio Manager of the Federated Prudent Bear Fund and Federated Prudent Global Income Fund since December 2008. Prior to joining Federated, Mr. Noland was employed with David Tice & Assoc., Inc. where he served as an Assistant Portfolio Manager and strategist of Prudent Bear Funds, Inc. Prudent Bear Fund and Prudent Global Income Fund from January 1999. From 1990 through 1998, Mr. Noland worked as a trader, portfolio manager and analyst for short-biased hedge funds including G. W. Ringoen & Associates from January 1990 to September 1996, Fleckenstein Capital from September 1996 to March 1997 and East Shore Partners, Inc. from October 1997 to December 1998. He earned a B.S. in Accounting and Finance from the University of Oregon and a M.B.A. from Indiana University. This post originally appeared on the economics website “The Prudent Bear” and is published here with permission.

No Asset Bubble?

Earlier in the week BlackRock’s Larry Fink commented on CNBC: “A Bubble is predicated on leverage.” Fink was implying that he didn’t see the type of leverage that had fueled the previous Bubble.

As part of my Bubble analysis framework, I have posited that the more conspicuous a Bubble the less likely it is to be systemic. The “tech” Bubble was conspicuous, though gross excesses impacted only a relatively narrow segment of asset prices and a subsection of the real economy.

I received a lot of pushback to my mortgage finance Bubble thesis during that Bubble period. The conventional view held that excesses were not a major issue, especially when compared to the Internet stocks and all the nonsense illuminated with the technology Bubble collapse. The Fed’s unwillingness to move beyond baby-step rate increases (to aggressively tighten Credit) played prominently in Bubble Dynamics. Today, conventional thinking sees a system that has been working successfully through a multi-year deleveraging process. Leverage and speculative excess are believed to be nothing on the order of those that gave rise to the (“100-year flood”) “Lehman crisis.”

As an analyst of Bubbles, I’ve definitely got my work cut out for me. I have seen overwhelming evidence in support of my “Granddaddy of all Bubbles” – global government finance Bubble – thesis. Yet the Bubble is so comprehensive – so systemic – that the greatest financial Bubble in human history somehow goes largely unappreciated – hence unchecked.

Understanding this era’s Credit Bubble (as opposed to the causes of the Great Depression) will prove the ultimate “Holy Grail of Economics.” The past 25 years have been unique in financial history. Indeed, the world is trapped in a perilous experiment with unfettered finance – with no limits on either the quantity or quality of Credit created. Closely associated with this trial in unchecked electronic finance (“money” and Credit) has been runaway experimentations in “activist” monetary management. Just as crucial is the experiment in unconventional economic structure – including the deindustrialization of the U.S. economy, with the corresponding unprecedented expansion of industrial capacity throughout China and Asia. This has engendered a period of unmatched global economic and financial imbalances – best illustrated by the massive and unrelenting U.S. Current Account Deficits and the accumulation of U.S. IOU’s around the globe.

The amazing thing to me is that the world has been subjected to more than 25 years of brutal serial boom and bust cycles (going back to 1987 – although there’s a strong case to start at 1971) – yet there has been no effort to reform either a patently flawed global financial “system” or a reckless policymaking doctrine. Instead, global central bankers have turned only more “activist,” drifting further into the bizarre (that passes for “enlightened”). The world’s leading central banks have resorted to rank inflationism, massive “money” printing operations specifically to inflate global securities markets. And the resulting raging “bull” markets ensure bullishness and a positive spin on just about everything. The sophisticated market operators play the speculative Bubble for all its worth, while the unsuspecting plow their savings into stock and bond Bubbles.

Credit is inherently unstable. Marketable debt instruments exacerbate instability. A financial system where Credit expansion is dominated by marketable debt (in contrast to “staid” bank loans) is highly unstable – I would argue unwieldy, whimsical and prone to manipulation. And a monetary policy regime that specifically nurtures and backstops a system dominated by marketable securities and associated speculation is playing with fire. Importantly, the more deeply central bankers intervene and manipulate such a system and the longer it is allowed to inflate – the more impossible for these central planners to extricate themselves from the financial scheme.

I’m fond of a relatively straightforward analysis that does a decent job of illuminating the state of ongoing U.S. (marketable securities) Bubbles. From the Fed’s Z.1 “flow of funds” data, I tally Total Marketable Debt Securities (TMDS) that includes outstanding Treasury securities (not the larger Federal liabilities number), outstanding Agency Securities (MBS & debt), corporate bonds and municipal debt securities.

My calculation of TMDS began the 1990’s at $6.28 TN, or an already elevated 114% of GDP. Led by explosive growth in GSE and corporate borrowings, TMDS ended the nineties at $13.59 TN, for almost 120% growth. Over this period, GSE securities increased $2.65 TN, or 209%, to 3.916 TN. Corporate bonds jumped 185% to $4.564 TN. It is worth noting that total Business borrowings expanded 9.2% in 1997, 11.5% in 1998 and 10.4% in 1999, excess that set the stage for the inevitable bursting of the “tech” Bubble.

The Fed’s aggressive post-tech Bubble reflation ensured already dangerous excess was inflated to incredible new extremes. On the back of a doubling of mortgage borrowings, TMDS expanded 102% in the period 2000 through 2007 to $27.50 TN. Over the mortgage finance Bubble period, Agency Securities jumped 89% to $7.40 TN. Corporate bonds surged 154% to $11.577 TN. Municipal bonds rose 135% to $3.425 TN.

This unprecedented Credit expansion fueled various inflationary manifestations, including surging asset prices, spending, corporate profits, investment, GDP and trade/Current Account Deficits. After beginning the nineties at $6.227 TN, the value of the U.S. equities market surged 409% to end the decade at $19.401 TN. As a percentage of GDP, the nineties saw TMDS jump from 114% to 147%. Spurred by crazy technology stock speculation, Total Securities – TMDS plus Equities – jumped from 183% of GDP to end 1999 at 356%. Although Total Securities to GDP retreated to 284% by 2002, mortgage finance Bubble excesses quickly reflated the Bubble. Total Securities ended 2007 at a then record 378% of GDP.

A “funny” thing happened during the post-mortgage Bubble’s so-called “deleveraging” period. Since the end of 2008, total TMDS has jumped $8.348 TN, or 29%, to a record $37.542 TN. As a percentage of GDP, TMDS ended Q1 2014 at a record 220%. Even more importantly from a Bubble analysis perspective, in 21 quarters Total Securities (debt & equities) inflated $27.2 TN, or 61%, to end March 2014 at a record $72.039 TN. To put this in context, Total Securities began 1990 at $10.0 TN, ended 1999 at $33.0 TN and closed 2007 at a then record $53.01 TN. Amazingly, Total Securities as a percent of GDP ended Q1 at 421%. For comparison, Total Securities to GDP began the nineties at 183%, ended Bubbly 1999 at 356% before peaking at 378% in a more Bubbly 2007. No Bubble today? “Valuations in historical range”?

Let’s return to “A Bubble is predicated on leverage.” Yes, Total Household Liabilities declined $715bn from the 2008 high-water mark (much of this from defaults). Yet over this period federal liabilities increased almost $10.0 TN. Corporate borrowings were up more than $2.3 TN. On a system-wide basis, our system is inarguably more leveraged today than ever.

Many contend there is significantly less speculative leverage these days compared to the heyday (“still dancing”) 2007 period. I’m not convinced. Perhaps there’s less leverage concentrated in high-yielding asset- and mortgage-backed securities. However, from today’s vantage point, there appears to be unprecedented “carry trade” leverage on a globalized basis. I’ve conjectured that the “yen carry trade” – using the proceeds from selling (or borrowing in) a devaluing yen to speculate in higher-yielding securities elsewhere – could be one of history’s biggest leveraged bets. Various comments also suggest that there is enormous leverage employed in myriad Treasury/Agency yield curve trades. I suspect as well that the amount of embedded leverage in various securities and derivative trades in higher-yielding corporate debt is likely unprecedented.

When it comes to leverage, the Federal Reserve’s balance sheet is conspicuous. Fed Assets will end the year near $4.5TN, with Federal Reserve Credit having expanded about $3.6 TN, or 400%, in six years. Few, however, appreciate the ramifications from this historic monetary inflation from the guardian of the world’s reserve currency. I find it astonishing that conventional thinking dismisses the market impact from this unprecedented inflation of central bank Credit.

Over the years, I have argued that “money” is integral to major Bubbles. A Bubble financed by junk debt won’t inflate too far before the holders of this debt begin to question the rationale for holding rapidly expanding debt of suspect quality. In contrast, a Bubble fueled by “money” – a perceived safe and liquid store of nominal value – can inflate for years. The insatiable demand enjoyed by issuers of “money” allows protracted excesses and maladjustment to impart deep structural impairment (financial and economic).

I’m convinced history will look back and view 2012 as a seminal year in global finance. Draghi’s “do whatever it takes,” the Fed’s open-ended QE, and the Bank of Japan’s Hail Mary quantitative easing will be seen as a fiasco in concerted global monetary management. The Fed’s QE3 will be viewed as an absolute debacle. After all, QE3 incited an unwieldy “Terminal Phase” of speculative Bubble excesses throughout U.S. equities and corporate debt securities, along with global securities markets more generally. It unleashed major distortions throughout all markets, including sovereign debt.

A quick one-word refresher on “Terminal Phases:” Precarious. Their inherent danger arises from egregious late-cycle speculative excess and attendant maladjustment coupled with timid policymakers. Over recent years I have repeatedly invoked “Terminal Phase” in my analyses of a progressively riskier Chinese Bubble backdrop impervious to hesitant policy “tinkering.”

Here at home, we’re beginning to hear the apt phrase “The Fed is behind the curve.” Traditionally, falling “behind the curve” indicated that the central bank had been too slow to tighten policy in the face of mounting inflationary pressures. “Behind the curve” dictated that more aggressive tightening measures were required to rein in excesses. These days, “behind the curve” is applicable to an inflationary Bubble that has taken deep root in stock and bond markets. With the Yellen Fed seen essentially promising to avoid even a little baby-step 25 bps rate bump for another year, highly speculative Bubble markets can blithely disregard poor economic performance, a rapidly deteriorating geopolitical backdrop and the approaching end to QE. Worse yet, market participants are emboldened that “behind the curve” and the resulting dangerous market Bubbles preclude the Fed from anything but the most timid policy responses. A dangerous market view holds that, after instigating inflating securities markets as a direct monetary policy tool to stimulate the economy, the Fed would not in any way tolerate a problematic market downturn.

Ref. June 26 – Bloomberg (Steve Matthews and Jeff Kearns): “Federal Reserve Bank of St. Louis President James Bullard predicted the central bank will raise interest rates starting in the first quarter of 2015, sooner than most of his colleagues think, as unemployment falls and inflation quickens. Asked about his forecast for the timing of the first interest-rate increase since 2006, he said: ‘I’ve left mine at the end of the first quarter of next year.’ ‘The Fed is closer to its goal than many people appreciate,’ Bullard said… ‘We’re really pretty close to normal…’ If his forecasts bear out, ‘you’re basically going to be right at target on both dimensions possibly later this year… That’s shocking, and I don’t think markets, and I’m not sure policy makers, have really digested that that’s where we are.’”

The same day Bullard was talking hawk-like, Federal Reserve Bank of Richmond President Jeffrey Lacker was also making comments that should have the markets on edge. Countering uber-dove Yellen, Lacker stated that the recent jump in inflation was not entirely “noise.” Interestingly, he suggested that the Fed follow closely the FOMC’s 2011 exit strategy. “It’s not obvious to me a larger balance sheet should change any of our exit principles. I still think we should, as our exit principles say, be exiting from mortgage backed securities as soon as we can…” And following the lead of Kansas City Fed head Esther George, Lacker believes the Fed should allow its balance sheet to begin shrinking by ending the reinvestment of interest and maturity proceeds. Bullard also said the Fed should consider ending reinvestment.

Market ambivalence notwithstanding, I’m sticking with my analysis that the Fed can’t inflate its balance sheet from $900bn to $4.5 TN – and then end this massive monetary inflation without consequences. Things get even more interesting when talk returns to the Fed’s 2011 “exit strategy” road map. Regrettably, instead of exiting the Fed doubled-down – literally. And Dr. Bernanke may now say (while earning $250k) that the Fed’s balance sheet doesn’t have to shrink even “a dime.” Yellen and Dudley likely agree. But there’s now a more hawkish contingent that has other things in mind, and I don’t believe they will be willing to simply fall in line behind Yellen as officials did behind Greenspan and Bernanke.

Actually, I believe the so-called “hawks” (i.e. responsible central bankers) are gearing up to try to accomplish something that might these days appear radical: normalize monetary policy. Read “Systematic Monetary Policy and Communication” presented this week by Charles Plosser. Read Esther George’s “The Path to Normalization.” Re-read Richard Fisher. While you’re at it, read John Taylor’s op-ed from Friday’s WSJ: “The Fed Needs to Return to Monetary Rules.” I’m with Taylor (and Plosser!) on having and following rules. I’m also with Bullard: “I don’t think markets… have really digested… where we’re at.”

About the Author:  Doug Noland has been the Senior Portfolio Manager of the Federated Prudent Bear Fund and Federated Prudent Global Income Fund since December 2008. Prior to joining Federated, Mr. Noland was employed with David Tice & Assoc., Inc. where he served as an Assistant Portfolio Manager and strategist of Prudent Bear Funds, Inc. Prudent Bear Fund and Prudent Global Income Fund from January 1999. From 1990 through 1998, Mr. Noland worked as a trader, portfolio manager and analyst for short-biased hedge funds including G. W. Ringoen & Associates from January 1990 to September 1996, Fleckenstein Capital from September 1996 to March 1997 and East Shore Partners, Inc. from October 1997 to December 1998. He earned a B.S. in Accounting and Finance from the University of Oregon and a M.B.A. from Indiana University. This post originally appeared on the economics website “The Prudent Bear” and is published here with permission.

California’s Green Bantustans

One of the core barriers to economic prosperity in California is the price of housing. But it doesn’t have to be this way. Policies designed to stifle the ability to develop land are based on flawed premises. These policies prevail because they are backed by environmentalists, and, most importantly, because they have played into the agenda of crony capitalists, Wall Street financiers, and public sector unions. But while the elites have benefit, ordinary working families have been condemned to pay extreme prices in mortgages, property taxes, or rents, to live in confined, unhealthy, ultra high-density neighborhoods. It is reminiscent of apartheid South Africa, but instead of racial superiority as the supposed moral justification, environmentalism is the religion of the day. The result is identical.

Earlier this month an economist writing for the American Enterprise Institute, Mark J. Perry, published a chart proving that over the past four years, more new homes were built in one city, Houston Texas, than in the entire state of California. We republished Perry’s article earlier this week, “California vs. Texas in one chart.” The population of greater Houston is 6.3 million people. The population of California is 38.4 million people. California, with six times as many people as Houston, built fewer homes.

And when there’s a shortage, prices rise. The median home price in Houston is $184,000. The median price of a home in Los Angeles is $530,000, nearly three times as much as a home in Houston. The median price of a home in San Francisco is $843,000, nearly five times as much as home in Houston. What is the reason for this? There may be a shortage of homes, but there is no shortage of land in California, a state of 163,000 square miles containing vast expanses of open space. What happened?

You can argue that San Francisco and Los Angeles are hemmed in by ocean and mountains, respectively, but that really doesn’t answer the question. In most cases, these cities can expand along endless freeway corridors to the north, south, and east, if not west, and new urban centers can arise along these corridors to attract jobs. But they don’t, and the reason for this are the so-called “smart growth” policies. In an interesting report entitled “America’s Emerging Housing Crisis,” Joel Kotkin calls this policy “urban containment.” And along with urban containment, comes downsizing. From another critic of smart growth/urban containment, economist Thomas Sowell, here’s a description of what downsizing means in the San Francisco Bay Area suburb Palo Alto:

“The house is for sale at $1,498,000. It is a 1,010 square foot bungalow with two bedrooms, one bath and a garage. Although the announcement does not mention it, this bungalow is located near a commuter railroad line, with trains passing regularly throughout the day. The second house has 1,200 square feet and was listed for $1.3 million. Intense competition for the house drove the sale price to $1.7 million. The third, with 1,292 square feet (120 square meters) and built in 1895 is on the market for $2.3 million.”

And as Sowell points out, there are vast rolling foothills immediately west of Palo Alto that are completely empty – the beneficiaries of urban containment.

The reason for all of this ostensibly is to preserve open space. This is a worthy goal when kept in perspective. But in California, NO open space is considered immediately acceptable for development. There are hundreds of square miles of rolling foothills on the east slopes of the Mt. Hamilton range that are virtually empty. With reasonable freeway improvements, residents there could commute to points throughout the Silicon Valley in 30-60 minutes. But entrepreneurs have spent millions of dollars and decades of efforts to develop this land, and there is always a reason their projects are held up.

The misanthropic cruelty of these polices can be illustrated by the following two photographs. The first one is from Soweto, a notorious shantytown that was once one of the most chilling warehouses for human beings in the world, during the era of apartheid in South Africa. The second one is from a suburb in North Sacramento. The scale is identical. Needless to say, the quality of the homes in Sacramento is better, but isn’t it telling that the environmentally enlightened planners in this California city didn’t think a homeowner needed any more dirt to call their own than the Afrikaners deigned to allocate to the oppressed blacks of South Africa?

The Racist Bantustan


Soweto, South Africa  –  40′ x 80′ lots, single family dwellings

When you view these two studies in urban containment, consider what a person who wants to install a toilet, or add a window, or remodel their kitchen may have to go through, today in South Africa, vs. today in Sacramento. Rest assured the ability to improve one’s circumstances in Soweto would be a lot easier than in Sacramento. In Sacramento, just acquiring the permits would probably cost more time and money than doing the entire job in Soweto. And the price of these lovely, environmentally correct, smart-growth havens in Sacramento? According to Zillow, they are currently selling for right around $250,000, more than five times the median household income in that city.

The Environmentalist Bantustan


Sacramento, California  –  40′ x 80′ lots, single family dwellings

When you increase supply you lower prices, and homes are no exception. The idea that there isn’t enough land in California to develop abundant and competitively priced housing is preposterous. According to the American Farmland Trust, of California’s 163,000 square miles, there are 25,000 square miles of grazing land and 42,000 square miles of agricultural land; of that, 14,000 square miles are prime agricultural land. Think about this. You could put 10 million new residents into homes, four per household, on half-acre lots, and you would only consume 1,953 square miles. If you built those homes on the best prime agricultural land California’s got, you would only use up 14% of it. If you scattered those homes among all of California’s farmland and grazing land – which is far more likely – you would only use up 3% of it. Three percent loss of agricultural land, to allow ten million people to live on half-acre lots!

And what of these lots in North Sacramento? What of these homes that cost a quarter-million each, five times the median household income? They sit thirteen per acre. Not even enough room in the yard for a trampoline.

There is a reason to belabor these points, this simple algebra. Because the notion that we have to engage in urban containment is a cruel, entirely unfounded, self-serving lie. You may examine this question of development in any context you wish, and the lie remains intact. If there is an energy shortage, then develop California’s shale reserves. If fracking shale is unacceptable, then drill for natural gas in the Santa Barbara channel. If all fossil fuel is unacceptable, then build nuclear power stations in the geologically stable areas in California’s interior. If there is a water shortage, than build high dams. If high dams are forbidden, then develop aquifer storage to collect runoff. Or desalinate seawater off the Southern California coast. Or recycle sewage. Or let rice farmers sell their allotments. There are answers to every question.

Environmentalists generate an avalanche of studies, however, that in effect demonize all development, everywhere. The values of environmentalism are important, but if it weren’t for the trillions to be made by trial lawyers, academic careerists, government bureaucrats and their union patrons, crony green capitalist oligarchs, and government pension fund managers and their partners in the hedge funds whose portfolio asset appreciation depends on artificially elevated prices, environmentalism would be reined in. If it weren’t for opportunists following this trillion dollar opportunity, environmentalist values would be kept in their proper perspective.

The Californians who are hurt by urban containment are not the wealthy elites who find it comforting to believe and lucrative to propagate the enabling big lie. The victims are the underprivileged, the immigrants, the minority communities, retirees who collect Social Security, low wage earners and the disappearing middle class. Anyone who aspires to improve their circumstances can move to Houston and buy a home with relative ease, but in California, they have to struggle for shelter, endlessly, needlessly – contained and allegedly environmentally correct.

*   *   *

Ed Ring is the executive director of the California Policy Center

Drone Transport Ships, Automation, and the Bubble Economy

Editor’s Note:  This article by Mike Shedlock leads off with a report on “drone transport ships,” but moves on to explore a provocative and very pertinent question:  Are policies that create the “bubble economy,” i.e., artificially inflated asset values, partly motivated by a desire to counter the deflationary pressures caused by automation? We have explored this issue most recently in “Pension Funds and the Asset Economy,” and also in a post from 2013 entitled “Exponential Technology and the Role of Unions.” Shedlock may not have all the answers here – who does – but he is asking a question that must challenge anyone serious about promoting effective policies to stimulate sustainable economic growth. And Shedlock’s basic point – intervention to counter “good deflation” is futile, if not counterproductive – is consistent with the lessons of history. Every innovation ever conceived of was deflationary; only by deflating the value of existing services can you free up capital to invest in the next wave of innovation.

Here is the question of the day: Are drone, workerless ocean freight transport ships coming?

If shippers can pull it off, the cost saving would be immense. But what about the job losses? Insurance? Inflation?

Let’s explore the questions with a look at the Bloomberg article Rolls-Royce Drone Ships Challenge $375 Billion Industry.

“In an age of aerial drones and driver-less cars, Rolls-Royce (RR/) Holdings Plc is designing unmanned cargo ships.

Rolls-Royce’s Blue Ocean development team has set up a virtual-reality prototype at its office in Alesund, Norway, that simulates 360-degree views from a vessel’s bridge. Eventually, the London-based manufacturer of engines and turbines says, captains on dry land will use similar control centers to command hundreds of crewless ships.

Drone ships would be safer, cheaper and less polluting for the $375 billion shipping industry that carries 90 percent of world trade, Rolls-Royce says.

The European Union is funding a 3.5 million-euro ($4.8 million) study called the Maritime Unmanned Navigation through Intelligence in Networks project. The researchers are preparing the prototype for simulated sea trials to assess the costs and benefits, which will finish next year, said Hans-Christoph Burmeister at the Fraunhofer Center for Maritime Logistics and Services CML in Hamburg.

Even so, maritime companies, insurers, engineers, labor unions and regulators doubt unmanned ships could be safe and cost-effective any time soon.

Crew costs of $3,299 a day account for about 44 percent of total operating expenses for a large container ship, according to Moore Stephens LLP, an industry accountant and consultant.

The potential savings don’t justify the investments that would be needed to make unmanned ships safe, said Tor Svensen, chief executive officer of maritime for DNV GL, the largest company certifying vessels for safety standards.

While each company can develop its own standards, the 12-member International Association of Classification Societies in London hasn’t developed unified guidelines for unmanned ships, Secretary Derek Hodgson said.

“Can you imagine what it would be like with an unmanned vessel with cargo on board trading on the open seas? You get in enough trouble with crew on board,” Hodgson said by phone Jan. 7. ‘There are an enormous number of hoops for it to go through before it even got onto the drawing board.'”

100% Guaranteed to Happen

Anyone who does not think drone, workerless ships will happen, cannot think clearly.

Skeptics did not think the auto would replace horses or trains. Skeptics thought flight was impossible. Even simple constructs we now take for granted such as coffee on airplanes was once considered ridiculous.

So yes, driverless cars and workerless ocean ships are 100% guaranteed. The only question is “what timeframe?”

I do not have an answer to that question, but let’s not bury our heads in the sand over what is inevitable.

Furthermore, it’s likely workerless ships arrive before driverless trucks hit mainstream.

After all, the ocean is a vast place and there are no road or other constraints except in docking. If landing is a major concern, how difficult would it be to helicopter in crews specifically for the final landing?

What About Jobs?

Let’s get a grip on the problem of jobs. Yes, many will vanish. But others will appear. I cannot name one technological advancement in history that did not ultimately create more jobs than it destroyed.


  • Lightbulbs replaced candles
  • Cars replaced horses
  • Trains replaced the Pony Express
  • Personal computers
  • Internet replacing libraries

Can someone tell me why it’s supposed to be different this time?

What About Inflation?

Therein lay the problem. Driverless cars, the internet, and other price-deflationary advances have outstripped central banks ability to inflate prices and wages.

Try as they might, central banks have only managed to foster asset bubbles (they don’t even see) not the 2% price inflation they want.

Yet they keep trying. Prices went up but not as much as central banks want. Wages rose less than prices, especially for those on the bottom end. Home prices soared so Congress initiated countless affordable home programs. Then home prices crashed and Congress and the Fed acted to prop up home prices.

No one really wanted affordable homes, they just wanted ill-advised affordable home programs. Now people scream about income inequality and for higher minimum wages.

This all stems from one bad idea – central banks fostering inflation.

One Bad Idea Leads to Another, and Another

In the effort to produce 2% inflation, One Bad Idea Leads to Another, and Another

That construct is corollary number six of the greater “Law of Bad Ideas“.

Can the Fed Prevent Boom-Bust Cycles? 

Heck no, the Fed causes them! For details, see Bubblicious Questions: What Causes Economic Bubbles? When Do Bubbles Burst? Can the Fed Prevent Bubbles?

Also consider Deflation Theory Reality Check.

Losing Battle

Such are the challenges the Fed faces, and they are losing the battle because the advancement of technology is inherently price-deflationary. Technollogy has overtaken the Fed’s (central bankers in general) ability to inflate consumer prices.

Here’s the irony: Ridiculous efforts to prevent price-deflation cause asset bubbles that inevitably collapse, which in turn bring the very conditions central banks wish to prevent.

About the Author:  Mike Shedlock is the editor of the top-rated global economics blog Mish’s Global Economic Trend Analysis, offering insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education.