Well, there’s the bounce. The Dow up 181 points yesterday. Gold off $3 an ounce.
The end will come – sooner or later – for the big bull market in US stocks… and for the debt bubble. But it didn’t come yesterday. Will it come today ortomorrow? We don’t know. All we know is you want to be prepared. (Unlike bonds, gold has no counterparty risk.)
Today, we explore the time that land forgot. That phrase doesn’t really make any sense, but we wanted to try it out anyway. We’re talking about the space on the calendar filled by “eventually” and “sooner or later” – that part of the future where things that can’t last forever finally stop.
Specifically, we wonder about when and how the biggest debt bubble in history finally blows up. Recall that Planet Debt added $30 trillion to its burdens in the last six years – a 40% increase. That can’t continue forever. But how does it end? Inflation… deflation… hyperinflation… hyperdeflation?
To make a long story short, a bubble can’t blow up without a lot of “flation” of some kind. And with a bubble so big, it’s bound to be a humdinger. Most likely, we will see “flation” in all its known forms. And maybe in forms we haven’t heard of yet.
People who could borrow at the Fed’s low rates, did so. Washington borrowed more heavily than ever before – just to cover operating expenses. Corporations borrowed, too – mainly to refinance existing debt at lower interest rates and to buy back shares (raising the price of remaining shares and, coincidentally of course, giving management bigger bonuses).
The most recent figures we have are from the third quarter of 2013. Those three short months saw $123 billion of buybacks of US shares – up 32% from the same period a year before. If that rate were to persist throughout 2014, it would mean nearly half a trillion dollars devoted to boosting corporate stock prices, coming from the same corporations that issued shares in the first place.
Is management stupid… or just greedy? The sage advice of “buy low, sell high” doesn’t seem to have sunk in. At the bottom of the crash in 2008-09, reports Grant’s Interest Rate Observer, hardly any US corporations availed of the opportunity to buy their own shares at a bargain price. Now, that prices are high again, almost all seem to want to buy.
Surely, that is something that must end too. It doesn’t take a lot of imagination to foresee what will happen when it stops: Stock prices will fall.
The “Poverty Effect”
First, credit expands, and asset prices rise. Then credit shrinks, and asset prices fall. Asset prices typically foreshadow consumer prices.
After so much inflation in credit, we’d expect to see a helluva deflation when the bubble bursts. All of a sudden the “wealth effect” would become the “poverty effect” – with consumers cutting back on expenses, investments and luxuries.
This would be normal, natural and healthy. A debt deflation doesn’t create bad debts or bad investments. It just forces people to own up to their mistakes.
Businesses go broke; they can no longer borrow nearly unlimited funds at nearly invisible yields. People can once again default… and have plenty of company in doing so. The $5 trillion in paper wealth that came into being – almost magically – as the stock market rose… suddenly disappears from whence it came.
There is no mystery about the credit cycle. Wealth created “on credit” goes away when the credit is cut off. Then you find out who’s made the most serious mistakes.
The open questions are: How big can this bubble get before it explodes? And how will central bank meddling affect the outcome?
The first question gets the obvious reply: Who knows? Central banks are still at it – led by the US and Japan. The corporate and government sectors are still willing borrowers. Corporations are still borrowing money at ultra-low interest rates and using it to buy back their shares. And asset prices, as near as we can tell, are still going up. It could go on for a while longer. No one knows how long.
Tomorrow, we take up the second question: When the end comes, what form will this new “flation” take?
This week in Washington Janet Yellen will chair her fist policy-setting Fed meeting.
It will be a milestone for Planet Debt. Expectations are that, under Yellen, the Fed will continue to scale back on the Fed’s bond buying program (QE) with another $10 billion-per-month cut.
By removing another $10 billion per month in demand from the US bond market, we can reasonably expect bond prices to fall and yields to rise. This will put upward pressure on borrowing costs throughout the economy (which are based off Treasury yields).
Much focus has been given to the effect this will have on US stocks… which have more or less tracked the expansion of the Fed’s balance sheet since the start of QE at the end of 2008.
But the real trouble could be in the bond market.
As Gillian Tett points out in the Financial Times, using figures from Morningstar:
US investors have put $700 billion of new money into the most mainstream taxable US bond funds since 2009. Since bond prices have risen, too, the value of these funds has doubled to $2 trillion. That is striking. But more notable is that these inflows to fixed income have outstripped the inflows to equity funds during the 1990s tech bubble – in both absolute and relative terms.
Meanwhile, Goldman Sachs estimates (using slightly different forms of calculation) that $1.2 trillion has flowed into global bond funds since 2009, compared with a mere $132 billion into equities. And a new paper from the Chicago Booth business school estimates that inflows to global fixed income funds have been almost $2 trillion since 2008, four times that of equity funds.
More money flowing into bond funds than flowed into equities during the 1990s tech bubble. Four times as much money flowing into bond funds than into equity funds since 2008. Meanwhile, junk bond issuance is at record levels and junk bond yields at historic lows.
These are all worrying signals of complacency at least, if not an outright bubble. Bonds are best avoided right now. We prefer to diversify outside of stocks using gold.