Six years after the height of the financial crisis, we may be living in one of the most prolific financial bubbles in recent history. Under Dr. Bernanke’s guidance the US Federal Reserve system expanded its balance sheet to about 4.3 trillion dollars, with asset purchases creating a disproportionate wealth effect in equities and debt-based financial instruments.
Despite this massive injection of liquidity, by and large the US economy has not significantly recovered. Yet the US stock market (with the exception of the NASDAQ) is at all time highs. This disconnection in equity prices vs. measurable economic recovery is the primary reason that I believe a bubble exists. In addition, the artificially low interest rate environment (see: ZIRP and QE) has also created an enormous bond market bubble as reflected in US treasury bond yields.
The US workforce is languishing
A quick glance at the US Department of Labor’s recent U3 unemployment data would have us believe that almost as many Americans are employed as had been before the Great Recession. Unfortunately the Department of Labor’s U3 unemployment rate is based on the amount of Americans currently on unemployment benefits — not the number of Americans out of work.
The US Labor Participation Rate is at its lowest levels since 1978, indicating that US job creation is not sufficient to support widespread employment. In addition, the quality of new jobs being created is equally deficient, with lower pay being a prevailing theme. One of the Federal Reserve’s mandates is maximum employment. A mandate they seem to be failing to uphold when utilizing more objective measures of employment.
Raw materials are rolling over
While equity markets re-test all time highs, commodities are sinking fast. Traditionally weakness in industrial commodities and energy prices signal global economic weakness. Since July we have seen that weakness accelerate as the sell-off in commodities prices took the CCI (a broad measure of commodities prices) to multi-year lows. This is a powerful sentiment indicator.
Optimism about global growth would be expressed in higher commodities prices — as more orders for raw materials would increase demand. Another mandate of the Federal Reserve is stable prices. A cursory glance at the above chart shows we certainly don’t have stable prices.
Stronger dollar, weaker world?
Part of the recent decline in commodities prices has been attributed to recent strength in the US dollar index, which is in its most basic form, a measure of the dollar’s spot value vs. the Euro, Yen and GBP. There are other currencies in the basket, but none are quite as influential. In essence, the US dollar currently signals that it is more favored than the Euro, Yen and GBP through its ascent towards 87.
As commodities are priced in dollars, it is expected that some weakness will occur if the US dollar strengthens, especially under the back drop of softening global demand. But one must also question the utility of the current US dollar index structure — and whether or not such an index is relevant in a world that seems to be increasingly moving away from the dollar as the primary trade currency.
Stocks surged on stimulus. Now what?
With the S&P 500 back above 2,000 and optimism among fund managers back to similarly lofty levels, it may be time to examine the US stock market with a degree of skepticism. There exists a very high probability that we are in a bond and equity bubble that was fomented by the US Federal Reserve system. And traditionally these bubbles deflate when policy makers begin to head for the exits.
With QE3 over, and no immediate sign of further stimulus in sight, as well as the Fed signaling that rates are going higher in 2015, perhaps we are closer to seeing this bull market mature. After all, it’s been largely driven by liquidity injections and those have since ended.
A direct connection: Fed assets and stock prices
The correlation here is uncanny. QE’s various incarnations have an incredibly potent effect on boosting US equity prices to all time highs. Just about every dollar the Federal Reserve has injected in to the US bond and mortgage market has found its way in to US equity markets directly or indirectly.
Now that QE3 has ended, what policies will be utilized next? Is the Japanese QE-to-infinity program going to be enough to generate a new carry trade that pops US equities higher? Or are we finally witnessing the tail end of one of the biggest financialized bubbles in US history? One that has brought bond yields to the lowest levels in decades whilst simultaneously inflating mortgage-backed securities (lowering interest rates) and equity prices.
Is this bond bubble ready to bust or is it signaling something worse?
Bond yields are an inverse indicator of the underlying asset price. That is to say, the lower the bond yield, the higher the paper price to buy that bond. This chart illustrates US Treasury bond bubble in no uncertain terms. With US government debt exceeding GDP, whilst simultaneously at all time low yields, there is something wrong with this picture.
Typically the higher the debt level, especially as it exceeds the GDP of a country, the worse its debt outlook becomes. The only exception we’ve seen to this rule has been Japan, which has ‘enjoyed’ a 25 year economic malaise that was culminated by their very own real estate bubble. The deflationary forces at work there have been keeping bond yields and economic activity pinned down for a quarter century.
Reading the tea leaves of macroeconomic data
Signs seem to be pointing to an intermediate term deflationary bias. It’s likely that this situation will be greeted by more quantitative easing from central banks of developed countries around the world. Signals include a rocketing dollar, collapsing commodities, the Bank of Japan already engaging in record QE and the weaker EU countries slipping back in to recession or worse. In addition, China’s miracle growth story seems to be concluding with a not so happy ending.
Velocity of money sinks to lowest level on record
Worse yet, with all of the Fed’s easing and stimulus, the velocity of US money has been collapsing. This is an indication of economic activity insofar as how fast money is changing hands. Generally during periods of strength the velocity of money will increase. What we’ve seen since about 2002 has been just the opposite. A marked decrease in the velocity of money across all measures to the lowest levels ever recorded.
Leverage and levitating stock prices
Margin debt on the NYSE (see above chart) is at record highs, and similar leverage is being employed across many equity and bond markets around the world. That means that the level of debt-based risk taking now exceeds what we saw during previous bull market peaks and as such a reversal in psychology would be even more dangerous to stock prices.
A replay of 2008’s volatile panic selling of various asset classes is quite possible. The level of complacency and leverage in financial markets is similar to where we were in the fall of 2007 before the financial system began to collapse.
Watch these trends carefully. Further deterioration of M2 stock velocity, commodity prices and increased dollar strength will signal the increased potential for a renewed deflationary global recession. If such a situation unwinds, and if equity prices are dragged down in sympathy, then I do believe the Federal Reserve will begin to reinvigorate its stimulus programs and we could see the pendulum swing back towards a more inflationary bias.
What remains a mystery is how the Fed will do so when it already possesses the biggest balance sheet in its history — and has largely failed across many metrics to remedy the economic problems that face the US. Alternatively, if Bernanke’s Bubble is allowed to burst, the consequences will be catastrophic, not the least of which for the Federal Reserve and its balance sheet.