Q1 2024: “Bubbles Being Bubbles”
Markets were unsettled to begin Q2. With the economy and inflation proving more resilient than expected, 10-year Treasury yields surged 50 bps to an April 25th high of 4.7%. The global yield spike triggered a bout of de-risking/deleveraging, with EM currencies and bonds under notable pressure. The Nasdaq100 sank 7.0% in the six sessions ending April 19th, as the S&P500 dropped 4.5%. Global currencies turned unstable. And with trading turning disorderly, the yen sank to the weakest level versus the dollar back to 1990.
Right on cue, Chair Powell struck a less hawkish tone at his May 1st press conference. Downplaying inflation risk, he discussed potential paths to rate cuts – including softening labor markets. Stocks and bonds rallied sharply, with global “risk on” regaining momentum.
Fed assertions of restrictive policy notwithstanding, financial conditions loosened further. Corporate risk premiums, CDS prices, and other indicators moved back to near multi-year lows. Importantly, easy conditions stoked an historic AI arms race, mania, and bubble. At its June 20th peak, Nvidia enjoyed a y-t-d gain of 180% and market capitalization of $3.3 trillion. The Semiconductor Index was up 38% y-t-d, with an 80% eight-month advance. It was a classic speculative blow-off – the kind of crazy mania that would be a fitting finale to history’s greatest bubble.
“Bubbles Being Bubbles” – even for me, that’s a quirky title. The point I want to stress is that as extraordinary, incredible, and crazy as things have been – the backdrop is consistent with how powerfully mature bubbles will behave if left to their own devices. And as things unfold, there will be a lot of confusion. I expect most economists, Wall Street strategists, and policymakers to be confounded by developments. Confusion has been apparent over the past week. Our hope is to offer an analytical framework that helps make some sense of what will continue to be an extraordinary environment.
Lately, I find my thoughts returning to the mid-nineties. I was deep into macro analysis, and by the end of 1994 was convinced that finance had fundamentally and momentously changed. It was out with traditional banking and in with market-based finance – the repo market, asset and mortgage-backed securities, hedge funds, money-market funds, Wall Street structured finance, and the government-sponsored enterprises. I watched in awe as Fannie and Freddie operated as quasi-central banks as they bailed out the hedge funds during the 1994 bond market dislocation. This had followed the Greenspan Fed’s early-nineties rate collapse and yield curve manipulation that surreptitiously bailed out the banking system following the bursting of the eighties “decade of greed” bubble.
I became convinced that the inflating bubble was the most monumental since the “Roaring Twenties.” I began diligently researching that period, seeking better understanding of the nature of bubbles, inflationary dynamics, and speculation. And the deeper I dug, the more complex and fascinating it all became. I often found myself thinking, how could everyone have come to believe all the hype and nonsense? How could they have put blinders on and ignored so much? And how on earth could things have turned so crazy, especially during the climactic 1927 to ‘29 manic speculative blowoff? Those questions no longer puzzle me – not after witnessing markets over the years – and especially over recent months.
Back in the year 2000, I titled a presentation “How could Irving Fisher have been so wrong?” He was, after all, the preeminent economist of that era that went on to write authoritative work on debt deflations and the Great Depression. His keen interest is understandable. Fisher made his infamous - “stock prices have reached what looks like a permanently high plateau” – just days before his fortune was wiped out in the 1929 stock market crash.
Virtually all were completely blindsided. There were some skeptics and a group of naysayers that recognized the peril of bubble excess, but by 1929 they had largely turned silent. To the naked eye, that period’s incredible prosperity appeared sound and sustainable.
Importantly – and most pertinent to today’s backdrop - things must appear extraordinary for bubbles to inflate to ever greater excess year after year – the type of long-term bubble inflation that ensures deep structural maladjustment.
Things look extraordinary today – accelerating technological advancement – AI, quantum computing, robotics, biotechnology, advanced telecommunications, and the like.
The “Roaring Twenties” period is analogous with respect to monumental technological advancement - the widespread availability of electricity, the growing use of production line manufacturing, affordable automobiles for the masses, radio broadcasting, widespread use of the telephone, expansion of aviation, the liquid-fueled rocket - to name just a few, along with wonderful breakthroughs in science and medicine.
There are loads of research, studies and theorizing over what went so horribly wrong to cause the Great Depression. Adherents to more of an Austrian Economics perspective believe credit excess and breakdowns in market function led to epic resource misallocation. There are insightful contemporaneous accounts and analyses that collect dust on library bookshelves. I’m intrigued by a debate of whether the key issue was over-investment or mal-investment – though it seems years of easy money and market euphoria ensured plenty of both.
I remember reading analysis that particularly resonated. It discussed how technological advancement tends to evolve in clusters – key breakthroughs inspire scientists, inventors, creators, entrepreneurs, and financiers alike. For example, electrification spawned exciting new inventions including refrigerators, washing machines, irons, toasters, electric razors, vacuums, and such – along with massive infrastructure investment. The mass-produced affordable Model T spurred advancements in road and highway construction, traffic signals, gas stations, leisure activities, and tourist destinations. Radio broadcasting promoted the development of home radio units, phonographs, the jukebox, instant cameras, silent movies, and cinemas.
Waves of exciting new technologies changed the way people lived – and how they thought about the future. A deep sense of optimism took hold, with borrowers more willing to take on debt to purchase homes, cars, and myriad new products. With the future so bright, businesses and entrepreneurs borrowed lavishly for investment across the economy. And, of course, booming markets enticed an historic expansion of speculative credit - including margin debt, broker call loans, and the highly levered investment trust sector.
Ben Bernanke is considered the foremost contemporary expert on the Great Depression. He comes from the revisionist Milton Friedman school of thinking that views the 1920s as the “golden age of Capitalism” tragically brought to an end by inept Federal Reserve policymaking. Bernanke argues that the Fed grossly erred by tightening policy into 1929, in the face of weak commodities prices and mounting signs of economic vulnerability. Bernanke is fond of deriding what he refers to as the “bubble poppers” fixated on the speculative market and Wall Street excess. Moreover, Bernanke professes the view that the Fed’s gravest error was its failure to print sufficient money to recapitalize the post-crash impaired banking sector, a policy blunder he holds directly responsible for the Great Depression.
I’ve long been fascinated by this analytical debate – and have argued against inflationism for years now. History teaches us that monetary inflation is such a slippery slope: once commenced it becomes difficult if not impossible to rein in. The Fed doubled its balance sheet to $2 TN in 2008, doubled it again between 2011 and 2014, and then double it once more to about $9 TN during the pandemic inflation. I fully expect the next serious crisis will compel the Fed to begin doubling its holdings yet again. After all, each QE fueled inflation ensures a much larger and perilous bubble.
Bubbles being bubbles, there are alarming parallels between current bubbles and those from the “Roaring Twenties.” Today’s global government finance bubble inflation emerged out of the crisis response to the bursting mortgage finance bubble. Late-twenties bubbles were the culmination of a great inflation spawned by the first world war. Just as Bernanke argues that policy was perilously tight in 1929, many on Wall Street today contend that excessive Fed tightening risks a hard landing for markets and the economy.
But it’s no coincidence that a 5% policy rate both in 1929 and over the past year neither tightened financial conditions nor restrained asset inflation and speculative bubbles. Bubbles being bubbles. Over time, bubbles attain greater power and become increasingly immune to policy tightening measures.
The bubbles of 1929 and today are both phenomenally long-duration, late-stage – and extraordinarily powerful. During protracted boom cycles, the aggressive risk-takers rise to the top – whether it be corporate executives, technology innovators and CEOs, entrepreneurs, bankers, financiers, or speculators. The more cautious and risk-focused get pushed to the side. Businesses large and small that take every ebb in economic activity to aggressively expand for the future are handsomely rewarded. Investors and speculators that take greater risk and buy every market dip enjoy the strongest returns and accumulate the most assets.
By 1929, it was believed that the creation of the Federal Reserve some 15 years earlier had fundamentally reduced the risk of financial and economic crises. The easing of monetary policy in 1927 – the infamous “coup de whisky” – solidified confidence that the Federal Reserve was fully equipped to safeguard prosperity.
The Fed’s $5 TN pandemic stimulus – and also the March ‘23 banking crisis response – crystalized the view that took hold after years of Fed interventions, bailouts and reflations: Market players and the business community operate today with full confidence that the Fed will do whatever it takes to ensure ongoing robust financial markets and an expanding economy.
Things get crazy near the end of protracted cycles. The interplay of powerful bubbles – in credit, in assets markets, and in the economy – takes on a precarious life of its own. Excess begets excess. Late-cycle credit bubbles thrive on years of strong self-reinforcing credit growth. Boomtime lending profitability incentivizes financial innovation, with a proliferation of new age lenders and financial products. And with Fed QE ready to backstop the Treasury market, Washington takes full advantage of its blank checkbook.
In business, the most successful have over the cycle accumulated huge war chests of financial resources - to be aggressively deployed to secure market power. And nowhere is this more apparent than within the powerful tech oligarchy.
I think of the clusters of innovation phenomenon and the hundreds of billions of cash resources accumulated over this long cycle by the dominant technology companies. The PC, internet, advanced telecommunications, the smart phone, enterprise software, the cloud and such – and now artificial intelligence.
The purview of AI is just so far-reaching – and the big technology companies today have their massive war chests to engage in a truly historic late-cycle investment arms race. Meanwhile, the long boom cemented loose credit conditions – from aggressive bankers and non-bank lenders to over-liquefied corporate credit markets – all eager to fund massive spending on data centers, hardware, semiconductor manufacturing, energy infrastructure, and the like. Meanwhile, a manic equities market bids up prices for anything related to AI – similar to how stocks in anyway tied to radio broadcasting skyrocketed during 1929’s blowoff. In short, the powerful forces of late-cycle bubble excess have coalesced in historic fashion.
But there’s a reality that should not be ignored: by their nature, manias and speculative melt-ups are relatively short-lived. Meanwhile, credit bubble excess sows the seeds of its own destruction. There are credit cycle realities: risky lending fosters over indebtedness and, eventually, impaired lenders. Bubbles being bubbles, late-cycle optimism and manic excess - coincide with deepening underlying financial fragility and economic vulnerability.
When I initially warned in 2009 of the risk of an unfolding global government finance bubble, I never could have imagined the degree of excess – or its breadth and duration. And just as big tech built their arms race war chests, China and EM countries over the cycle accumulated huge international reserve positions. These reserves, China, in particular, with its massive $3.2 TN, have been instrumental in extending the cycle.
The Chinese credit boom inflated a historic apartment bubble, yet its bursting has yet to ignite the usual financial crisis and run on its currency. This is specifically because the Chinese currency, as vulnerable as it has become, is underpinned by confidence that Beijing will deploy reserves to support the renminbi as necessary. And with its currency well defended, Beijing maintains the rare capacity to direct its banking system to lend aggressively – last year to the tune of a record $5 TN of asset growth. And with this huge ongoing state-directed credit expansion, China will likely meet its 5% GDP mandate.
It’s tempting to believe that Xi’s Jinping’s China has subverted credit and business cycles. In reality, the Chinese have only extended cycles and accommodated history’s greatest credit bubble – and with it unprecedented over-investment, malinvestment, and financial vulnerability. Despite ongoing massive credit growth and government stimulus, Beijing today is pushing on the proverbial string.
Meanwhile, Japan embarked on its own perilous government finance bubble subversion of market forces and promotion of late-cycle excess – years of massive monetization, zero rates, and even the pegging of government bond yields. Most importantly, the interplay of ultra-loose Bank of Japan policies and global leveraged speculation certainly extended late-cycle financial excess. I suspect that the yen “carry trade” – borrowing cheap in Japan and using proceeds to lever in higher yielding securities globally – inflated into one of history’s great speculations. Now, the Bank of Japan timidly raises rates to 25 bps and global markets start to unravel. A strong case can be made that government finance Bubble excess – across the entire globe – has reached a critical phase.
This is a good segue to recent market developments. I believe the odds are reasonably high that markets have reached a critical juncture. Bubbles being bubbles, end-of-cycle craziness typically has markets succumbing to manic speculative blow-offs. We’ve witnessed this dynamic. History provides us a critically important warning: these upside dislocations set the stage for acute instability – volatility, destabilizing reversals, downside dislocations, and even panic.
We’re now witnessing key speculative bubbles falter – most notably, yen “carry trades” and the AI/big tech mania. After trading to almost 162 on July 11th, the yen rallied 14% to 142 to the dollar at Monday’s high. Since the 11th, the Mexican peso sank as much as 19% versus the yen, the Brazilian real 16%, the Chilean and Colombian pesos 15%, and the Argentine peso 13%.
The global leveraged speculating community, which had aggressively shorted yen to take levered positions around the world, has suffered major losses and been forced to begin unwinding leverage. The global liquidity created in great abundance as these levered trades expanded has now begun to contract.
Liquidity is also being destroyed with the reversal of leverage throughout the crowded AI/big tech trade – the unwind of margin debt and enormous derivatives-related leverage. Speculating in call options on the major tech stocks and indices became a phenomenally popular strategy – and certainly helped fuel the manic melt-up, as derivative dealers aggressively purchased stocks to hedge in-the-money call options they’d written. Now, with the tech stocks and major indices having reversed course, those aggressive buyers abruptly shifted to frantic sellers. Moreover, market players are now rushing to hedge their exposures, with the buying and hedging of put options creating significant downside market pressure. The VIX Index’s Monday spike to 66 elicited the headline, “The VIX Just Did Something it Hasn’t Done Since 2008.”
When analyzing market liquidity and crisis dynamics, I lean heavily on the “periphery and core” analytical framework. Risk aversion typically emerges first at the “periphery” – the domain of the most indebted and vulnerable asset classes, regions, countries, sectors, and companies. Often, nascent instability at the “periphery” initially bolsters the perceived safer “core” – a dynamic that had benefitted the “core” U.S. credit market over recent weeks.
But trouble at the “periphery” unleashes contagion effects that, left unchecked, gravitate toward the “core.” The impact of deleveraging and waning liquidity mounts as “risk off” gathers momentum. Effects tends to be nonlinear, with crisis dynamics accelerating significantly as risk aversion strikes nearer the “core.”
Believing de-risking/deleveraging had made the consequential jump to “core” U.S. markets, I titled last Friday’s Credit Bubble Bulletin, “The Critical Leap.” I highlighted a Bloomberg article: [in quote] “Wall Street banks are calling for aggressive interest-rate cuts by the Federal Reserve... Economists at Bank of America..., Barclays, Citigroup, Goldman Sachs… and JPMorgan… revamped their forecasts for US monetary policy Friday after data showed the US unemployment rate rose again in July.”
Citigroup expected two 50 and one 25 bps cuts by year-end – with JPMorgan calling for the same 125 bps of cuts, but also beckoning for the Fed to take the unusual step of slashing rates prior to next month’s FOMC meeting. Calls for an emergency inter-meeting cut got louder following Monday’s turbulence. In early Monday trading, the market was pricing as much as 148 bps of Fed rate reduction by year end.
Let’s be clear: there’s nothing in the economic data that would justify aggressive 50 bps cuts – let alone an emergency move. But these banks are monitoring de-risking/deleveraging from high in their catbird seats – and they clearly see market developments that have them quite alarmed.
As I highlighted in Friday’s CBB in some detail, last week saw some of the most dramatic moves in various risk indicators since the March ‘23 banking crisis. A key short-term rate, the one-year overnight swaps rate sank 49 bps in three sessions - the largest drop since March ‘23. Same for two-year Treasury and MBS yields that dropped 50 bps.
I closely monitor various corporate yield spreads to Treasuries, along with credit default swap prices – or the cost to purchase insurance against bond defaults. A mosaic of risk premiums throughout the markets provides an invaluable tool for monitoring market risk perceptions – and more specifically - the progression of “risk off” from the “periphery” to the “core.”
I’ll briefly underscore quite important recent developments in corporate credit. High yield CDS last week posted the largest one-day (22bps) and weekly (38bps) gains since the banking crisis. At Monday’s close, high yield spreads to Treasuries had surged an extraordinary 67 bps in three sessions, as high yield CDS surged 74 bps and investment-grade CDS jumped 14 bps. This was the most dramatic spike in corporate risk premiums back to March 2023.
A few Tuesday headlines corroborated the tightening financial conditions thesis: “Risky Borrowers Discover Doors Are Closing in Bond, Loan Markets.” “US Corporate Bond Market Issuance Set to Slow Amid Market Volatility.” And “Leveraged-Loan Outflows Poised to Be Most Since 2023 Bank Crisis.”
Also indicative of “core” instability, bank and broker stocks have been under heavy selling pressure – at home and abroad. In just three sessions, the KBW Bank Index lost almost 10%, with the Broker/Dealers down 9%. European bank stocks sank 10%, while Japanese banks collapsed 26%.
The yen jumped almost 5% versus the dollar last week – and was up another 3% in early Monday trading. Gains were more extreme against key “carry trade” currencies. Meanwhile, the semiconductors over three sessions were clobbered almost 14%. It is a major development when two highly levered and momentous speculative bubbles are concurrently under signficant stress. Moreover, panic buying of Treasuries has been indicative of fear of more systemic de-risking/deleveraging.
There is evidence to suggest unprecedented speculative leverage has accumulated throughout the U.S. credit market – comprising the “core” in my “periphery and core” framework. There’s the so-called “basis trade” – where a few dominant hedge funds borrow in the repo market to take the most extreme levered positions in Treasuries - playing the tiny spread between Treasury bonds and futures. This trade is reported to be in the Trillion-dollar range. I suspect leverage has also ballooned in MBS and agency debt markets. And “carry trades” became a popular and lucrative speculation throughout corporate credit, where speculators can use the proceeds from shorting Treasuries to lever in higher yielding corporate bonds, leveraged loans, private credit, and structured products such as collateralized debt obligations. Speculative leverage even stormed the muni market. Panic buying of Treasuries widened yield spreads, placing pressure on myriad levered bets.
If I am correct that a major de-risking/deleveraging in U.S. credit is likely now unfolding, this tightening of financial conditions will hit egregiously speculative asset market bubbles and a grossly unbalanced and maladjusted economy.
It’s worth noting Gold’s $52 jump last week as financial assets were in the throes of instability. As we saw Monday, the precious metals can get caught up in deleveraging, with the levered players forced to liquidate some holdings as they scramble to de-risk. But I do see this year’s solid metals performance supporting the thesis that the Fed and global central banks will have no alternative than to aggressively expand their balance sheets to accommodate deleveraging and thwart collapse.
Bubbles being bubbles, I know as well as anyone that there’s a chicken-little element to the analysis. Bubbles have a proclivity for approaching the precipice, only to recoil and then proceed to gain additional strength. Once having attained momentum, Bubbles are very difficult to contain. So it’s incumbent upon central bankers to recognize and quell bubble dynamics early. But inflationist contemporary central bankers are in the business of inflating bubbles – not reining them in. Current bubbles have become so powerful that even a Fed policy rate above 5% imposed little restraint.
Most important and pertinent, bubbles do eventually burst – and the longer this inevitability is postponed the more destabilizing the consequences for markets, economies, societies, and the world order.
I believe this period will be debated for decades, if not longer. Conventional analysis will surely blame overzealous Fed tightening for needlessly harming what were robust markets and a sound economy – just as the revisionists have done with the 1929 crash and Great Depression.
But let there be no doubt: the excesses of the preceding boom are responsible for devastating busts – and, of course, the inflationist policies that nurtured, promoted, and sustained boomtime excess. I hope history will scrutinize the FOMC meeting from last December. Powell pivoted dovish, despite ongoing loose financial conditions, a highly speculative market environment, and virulent asset inflation. Between that fateful Fed meeting and July 10th peak highs, the semiconductors inflated 50%. Nvidia ballooned 180% to surpass $3 TN in market cap. The Nasdaq100 returned 27% and the S&P500 22%.
Moreover, the speculative mania ensured markets disregarded troubling economic, political, and geopolitical developments. The U.S. bubble economy has become increasingly plagued by wealth disparities, imbalances, deep maladjustment, and a fateful addiction to loose credit. Our country remains deeply divided heading into what will be a close, hotly contested and, likely, unsettling presidential election. And the geopolitical environment seemly could not be more fraught with risk – the Ukraine/Russia war, tensions in the Taiwan Strait and South China Sea, North Korea, and the Middle East that appears at the brink of exploding into a full-fledged regional war – or worse.
It was a wildly unstable first half of 2024. Believing the deflation of history’s greatest bubbles has likely commenced, there’s every reason to expect an historic second half.