Tag Archive for: bond bubble

Economic Headwinds Came Long Before Trump’s Presidency

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After the unexpected election of President Donald Trump, something else unexpected happened. The stock market soared.

In the final week before the 2016 election, the Dow Jones Industrial Average closed at 17,888, an unimpressive level, since it had reached that same point nearly two years earlier in December 2014. But following Trump’s victory, the Dow went wild. By the time he took office in January 2017, it had already jumped over 12 percent, to 20,094. By January 2018, it peaked at 26,616, then edged upwards to 26,828 on October 3, 2018. In less than two years, the Dow Jones Index grew by an astounding 50 percent.

Since then, however, the Dow, along with the other major U.S. indexes, have been tumbling. By Christmas Eve, the Dow was 19 percent off its high, down to 21,792. What had been called the “Trump Bump” is now being called the “Trump Slump.”

While President Trump has been criticized for taking credit for the stock market rise, Barack Obama also got into that action, claiming in October 2018 that “the booming started on his watch.” But today’s economy, and especially the stock market, are reacting to longer-term trends for which neither president deserves full credit or blame.

Depicted on the chart below is the performance of the Dow from 1995, when the markets began first showing signs of “irrational exuberance,” to the extremely exuberant present day. On clear display are the past two bubbles, the internet bubble of 2000, the housing bubble of 2007, and what we may call the “super bubble” or “everything bubble” of 2018.

It doesn’t take an economist to notice a pattern. The Dow, which tracks closely with all publicly traded equities in the United States, more than doubled in the four year heady runup to its January 2000 peak, then went into decline for nearly four years, before doubling again between 2004 and 2007. Then, when the housing bubble popped, the Dow went off a cliff, dropping to half its 2007 peak in a little over a year. In past 10 years, the Dow has exploded again, tripling to a high of 26,828 in October. What now? Visually, at least, another correction appears logical.

There are all kinds of economic reasons why what is visually indicated on the above graph should happen. At best, we may hope for stocks to correct but not crash, which is sort of what happened after the internet bubble popped. But what’s different this time?

One key difference this time around is that dramatically lowering interest rates is not an option. In January 2000, the Federal Funds Rate was 5.5 percent. By June 2003, it had dropped to 1 percent. When interest rates drop, stocks become relatively better investments than fixed-rate investments. Lower interest rates also induce more people to borrow, creating liquidity, stimulating consumer spending, which helps corporate earnings which drives up stock prices. The cause and effect is reflected in the stock market history—by 2003, after lowering interest rates by 4.5 percent, the stock market finally began to recover.

In October 2006, the rate had risen to 5.25 percent. In September 2007, as home sales were starting to drop, it was lowered to 4.75 percent. When the housing bubble popped, and the stock market crashed, the Federal Reserve responded by steadily lowering the Federal Funds Rate. By December 2016, it had dropped to 0.25 percent, the lowest rate possible.

What should be of concern, is that the rate today, 2.5 percent, is only half as high as it was during the past peaks. During the previous two bull markets, the Federal Reserve was able to bounce the rate up to around 5 percent before the bears came calling. This time, assuming we’ve hit the peak, only half that increase, to 2.5 percent, was achievable.

Debt Accumulation Is Not a Sustainable Way to Stimulate Economic Growth
A consequence of low interest rates is more borrowing, which can be a good thing if that borrowing stimulates economic growth that translates into investments in productivity. But today, borrowing has not been used to stimulate productive investments. Instead, much of the corporate borrowing over the past decade has been used to finance stock buy-backs. This is a dangerous strategy, causing short-term growth in earnings per share, but loading debt onto corporate balance sheets that will have to be refinanced at increasingly high interest rates, at the same time as investment in research and modernizing plants and equipment has been neglected.

In recent years, federal, state, and local governments have also over-borrowed. Federal borrowing accelerated in mid-2008, and hasn’t slowed since—climbing to more than $21 trillion by the third quarter of 2018. As interest rates rise, servicing this debt will become far more difficult. Meanwhile, all U.S. credit market debt—government, corporate, and consumer—has continued to increase. After dipping slightly to $54 trillion in the wake of the burst housing bubble, it was up to a new high of $68 trillion by the end of 2017.

When interest rates fall, not only is the stock market stimulated. Bonds make payments at fixed rates, so when the market rate drops, the price of these bonds increases, since they can be sold for whatever price will give the buyer the same return as the current market rate. Interest rate reductions also cause housing prices to rise, since when interest rates are low, people can afford bigger mortgages as they make lower monthly payments. The opposite is also true, which is unfortunate for investors. All else held equal, rising interest rates means lower prices for bonds and housing.

If the super bubble pops and crashes this time, all assets—equities, bonds, and real estate—will drop in value. Even if extraordinary measures are taken to stop the decline—such as the fed purchasing corporate bonds—there will be nowhere to run.

Focusing on Helping America, Not Wall Street
Unwinding the debt accumulated during a credit binge lasting decades will impact all sectors of the economy. In the short run, federal budget deficits are structurally impossible to eliminate. But what can be changed is how the money is being spent. Here, the policies of President Trump reflect a canny awareness of costs and benefits. For example:

  • Investing $20 billion in border security may significantly reduce the cost of illegal immigration which has been estimated well over $100 billion per year.
  • Pressuring wealthy nations to pay more for their own security will allow the Pentagon to redirect military spending towards research and development and modern weapons that will maintain deterrence.
  • Renegotiating trade agreements will reduce trade deficits, which in-turn will create jobs and slow foreign acquisition of American assets.
  • Bringing jobs back to the United States will create millions of new jobs, with the boost in consumer spending power more than offsetting the increased prices for goods.
  • Enforcing tariffs on strategic commodities such as aluminum and steel help keep and expand these vital production capacities onshore.
  • Holding nations such as China accountable for theft of intellectual property helps preserve America’s competitive advantage in the technologies of the future.
  • Rolling back regulations across all business sectors has already greatly improved America’s business climate, stimulating investment and creating jobs.
  • Pushing for new public/private investment in infrastructure, neglected for decades, can create jobs, improve safety and resiliency, and enhance quality of life.

The United States has significant economic advantages that Trump, unlike his predecessors, is using to benefit ordinary Americans, and it’s about time. America can engage in the tactics just described because the American currency remains unchallenged as both the global reserve currency and the global transaction currency. As long as America’s economy is healthier (or less afflicted) than other major national economies, America’s currency will remain strong even as the U.S. Treasury continues to issue hundreds of billions in new T-Bills to cover deficits.

The only currencies that might challenge the U.S. dollar are those of China or the European Union, but these economies face debt overhangs as severe as America’s. And unlike the United States, China and the EU confront an array of challenges, including an aging population, less diverse economies, fewer domestic supplies of energy, less agricultural capacity, less internal stability, and less military power. Until there is a serious competitor to the U.S. dollar, Americans have time to get their federal budget deficits under control.

When Trump called attention to the soaring stock market, and raved about increasing economic growth, he was doing what a president should do—be America’s greatest cheerleader. But the reality is that Trump has inherited an economy that survived the subprime mortgage crisis of 2007 by even more borrowing. It is an economy in which stock values rose because corporations took advantage of low interest rates to borrow cash to buy-back their own stock; an economy where consumers resumed borrowing to buy cheap imported goods and pay punitively overpriced tuition to send their children to college; an economy where infrastructure spending and strategic military investments were deferred in order to fund more domestic entitlements and fight endless police actions overseas.

A correction to the stock market is inevitable. The relentlessly hostile political and media establishment will blame the correction on Trump. But Trump’s economic policies are appropriate for the times in which we live. They are designed to restore America’s strength and security, and to minimize the degree to which the problems on Wall Street spread to Main Street.

This article originally appeared on the website American Greatness.

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The Razor’s Edge – Inflation vs. Deflation

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Deficit spending has been touted as a potential driver of inflation, because only with devalued (inflated) currency can we hope to erode the real value of our mounting levels of government debt. Continuing to print U.S. dollars, it is claimed, can only lead to too many dollars in the system, and hence a devalued dollar. We should be so lucky.

A few years ago, in Sept. 2007, in a post entitled “Inflation vs. Deflation,” I cited a recent (at the time) quote from Paul Kasriel, an economist with The Northern Trust Co. in Chicago. He explained the danger of deflation quite well, describing what happened in Japan:

“Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.”

Another way to put this is as follows: Liquidity is a function of two factors, money supply and collateral. But the impact of available collateral is far more critical to maintaining liquidity than the money supply. Let’s suppose the entire privately held asset base of the United States is 25 times GDP – it’s probably worth much more than that, but let’s use these multiples – this suggests that the total private collateral in the U.S. is worth nearly 400 trillion dollars. On the other hand, let’s suppose the combined deficit spending – otherwise known as “stimulus” spending – in the U.S. is 10 trillion dollars per year – it’s much less than that, at least so far. Yet this 10 trillion dollars, in terms of liquidity, is a mere trickle compared to the value of the collateral, which is the basis of credit lending. What happens if entire sectors, such as the housing sector, decline in value by 50% or more? What if the entire asset base of the U.S. declined by 50%? Can a ten trillion dollar annual trickle of newly minted dollars make up for a decline in the borrowing base (the asset base) of 200 trillion dollars? No chance. This is what happened in Japan in the 1990s, this is what happened in the United States in the 1930s, and this is the specter we face today. Deflation is the devastating scenario that every fiscal and monetary policymaker in the United States is doing everything they can to avert. Inflation would be a cake-walk by comparison.

To further understand why deflation looms as a greater threat to the U.S. economy than inflation, consider what additional bubbles still remain in the U.S. economy. Two huge sectors come immediately to mind – the municipal bond market, and the commercial real estate market. Municipal bonds are at risk of default because public entities, nearly everywhere in United States, are on the verge of bankruptcy. The reason they teeter on the edge of bankruptcy is because these public entities have negotiated pension and compensation plans for public sector workers that are far more generous than anything available to ordinary workers or professionals in the private sector, and these inordinately expensive personnel costs have now far outstripped the willingness or the capacity of taxpayers to pay through even higher taxes. Barring dramatic and immediate reforms – lowering compensation and benefits in order to eliminate these deficits – municipal entities in much of the United States are on a collision course with bankruptcy. If they default on their bond payments, the value of municipal bonds will collapse. Meanwhile, investment has been pouring into bonds as the returns on equities have corrected. The bond market in general, and the municipal bond market in particular, is a massive asset bubble that is on the verge of bursting.

The commercial real estate market is in similar danger. Currently landlords are enduring high vacancies but are, in general, refraining from releasing space at lower rates. They know that if they lower leasing rates for their space, this will cause the value of their commercial property to be reassessed, reducing the amount of collateral their property will support. This reduction, in turn, will trigger calls for principal reduction payments by banks who service the mortgages on these properties, since lowered property values can put property owners into default on their loan covenants. A similar situation already exists with residential properties, except in this case instead of tolerating vacancies to keep rates high, banks are holding foreclosed properties to avoid flooding the market which would cause the price of residential real estate to drop even further. It is difficult to overstate the threat of deflationary impacts if any these precarious situations snowball, once a breach occurs.

Another potential bubble of staggering magnitude is the public employee pension funds. It is ironic, that public sector unions, who pretty much control the messaging in elections (which they buy, using taxpayer’s money), in our public schools, and through their supporters in the media, have taught the gullible among us to loath capitalism, resent private wealth, and vilify Wall Street, yet their public employee pension funds are now engaging in perhaps the most irresponsible example of casino capitalism yet. Rather than support reducing the bloated pension benefits they are currently obligated to fund, and rather than accept a conservative real rate of return on their investment portfolio of 3.0% per year, the public employee pension funds are engaging in investment activity that is riskier than ever in a desperate attempt to reflate their asset base. Read this from Pension Pulse’s Leo Kolivakis, written on March 9th, 2010, in a post entitled “Public Pension Funds Doubling Up to Catch Up“:

“Private pensions are in no mood to crank up the risk, but public pension funds are back to business as usual, and even looking to leverage up to obtain their magic 8%. Many public plans are still sticking to the motto that more private market assets will lead them out of their troubles. They’re in for a nasty surprise. Last January, I wrote that the alternatives nightmare continues, and I don’t see it getting much better. In fact, as mighty endowment funds like the Harvard Management Company look to unload real estate and other private equity holdings, private markets will likely suffer a long drought, especially since public markets are not going to deliver anything close to what they delivered in the last 30 years. So what are public pension funds doing? Cranking up the risk, investing in failed banks, leveraging up, shoving more money in private equity and hedge funds, whatever it takes to achieve that insane 8% average annual return they’re all still fixated on.”

Bonds, real estate, and pension funds, ultimately, are all collateral – the primary engine of liquidity. Over the long-term, the only way to stabilize the value of collateral is to establish a sustainable positive cash flow. When the financial history of early 21st century America is written, it is interesting to wonder how historians will characterize the behavior of public sector unions, who were indifferent to deficits, who were incestuous with Wall Street, who rode the waves of unsustainable debt and deficit-fueled phony booms to guarantee their members would enjoy magnificent benefits calibrated on bubble values, but contracted to endure even after the bubbles burst. Will the refusal of all-powerful public sector unions to embrace fiscal reform be seen by future historians as contributing to the collapse of the bond markets, the pension funds – and under the burden of new taxes instead of reform, property values, as the nation’s collateral imploded? At the least, it is fair to say that what today’s leadership of public sector unions decide – whether they embrace concessions for the sake of the nation, or not – is one of the biggest opportunities remaining to avert further financial calamities.