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- Credit is now the new money – A game that can’t last
- “Moneyness of Credit,” works as long as the Fed can turn fear to greed
- Noland sees credit dystopia vs Duncan’s credit utopia (next week’s show)
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Doug Noland: It’s Too Late To Turn Back Now… I Believe You Should Take Cover!
August 5, 2020
“At some point, a crisis of confidence in this so-called money is inevitable. People aren’t going to trust it forever if you continue to create trillions and trillions backed by nothing but a promise from a central bank and a promise from governments. That’s the flaw in all of this. You can’t sustain the perceptions of moneyness forever. History has many examples of how money is destroyed by over-issuance, and now we’re watching it in real time.”
– Doug Noland
Kevin: I’m really looking forward to the next two weeks, Dave. This week we’ve got, of course, Doug Noland on, and Doug Noland has been a master at analyzing the dangers of credit for the last three or four decades. He’s now on the team. He was somebody that we’ve read for decades before he ever came on with you and I love it. I love listening to you guys talk.
David: He joined our asset management team four years ago and time has gone by very quickly. Love working with Doug. When you work with people who are incredibly sharp, it sharpens you. And I think the last 3-4 years have been… I’m grateful. I’m grateful for just being able to continue to grow and hone a skill set within the asset management space. Noland is someone who is very analytical. Next week we have a person who is very analytical as well and actually loves the study of money and credit as well. So we go from Doug Noland this week to Richard Duncan next week.
Kevin: But they don’t necessarily agree on outcomes.
David: You’re right. There is a fork in the road. As they analyze similar things in terms of money and credit, there is a potential for a negative outcome in terms of Noland’s analytical framework. And there’s also potential for a negative outcome in terms of Richard Duncan’s framework and that necessitates a different set of decisions. And so there is an inevitability to credit growth and expansion. For Noland that comes at a high cost, ultimately. And for Duncan, it also comes at a high cost, but that’s why we must press on and press forward.
Kevin: You know, I think about where the two of them agree. They would both say that we’re past the point of no return, that money turned into credit, and we’re now in a credit expansion. Noland would say kicking the can down the road is ultimately going to end in dystopia. What Duncan would say is, it’s our only chance at utopia. And they both know that credit probably ends badly, but I think Duncan would just like to have it end badly after he passes away.
David: That may be, so if we have a shot at utopia, let’s spend a little bit more. And that’s a little bit like looking at the hair of the dog as the real solution to a problem with alcoholism.
You’re right. It will take away some of the consequence in the short run.
Kevin: Do you remember Ian McAvity said that a doctor told him to not stop smoking because he had smoked so much that it would probably kill him.
David: That’s right. “You quit now and you’re dead.” That’s really what we’re talking about. Great back-to-back weeks here. I hope for the listener that they appreciate the tension that’s created and the appropriate place to sit, somewhere right in between, sitting with that tension and allowing that to sort of inform your more critical appraisal of the markets.
Kevin: Right. And it may create some aggravation. If you’re not debating with the people you’re listening to, you’re not thinking because you have to take the other side. You’re going to be talking to people who right now believe the stock market in the credit markets can expand forever. Well, how do you have an argument unless you’ve actually talked to somebody who believes that, who’s actually analyzed that? Then there’s the other side. What Duncan’s talking about has never happened before. Credit has never expanded forever, and it’s worked. What Doug Nolan says is “No, economic history hasn’t changed, and we will have a bad outcome. We need to be careful.
* * *
David: Doug, we try to have you on the Weekly Commentary at least annually and talk about not only the credit markets but what we’re doing on the asset management side here in house, and love your perspective. Of course we get the benefit of that not only from the Credit Bubble Bulletin, which you put out every Saturday, but also multiple times a week as we compare notes. You joined our asset management team four years ago. It’s been an extraordinary experience working with you and learning from you, and today I think it’s fair to say the financial markets are in a late inning, if you want to borrow that picture from baseball. And if you look at valuations, things are pretty stretched, looking at equities in particular. And while we as a group see reason for caution, if you turn to the markets in general, on any given day maybe you’ve got a little retrenchment here or there. But it seems like caution in general has been thrown to the wind.
Let’s start with some context. First of all, you’ve been doing this for a long time. You’ve been in the short side or on the short side of the market since 1990 and writing the Credit Bubble Bulletin for 20 years. So, love for you to give us a little context for this market environment versus others you’ve seen in your 30-year career. Have you seen anything like this? And what is it most like?
Doug: Good to be with you, David. Thanks for having me back. And it’s hard to believe it’s been four years already, right? But it’s been great to be part of the team, part of the organization. I’m just thrilled with what we’re putting together.
This is crazy, right? And I often say from a bubble analysis framework, things get crazy at the end of the cycles, and that’s where we are. As far as what this reminds me of, over the last couple of months, in particular, there are elements of 1999. We have this whole Robin Hood trading dynamic. In many ways, the speculation today is much broader than it was in 1999. In 1999 it was kind of isolated in Internet stocks and some of the big tech stocks. Now it’s throughout the entire marketplace. And in 1999, even when we went into the first quarter of 2000, we started to see this big divergence between deteriorating industry fundamentals. Yet the market made this final moon shot to end the move in the first quarter of 2000. So it reminds me of that in a way. It also has elements of the period 2007-2008. From my framework, the mortgage finance bubble was pierced back in the spring of 2007. That’s when subprime erupted. That was kind of the beginning of the end of the mortgage finance bubble. But that didn’t stop the markets from going to all-time highs. In the fall of 2007 you had Fed rate cuts, the market turned very speculative and completely ignored what was unfolding – crisis dynamics, the burst in the credit bubble economic fund amounts, completely ignored it. But honestly, the bottom line is, this market environment is unique. The economy contracted at a 33% annualized pace during the 2nd quarter. That’s an unbelievable contraction, yet stocks posted their strongest gains in almost 20 years. Stock gains were, of course, powered by this unprecedented monetary and fiscal stimulus, and this extreme policy response unleashed these powerful short squeeze and the reversal of hedges. So I’ve seen a lot in past 30 years, but this is something different. This is a whole new degree of excess from my analytical perspective.
David: You talk about broader speculation than in 1999, and not just tech like we had in 1999. I think about past periods of credit excess. At one point, to think about credit bubbles was really to think about bank credit. Now we have other and larger conduits for the creation and distribution of credit. Maybe you could expand on that. Some people have called it shadow banking, and there are other ways of considering it that is not directly through the banks. Maybe you can give us your opinion on the systemic nature of credit crisis and those dynamics today. Again, if you’re talking about broader speculation, you’re also talking about a broader distribution of the issues underlying. So credit crisis now versus an earlier instance of credit crisis which was predominantly the banking sector.
Doug: Yes, that’s right, David. When I think back early in my career, the Fed didn’t even signal when they were adjusting rates. They would do it quietly, and you had these Fed watchers that would see if the Fed was adding or subtracting reserves. And that would be the signal that they were on the margin slightly increasing or decreasing the cost of overnight bank funding, and that change in the cost of bank funding, that was to reverberate out to the economy. Bank lending would ease or tighten based on, you know, the Fed’s subtle moves.
Today, this is all about the financial markets, right? The Fed has this framework where they target financial conditions. What does that mean? Well, they basically target strong financial markets when the financial markets are strong. This year? We could have record corporate debt issuance this year in the face of this economic contraction, so corporations don’t even need to tap the banks, they can go and tap the markets. Why will we have record corporate debt issuance? Because of the enormous liquidity that the Fed injected into the marketplace.
This liquidity must find a home. It will find a home in higher yielding corporate credit, and that loosens financial conditions. But it also leads to excesses in the financial markets. And Chairman Powell, in his recent comments, he will say that the U. S banking system is well capitalized. It’s in a much better position than it was back in the 2008-2009 crisis.
Well, that’s not the most important issue. As we saw in March, the key issue is the markets. We’re at the point now where the speculative bubble, domestically and internationally, is so big, if you have a risk-off bout of de-risking, de-leveraging, as we had in March, then the markets become immediately illiquid. You start this self-reinforcing downturn in the markets, and they dislocate, and we were very close to a global financial meltdown just back in March. And it doesn’t matter at that point what bank capital is, right?
So the shadow banking system, a lot of that is corporate credit. It’s these massive derivatives markets, and when it comes to derivatives, there’s not much transparency. My thesis is that you have unprecedented speculative leverage here in the U. S., but also globally – China, the emerging markets, Europe. It’s everywhere. And as we saw in March, if you start to get into a de-risking, de-leveraging environment, and that’s basically hedge funds and these leveraged players trying to de-risk, reduce their amount of leverage, the markets immediately become illiquid and quickly succumb to crisis dynamics.
So this is a completely different financial structure than we had back when I started in the business, and I would argue that this financial structure has changed markedly since the last crisis where speculative leverage, derivatives, has made it into every nook and cranny of global finance in global financial markets, which creates a very, very unstable, vulnerable, fragile structure.
David: It was a defined universe when it was the banking system, which had to be fixed or corrected, and today it doesn’t seem as defined. You talk about corporate credit, you talk about derivatives. Is this easier or harder to manage? Maybe we don’t know, because this is a new experiment. It is unique in that sense. But yes, if you were Chairman Powell would you look and say, “My job is actually quite a bit harder than Ben Bernanke’s was and certainly more difficult than Greenspan’s.”
Doug: Well, I don’t really think they can manage it at this point. But what they can do is take aggressive measures to ensure that the bubble either reflates or continues to inflate. That’s the dilemma. Contemporary finance works miraculously as long as it’s inflating. What do I mean by that? As long as credit is expanding rapidly, as long as the leverage speculating community is adding leverage, as long as investors in the U. S. and globally are confident, believe in the central bank backstop and want to continue to purchase more and more risk assets, then this structure seems like it’s bulletproof. It seems like the Fed has it all under control.
Well, we saw in March how quickly – we were 10 sessions from all-time market highs to an emergency Fed meeting, and only a few weeks from record highs to trillions of dollars of QE. So that’s how they manage it today by just trying to keep the system inflating. And that’s dangerous because that just leads to greater speculative excess, bigger bubbles and more fragility. And in the future the markets assume only greater monetary stimulus, and it kind of feeds on itself in this late cycle dynamic of aggressive policy and aggressive market speculation.
David: Today we have this massive global leverage speculative community, and they’re going to make money as long as financial conditions remain loose. That’s what the world central banks have tried to do, sort of play with incentives and keep conditions loose. How is it that you go from, and admittedly you just said this is not a manageable thing, but they’re playing with incentives such that they can try to get the majority in this leveraged speculative community on their side, making bets that continue the trend of reflation and leverage speculation. What happens when there is even the slightest tightening of financial conditions? And is that actually in the hands of the world’s central bankers to ultimately influence?
Doug: I would argue, with this structure, and again it used to be about the banking system and bank lending, responsible lending, and now it’s about the markets and the markets have turned highly speculative. So this is a completely different dynamic than we faced in the past. And I think the key dynamic here is greed and fear. Greed and fear. And as we saw in March, if the markets become fearful, bad things happen very quickly. This thing unwinds with stunning speed.
So the Fed comes in aggressively. Global central bankers come in aggressively. And what do they do? They shifted back to greed. Okay, that’s fine for now, but greed doesn’t last forever. Markets don’t go up forever. You’re going to have market cycles, and now it’s just feeding on itself on the upside, and then we’re going to have to sit and wait to see how this unfolds the next market correction we have because I would argue the amount of leveraged speculation is only greater today than it was in March. The speculative excesses are greater today than March, and it will take another aggressive policy response to keep the markets liquid the next bout of dislocation we have.
So the Fed, in my mind, global central bankers, are fighting a losing war here. They have this huge bubble, and I imagine they would like some air to come out of this bubble, but it doesn’t work that way. It’s not like you can bring this bubble down gently, carefully. At this point, it either inflates aggressively or goes quickly into this mode of collapse and dislocation. So, not a situation where the central bankers want to be. And you asked before, does this make it easy or difficult on central bankers? It’s a difficult job, but they only really have one solution in their minds, so they’re just, at this point, concocting different measures to stimulate the markets and stimulate the economy and hope it works out going forward.
David: It makes me think that if we’re talking about mood, this dynamic of greed and fear, there is a parallel in psychology with the manic/depressive tendencies, the swings from one extreme to the other. And, essentially, what the central bank community is trying to do is argue that they’re bringing stability, when in fact it’s not stability. It’s just one side of a mood swing, which is extreme in itself. They prefer the manic side as opposed to the depressive side, and they call managing the manic a move towards stability, when it’s not. It’s just a preference for one side of that key dynamic you’re talking about, greed and fear.
Doug, you and I have been offering the Tactical Short product for a few years now, and in that time we’ve seen some remarkable developments. We’re talking about monetary policy experimentation, and even a degree of fiscal policy unification there in Europe in recent weeks, which I mean is really quite remarkable. You are the Tactical Short portfolio manager, but there are a number of major contributions you make to our asset management team beyond that, and I won’t list them all. But process drives a lot of what needs to be done in asset management. There are processes we follow, both on the Tactical Short and our hard asset portfolios, the MAPS side of the equation, that are key. Why is process so important?
Doug: I cannot imagine managing money without a sound and comprehensive investment process. And I guess some money managers that are basically mimicking the indexes can live without a disciplined investment process, but certainly not in the short side and not in managing a hard asset portfolio.
Over the years, I’ve had very strong views develop on management and process, and for starters, I believe this to my core, team decision-making is superior to having everything rely on one single individual. And David, as you’ve witnessed, when you bring a team together, members with different experiences, analytical perspectives, and diverse views, it really stimulates a depth of discussion and debate that promotes, and I’ll say, promotes on average, better decisions. It tends to even out our individual biases. It removes the emotional component, and it brings in a greater level of, I’ll call it, analytical vigor.
It’s just a completely different dynamic if you get a group together to make decisions. And I’ve also believed over the years in this investment philosophy, and I know, David, you share this, too, of rigorous bottom-up analysis meets rigorous top-down analysis. These are two distinct skill sets and processes. Also risk management is fundamental to a sound investment process.
And I can imagine many listeners are sitting home saying, “Yeah, this this all makes sense – team decision-making, melding the micro company research with the macro analysis and a risk management overlay. And that all makes perfect sense. Well, let me tell you, it’s great in theory, but a real challenge to execute on a daily basis. And that’s where investment process becomes just crucial. There has to be a systematic process for the analysis, for the decision-making. It’s absolutely imperative. There is no other way around it. And without it, you get lost in this complex and challenging financial policy and market landscape that we operate in. So I’m a big, big process guy.
David: Well, it’s easy to see sort of your intellectual progression from studying accounting to getting an MBA and moving through and learning the ropes on the short side 30 years ago, whether it’s with Gordy Ringon or others within the hedge fund community. You get to see mistakes that are made, you get to see a better way of doing things, and so the risk management overlay is key, the macro is key, the micro is key, and then the execution – what it takes to actually drive toward a decision on the basis of that process. This is something that, as you say, is easier said than done, and I think it’s a fairly rare engagement to see Wall Street professionals actually do that. It’s a lot easier to follow a market index or just kind of make a pretty pie chart and say, OK, we’re just going to own a little bit of everything and call that good. And if you take the efficient market hypothesis, then that’s really all you’re obligated to do. So faith in the efficient market hypothesis basically gives you a free pass to avoid the hard work, which again is easier in theory than in practice.
I want to bring in something from the short side, which is kind of interesting. This is a unique opportunity to look at, in real time, the challenges of managing a short portfolio. Some of the smartest short sellers on the planet picked on Tesla this year, and being smart didn’t keep them from getting their heads handed to them. You were not short Tesla. Simply, what kept you from playing that game?
Doug: Sure, David. And to follow up on your previous question, or discussion, as far as process. What also has had an impact here is, in the marketplace everyone just believes in the Fed. They believe that the markets always go up eventually. If the market comes down, markets are always going to end up higher. And I think that mindset also makes it pretty easy not to follow a disciplined process, just play the market, play the indexes. I have not had that luxury on the short side, over 30 years. I haven’t had the luxury of just saying, okay, the Fed’s on my side, markets always go in my direction eventually.
I made this comment in our Tactical Short conference call, David. Over the past 30 years I’ve learned a lot of hard lessons the hard way. I’ve been caught in some brutal short squeezes. And from these painful experiences, it became clear to me that avoiding outsized losses was absolutely essential for long term success in the short side. And the key to avoiding outsized losses was not to be short [unclear] or at least short individual company stocks or highly volatile stocks in a market environment where there’s a high probability for a strong rally.
There was a huge amount of shorting and hedging back in that March/April period of market instability. And then you had the Fed inject 3 trillion into the marketplace. If the Fed’s extreme measures were able to turn the markets, and you had to contemplate that that was not necessarily a low probability event scenario, these crowded short positions were sitting ducks. You have these big positions, shorts are all hunkered down in these big positions. If you have a speculative marketplace all of a sudden rallying, it’s going to gravitate to these names, it’s going force these stock prices higher, and it’s going to force the shorts to cover, and panic on the short side, and that’s what’s called a short squeeze. You can see huge, huge price gains in a short period of time. I mean, Tesla was up hundreds and hundreds of points quickly. The stock at one point was up 300% year to date. So the risk in heavily shorted names becomes so high that my investment philosophy dictates that I avoid them.
Many short analysts, and I mentioned at Tesla, some of the smartest, most experienced short analysts in the business were caught in that short squeeze. They focus on individual company fundamentals and potential rewards in shorting fundamentally suspect companies. That’s their primary focus. Over the years, I’ve learned to start the analysis differently. I begin with the top-down analysis and an assessment of risk before I start thinking about potential rewards. So stocks like Tesla and a lot of other ones would not even make the first cut because the risk of getting caught in a squeeze in this extraordinary environment were too high. So that’s just kind of fundamental to the risk management focus process.
David: So because you’re looking at the context, which is the Fed is very likely to introduce a policy response in the midst of a sell-off, it distorts the risk against and mitigates the potential reward being short those individual names. So if you’re cognizant of the context, all of a sudden the macro, even though the micro-analysis of the company is accurate, the macro militates against success. And again, that’s three decades experience. Sometimes opportunities you just have to say no to. Even though in the face of them there is something attractive, there is something just under the surface that makes it deadly.
Doug: Sure. David, let me jump in and add here, the reality of what the Fed and central banks have done. In the example we were talking about with Tesla, they create a disadvantage for those short Tesla, and hey create a huge advantage for those that want to squeeze Tesla, that want to buy that stock and force the shorts to cover. This has become a very significant element of this greater speculative bubble in the market place. They’ve given a competitive advantage to those that want to play games and squeeze shorts. They give a competitive advantage to those that buy calls, a competitive advantage to those that will sell market insurance.
So these are key distortions that, in aggregate, have created a highly distorted speculative marketplace, a bubble that just feeds on itself because the assessment of risk in the marketplace is just so distorted by this market backstop and the belief that if anything happens, the Fed’s going to be right there with liquidity, right there to do whatever is necessary, whatever it takes to make sure the market goes up.
David: That’s a great segue to a question about the assumptions about how risk is managed in the marketplace. You mentioned on the Tactical Short call a few weeks ago that there’s a ton of risk that cannot be effectively hedged. Yet the market seems to believe that it can be hedged. So in that context, even more risk is taken, and then there’s hedging to offset that risk. What are they missing? Who absorbs the risk exposure or takes losses in a really pressured environment? I guess what keeps me up at night is the concern that these dynamics suggest, ultimately, a de facto nationalization of the markets. What your thoughts?
Doug: Absolutely – an effective de facto nationalization. In the Tactical Short call you asked a question, and I said that I remembered clearly the dynamic in 1987, because I watched the crash in 1987 on a Telerate screen. I was just fascinated with the markets, fascinated with the macro analysis, and really that launched my passion for the markets. But after the 1987 crash there was a lot of focus on portfolio insurance. It was this new strategy. Why not play the upside of very speculative market in 1987 believing that you had this other portfolio insurance strategy that would protect you on the downside? Basically, you were buying market insurance. And then, the institution that was selling you that insurance, if the market started to go down they would short S&P 500 futures to provide them the cash flow to pay on this insurance that they had sold to these institutions. Well, yeah, right. As soon as the market started to break to the downside, it was just overwhelmed with this selling.
This dynamic has become so much larger than it was in 1987. In 1987 it was just a segment of the place. Now it’s everywhere. This whole notion of buying market insurance – the entire marketplace could go out today and buy out of the money put options. Let’s say they buy put options 10% below where the market is today. That means if the market goes below 10% then they make money on these options. So all participants could go out and buy these put options and believe that they were protected against a significant market fall, that we we basically locked in the entire bull market. Well, isn’t that wonderful?
The reality is, whoever is selling this insurance as we saw in 1987, if the market starts to go down, they have to sell something. They have to short stocks. They have to short ETFs, futures. They have to short something so they’re protected to pay out on this insurance that they have sold or written. So the problem becomes – it’s called dynamic trading, delta hedging. The sellers of this insurance, basically, it’s a computer program that says, okay, if the market starts to go down, I have to sell some here to protect myself. And in reality, if a lot of the market has bought protection, thinks it has protection, then the amount of selling that has to be done in the derivative marketplace to hedge this insurance, it will quickly just overwhelm the marketplace and lead to dislocation.
I think this is a very important part of the breakdown in the markets back in March was, because of the pandemic there had been a lot of derivatives purchased, put options and different types of derivative protection, and when the market broke to the downside, the related selling just overwhelmed the marketplace. I’ll stretch out this this answer just a little bit because what comes to mind also is, in one of the early CBBs I did this little fictional piece. I thought I would dabble in fiction and it’s tough. I don’t do that much anymore. But I think I titled it “The Derivative Story,” and I talked about this little town on the river that is just a sleepy little town because nobody’s going to build on the river because you can’t buy insurance. It’s just too expensive. No insurance company is going to insure homes on this river because it floods occasionally. Well, over time, there’s a drought and writing insurance becomes highly profitable. So all of a sudden, a bunch of companies come in and are selling insurance so people start to build on the river. And the building boom takes on a life of its own and those that have been writing the flood insurance during the drought are making a lot of money so more people are building, more players come into the insurance market writing more insurance, and you get a lot of speculators writing insurance with no plan to actually be an insurance company. They think if it starts to really rain they’re going to buy re-insurance in the reinsurance market. They’re just going to off-load the risk to someone else.
Well, the sad story is, you do get torrential rain coming and you get a lot of these so-called insurance companies out trying to buy insurance in the reinsurance market and that market collapses because nobody is going to sell insurance in a torrential rainstorm with the river rising. And at the end of the day, the insurance market collapses because these insurance players don’t have the wherewithal to pay when the flood comes in and you have a big wipeout. So not only do you have this big financial dislocation, you end up at the end of the day having huge, huge losses, much greater losses than you would have had without the insurance.
Why? Because you had all this risk-taking because you could get this cheap insurance. Everybody wants to build on the river, and you’re going to build lavish homes and it’s great. And then eventually the flood comes. What’s different in real life in my little derivative story is here, central banks, at least for a while, can control the rainfall. And everybody wants to write flood insurance, everybody wants to build on the river, everybody wants to take risk. Well, the problem is, at some point, there will be a flood.
David: I want to connect a couple of things here because, on the one hand you have monetary policy which is deliberately keeping interest rates at a lower level. You see that with the Bank of Japan now for many years, yield curve control as they’re popularly calling it today, but it’s the ECB and the Fed and others as well. So we have low rates, and yet you’ve got groups like insurance companies and pensions which have to meet a certain income expectation to meet their liabilities.
And so, fast forward, we have things like CLOs which have found their way into pension and insurance portfolios to boost yields. What are the issues that are likely to arise from the pensions and insurance companies getting loaded to the gills with CLOs. It kind of feels similar to what we had in 1908-1909, CEOs, CLOs. We even had CDO squared. It was just exotic financial products that were used to boost yields, and everybody assumed, well, I’ve got a longer timeframe so it doesn’t really matter if it gets priced lower. It doesn’t bother us because we’re long-term players. That’s the nature of a pension fund or insurance company. Talk to us about what the central banks have done and how it has forced the risk taking deep into these organizations and where you see that going.
Doug: The market believes central bankers will continue on the path of whatever it takes. So it’s interesting in the marketplace where the Fed says they’re not contemplating negative interest rates. They don’t even really want to go there necessarily in yield curve control, but the markets say, oh, you absolutely will. There’s no doubt in the market’s mind that the Fed will eventually do yield curve control, which is basically just pegging bond prices or pegging yields. They will likely go negative rates.
Why is the market so confident? Because the market knows that the Fed’s going to be forced into the next step. The markets are going to force the Fed into the next aggressive measure, the next part of the experiment, because the Fed is kind of stuck. They can intervene, they can lower rates, and at the end of the day they’re still going to have to do more. So this is forcing all types of distortions in the marketplace. The insurance companies are loaded up on CLOs. Right now, record corporate debt issuance. You have enormous credit growth in the face of really deteriorating economic conditions.
So the market right now is just focused on where the market can go to get yield, ignoring the risks. They ignore the risk because they believe the Fed will do whatever it takes to, I call it validating these prices. Corporate yields today are so low, especially respective of risk, but the market doesn’t even care about that analysis because all they care about is pricing it versus Treasury yields, and basically we’re almost at zero two-year treasury yields. So any corporate yield is a benefit to a pension fund or an insurance company with the view that the Fed will ensure that there’s not widespread defaults, credit losses, etc.
The risk is, this year’s enormous issuance of corporate debt and distortions in the marketplace significantly increase the odds of that scenario of a major systemic credit problem. That’s the issue now. There is complete disregard for risk. Institutions are loading up on – it could be equity risk, corporate credit risk, derivative risk, all based on the Fed backstop. And if the Fed is unable to keep the markets levitated, then you’re dealing with a very, very significant financial and economic shock to the system.
David: So we go from record highs in February to a near financial meltdown in only a few weeks. You mentioned that earlier. We have behavior – we now expect the Fed to step in, and so there’s moral hazard, sort of state-sponsored moral hazard in the markets. Could you argue that this is actually the rational thing to do? You buy the risk assets because, in fact, they are on the hook. They don’t have a choice. Negative rates to 3-4-5%. What that argues is maybe you do go out and buy German bund at -50 basis points, and it’s going to be a major capital gains winner for you. This is a really interesting time where what is rational in terms of being able to play out the step sequence or the chess moves of the world central banks is also incredibly dangerous.
Doug: David, I focus foremost on this bubble analysis and bubble dynamics, and I believe this analytical framework is invaluable for understanding both the markets and policy. Both of us have studied financial history. I always thought it was interesting, because when we think about bubbles, we think about these crazy manias – tulip bulbs and things, and there is a facet to that. But what you said earlier, just a few seconds ago, you said that it’s rational for people to participate. That’s key to this whole thing. It’s completely rational.
That’s the danger. It’s rational to buy Tesla, it’s rational to buy corporate debt. It’s rational to buy bunds, treasuries. It’s all rational because of this perception that the risk is low because of the central bank backstop and you have to participate in these markets. You have no choice. There is career risk. There are all types of risk. So you basically just have to jump on board and believe that the system is sound, believe the central banks have it all under control, and believe at the end of the day it’s all going to work out fine. I just don’t think it will. I just think these are all dynamics consistent with the late phase of, really, a super-cycle, a multi-decade bubble. And as I said, things get crazy at the end of cycles. They get really, really crazy at the end of a super-cycle because things become so distorted.
David: It seems like one of the distortions – we go back to the D- word, derivatives. We spoke about them earlier. I read an interesting Goldman-Sachs commentary on the increasing use of options. What kind of market do we have when derivatives trade in higher volumes than the underlying assets themselves? Isn’t that fascinating?
Doug: It is fascinating. It’s also scary to me. These derivatives – in March it was the put options that kicked in. People had bought market protection below the market. Call it out of the money puts. So when the market starts to go down, whoever wrote those puts has to go out and short things, as I mentioned before, to protect themselves. When the market shifted and fear turned into greed, we have had a huge, huge boom in option trading, and that’s institutions retail purchasing call options, out-of-the-money call options. Traders, speculators have made enormous profits.
Imagine back in March buying out-of-the-money call options on Tesla. That is a home run trade. This feeds on itself, and now you have option trading in large numbers of stocks, retail, institutional, and when the market starts to go up, it self-reinforces, it feeds on itself on the upside. Whoever wrote those call options, out-of-the-money, when the market started to rally, they have to buy the underlying instruments. As the price goes up, they have to buy Tesla to protect against call options that they’ve sold to someone.
The risk is, that leads to a market melt-up, and I mentioned the 1st quarter of 2000 as a similar dynamic. This is much more pervasive in the marketplace. You get a market melt-up, which creates a lot of fragility. For one, if you had a sharp reversal then the derivative players that were buying Tesla yesterday may have to dump Tesla quickly as the stock price goes down to hedge their derivatives. At the same time, you could have the market shift away from calls and all of a sudden buy puts again. So then you have the market self-feeding on the downside.
So my argument is, these derivatives, especially, because now they’ve become such an important aspect of the markets for institutions, for retail, online speculation, hedge funds, everything, they become such a big component of their markets that they just feed instability. And the instability looks great on the upside. It looks great, as it did on February 18th, the market highs. But it sets up vulnerability to a reversal and these big downside moves that catch everybody off guard.
David: So let’s back away from – it’s not exactly minutia, but some of the details of the financial market and look at a broader picture here, because when you’re talking about instability or uncertainty, not all of it is financial market. China – what is your perspective on the Chinese credit markets, and then, secondarily, just to order our conversation, talk to us about the geopolitical tensions that are brewing there. China and the rest the world, China and the U. S. So again, credit markets first, and then the geopolitical aspect second.
Doug: As an analyst of credit and bubbles, and I’m repeating myself. I say this often. I look at China in awe. I look at their banking system. During this decade cycle here, the banking system there has gone from a trillion to approaching 45 trillion. You look at their numbers today, they had 3 trillion dollars of credit growth in the first half of the year. That’s more than we had during the entire boom year of 2007. Their numbers are unbelievable to me. And we’re at the late part of the cycle, and I talk about the terminal phase of credit access at the late part of the cycle. What you do is you have rapid growth of credit, the quantity of credit, but you also have a very significant decline in the quality of credit. So if you imagine this hypothetical chart of systemic risk, it grows exponentially. That’s what we saw at the end of the mortgage finance bubble.
That’s what’s occurring in China today. So to me, it’s a disaster in the making in China. I think it just completely got away from policymakers there. They’re stuck. The only thing they can do is continue to create enormous amounts of credit, they direct their state lenders to lend aggressively. So it’s a really problematic situation in China there with their credit bubble just being out of control. Like we did in March, April, they come in with aggressive stimulus and they inflate another stock market bubble. So we talk about all the speculative excess here, they have it in China, online trading, a proliferation of hedge funds in China. You know they’re in a situation where they’re trying to stimulate the economy, but it just leads to more problematic excess in finance. So, very difficult spot for Chinese credit. And let’s also throw in, their credit feeds around the world. So it’s not just a Chinese issue.
As far as geopolitical, and I’ll just stick here a bit with the bubble framework. During bubble inflation, during the up-cycle, the perception is that the economic pie is expanding, economies are growing, so there’s an incentive. It’s perceived to be beneficial, an advantage to cooperate, to integrate. That’s the upside of the bubble cycle. During the upside of the bubble cycle we, as a nation, were pleased to trade with China. What’s not to like about that? We give them treasury debt and they send us enormous numbers of cheap imports. Why wouldn’t we want to feed that?
Well, the dynamic has changed now. I will say their global bubble has been pierced. The perception now is that the economic pie is shrinking, so that changes everything. Now there’s a bias to disintegrate. There’s a bias toward confrontation because various parties want to fight to get their share of the shrinking pot. It’s a zero-sum game now where everybody’s out working on their own self-interest and that certainly changes the geopolitical dynamic. And we’re seeing it. We’re seeing it in trade, we’re seeing it in an aggressive stance against Chinese technology companies, and it’s drifting into issues of the South China Sea, Taiwan, Hong Kong, etc., which is a direction that I find unsettling. I’ll use that word.
David: When the financial markets begin to struggle and it feeds into the larger economy, you can end up with political issues. And so to see a migration of concern into the political spheres, it shouldn’t surprise us that we’ve seen a consolidation of power in China and strongman dynamics all around the world. In this context of global disintegration, as you described it. So, as we described earlier, it’s rational for people to participate in credit expansion and speculation.
But one of the reasons why, even though it’s rational, it’s objectionable, is because there are long-term consequences. And when you begin to see the dominoes fall through the financial markets to the economic, economic to political, and ultimately to the geopolitical sphere, this is where you’re talking about the compromise of lives. This is where you’re talking about where the biggest wars have been fought. We’ve seen geopolitical disintegration before. This is not the first time we’ve seen credit excess, integration, and then things move into reverse. Yes, this is a fascinating period of time. China is a part of that story.
You and I spoke with a man on a different topic a little bit, a man that 40 years ago went through the Iranian Revolution, and he was reflecting with us about that period of social unrest. Again, we’re talking about political issues, social and cultural dynamics. That social unrest which he experienced, he looks at out on the West Coast from his perch there as very similar to what we see in our streets today. How would you say the current political dysfunction and social chaos factor into or reflect the waning days of a debt super-cycle?
Doug: Sure, David. This is such a critical issue. The one aspect of bubble analysis from a macro perspective that is so relevant today is, bubbles are really mechanisms for wealth redistribution and at the end of the day destruction. And, again, when the bubble is inflating it looks like it’s creating all this wealth and everybody benefits. It’s only when the bubble bursts that you realize that, holy mackerel, here we have really unjustly distributed wealth, not only within our society here in the U. S., but this has been a global dynamic. So you see this wealth inequality issue becoming so key to social health in the U. S. and geopolitical tensions.
And this is one of the dynamics that I am really uncomfortable with because the Fed gravitated toward using the markets as its mechanism to stimulate the economy, to move away from the old bank model to the markets. It was Bernanke that not only did QE, I think it was in 2014 when he said the Fed will push back against any tightening of financial conditions. When he said this, I was thinking, no, how can you say that? Because basically what he was saying is we’re there, if the markets start to weaken, we will intervene to ensure the markets are strong. Well, this is basically favoring the markets over the rest of the economy. This is putting trust in the in the institution of the Federal Reserve in jeopardy.
We now see this dynamic where there’s a lot of pressure on the Fed to participate in wealth redistribution. So there is enormous pressure on the Fed right now because of the social unrest and all these other factors to do something about it. What the Fed has been doing and what the Fed will continue to do is to try to intervene in the markets, and this only worsens this dynamic. So I fear what we’re seeing right now is kind of the tip of the iceberg as far social unrest, geopolitical tensions, to get a lot worse as this bubble deflates. We’re close to record high stock prices right now. Globally, markets have been pretty strong. So I fear things get much worse when the amount of wealth destruction becomes more apparent, domestically and globally.
I think it’s just a really, really dangerous dynamic, and this is one of the reasons I’ve been for these years so diligent arguing against the course of Federal Reserve policy-making because I just feared at the end of the day we would end up in a situation like this that’s so unhealthy for society, so unhealthy for our nation, so unhealthy for global stability, and the Fed is trapped where there’s going to be enormous pressure on them to do something, but all they can really do is make the situation worse, make the bubble bigger and only exacerbate inequality. It’s really a frustrating predicament to see that that we face today.
David: In 1968-1971, this period where we were walking away from the Bretton Woods agreement and disconnecting from sort of a stable reference point for the global monetary system, what it allowed us to do is nothing short of miraculous. We unlocked credit growth, and on the front end of that, it seemed absolutely brilliant. You’re not bound anymore by the limitations of your supply of money because now you’re, in essence, redefining money to being credit. And if you can create any amount, then you can create any amount of growth, and it seems almost like entering into utopia. What’s the transition point from credit growth utopia to credit destruction dystopia?
Doug: Imagine the old system where you had these bank loans sitting on a bank balance sheet, doing nothing, the Fed subtly intervening to encourage banks to lend, or contract. Forget that, let’s use marketable instruments so the Fed can go out and stimulate leveraged speculation, and instead of having these boring bank loans you can have securities that the Fed can manipulate their price and make them go up in price and make people want to speculate in them more, and leverage them more. It’s a powerful dynamic, as we’ve seen.
Back during the mortgage finance bubble period, I talked about this concept of the moneyness of credit, and what made that bubble very dangerous was that we were transforming very risky mortgage securities. They were triple-A rated, perceived liquid and safe instruments. I’ve always argued if you have a bubble financed by junk bonds, it can cause some havoc, but it’s not going to get deeply systemic because you can only issue so many junk bonds before the market says, “Wait, wait, no more junk bonds. I have enough. I don’t want any more junk bonds.”
Well, that ends the boom. If you have a boom and money, wow, because money, and this is my own definition, enjoys insatiable demand. It’s an instrument perceived as safe and liquid. People always want more of it. So if you have a boom, a bubble, financed by money, this thing can go to incredible excess because it can go for a lot longer into greater excess. What’s the problem? Where is the flaw in the miracle? Well, if you greatly increase money by expanding risky instruments, it’s only a matter of time, and we saw this in a mortgage finance bubble period, when people recognize – uh-oh, that Triple-A isn’t really triple A. It’s not safe. It’s not liquid.”
So what we’re doing now, and what makes this bubble so dangerous – I call it the granddaddy of all bubbles – this bubble has gone to the heart, the very foundation, of global finance and that central bank credit, sovereign debt, we now see they’re creating trillions of central bank credit on a whim. We will have a fiscal deficit this year approaching 5 trillion, could be trillions more next year. At some point, a crisis of confidence in this so-called money is inevitable. People aren’t going to trust it forever if you continue to create trillions and trillions backed by nothing but a promise from the central bank and a promise from governments.
That’s the flaw in all of this. You can’t sustain the perceptions of moneyness forever. History has many examples of how money is destroyed by over-issuance, and now we’re watching it in real time, and it’s frightening. Not only are we watching it in real time, we don’t see people carrying around wheelbarrows anywhere. We don’t need wheelbarrows because it’s electronic. It’s not going into the price of bread and consumer goods, it’s going into the asset markets, so it looks great. Everybody wants the markets up, basically, so everybody likes this system where the Fed manipulates and intervenes in the markets. There’s no one out there, with power, at least, saying, “Wait, this is crazy. This has to stop. You’re destroying the foundation of finance.” Nobody has that argument, and that’s what makes this so dangerous. And for me, candidly, it’s frightening the way this is developing.
David: The phrase, you can’t sustain perceptions of moneyness forever, I think, is really worth dwelling on a bit and thinking about, this transition of money being just bills to now being all manner of assets that have money-like qualities and that perception of safe, stable, etc., those moneyness characteristics, don’t get sustained forever. That’s the fly in the ointment. That is the transition, if you will, from utopia to dystopia in terms of this new credit experiment.
We could go on for hours and actually we do every week, which is kind of fun. This is a bit of the kinds of conversations we have on a routine basis. Of course, we’ve got our checklists and you go methodically through the various weekly indicators as they’re changing. So a little bit less narrative and more quantitative analysis in our weekly meetings. But I want to thank you for joining us, and I want to end with kind of an odd question, but I think our listeners would like to know, what is some interesting reading you’ve done in the last 12 months? What’s the most interesting thing you’ve come across? Calvin and Hobbes? Doesn’t matter to me (laughs). What are you enjoying these days?
Doug: The question I always dislike – I shouldn’t say always – a lot of times I dislike it when someone will say, “Doug, what book are you reading?” And my response is that I really wish I had the time to sit down and read a full book. I haven’t had that luxury in recent months. I’m just in front of that Bloomberg machine, and I’m reading as much as I can to try to follow developments, not only here in the US, but globally. It’s a full time job trying to stay on top of developments. And in this environment, it’s staying on top of China, it’s staying on top of Covid developments. It’s staying on top of policymaking. That’s the Fed, Washington, the administration. So I’ve never faced such a challenge of reading just to stay on top of current developments. So that’s been my focus. I know that’s pretty boring for our listeners to hear.
David: No, I’m the same in the same boat. I’ve got a stack of books on my bedside table, and I don’t have the time or energy to get into them because there is an overwhelming amount of data to sift through and sort through. We are living history and probably one of the most important periods in credit bubble excess. And I want to say one of the most important contributions you’ve made over the last several decades, Doug, is chronicling what this has been about and how it has morphed and changed, through your Credit Bubble Bulletin. And so there is a documentation for all time of what has happened in this very unique period of history and I think at some point somebody is going to compile it and condense it into a book so that we actually understand the gyrations, the policy responses, etc.
You’ve done a tremendous amount of heavy lifting there, and so I want to thank you for being a part of our team. I want to thank you for the contribution you’ve made to a broader audience with the credit bubble bulletin. And yeah, the hours that you are locked in front of that Bloomberg machine, it’s deeply appreciated. So many more people benefit from that. And I think probably more gratitude should be expressed to you. Hopefully, some of our listeners will do that. Thanks for joining us on the on the commentary today. It’s been great.
Doug: And David, you know, I want to add here a thank you for everything you do, what you do for our investors, what you do for me, our team, the organization, for your listeners. You’re an incredible individual and I’m honored to work alongside you. Thanks for having me on today. Thank you very much.
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