A blogger whose articles I always find insightful wrote a well-argued piece about the “great disinflation” – a period of lower and lower inflation – that continued in the US though the Fed was still printing prodigious amounts of money, and though, as he said, the US economy was “out of the woods.” He cited indicators of rapid growth and the possibility of “overheating” – which should have triggered inflation, but hasn’t yet. In his analysis, the Fed would view this disinflation as too close to actual deflation – with the specter of the Great Depression lurking nearby. Hence, the need to continue with QE.
Consumer price inflation is just one possible consequence of QE. But, like many others, he didn’t mention another consequence: asset price inflation in a highly leveraged economy. Asset bubbles. And the Fed is publically fretting about them.
After five years of QE, and $3 trillion in new money floating around, we now have asset bubbles everywhere: housing, farmland, stocks – including the total zaniness of the Twitter IPO – bonds of all kinds, the worst junk bonds even…. Risk is no longer priced into anything. In fact, risk has disappeared as a factor.
This happened while corporate revenues and earnings growth have stalled. Consumer confidence has soured. Retail sales are lousy. Inventories of unsold merchandise have jumped. Unperturbed, Wall Street uses fanciful financial engineering to embellish corporate results. It brandishes newly cobbled-together metrics based on carefully chosen data whose sole purpose is to show that valuations are still low though they’ve ascended beyond thin mountain air – metrics that even the SEC warned about.
Much of it is leveraged. Margin debt jumps from one all-time high to the next. Banks are extending loans based on inflated values, such as farmland that googly-eyed speculators are gobbling up like hotcakes, hoping for a quick buck. But once prices come back down to reality, these banks will be begging the Fed for another multi-trillion-dollar bailout.
The favorite short-term funding system? The ballooning repo market – favorite because it provides nearly free money, thanks to the Fed, and major corporations now rely on it. If it blows up, it would wreak havoc – including off Wall Street. Companies that rely on it suddenly won’t be able to meet payroll. It has gotten to be such a huge and precarious construct that even the Fed is worried about it. Among other issues in the repo market, the Fed would only have “limited tools” available “to mitigate the risk of pre-default fire sales,” the New York Fed wrote in its big report. And it confessed that “no established tools currently exist to mitigate the risk of post-default sales.”
The highly leveraged, gargantuan mortgage REITs have become dependent on the repo market. There, they fund overnight at near-zero interest rates their long-term assets, namely Mortgage-Back Securities. But if the repo market tightens up, or if interest rates rise, MREITs will be forced to sell their MBS. We have seen just a smidgen of it in early summer. It drove mortgage rates up the fastest in history! Banks are overexposed to MREITs, shaky as they are, and the Fed is so frazzled about it that it started to probe banks on that link in the spring – a probe that has been kept secret until it was leaked recently.
MREITs are a growing part of the shadow banking system. When they have to liquidate their holdings of MBS – of which the banks also held $1.3 trillion at inflated valuations – they might take some banks down with them. Over the last three years, MREITs’ holdings of MBS have nearly tripled to $460 billion. Fitch warned about it in June: “A repo funding disruption in which leveraged MBS investors need to liquidate some of their holdings could create negative knock-on effects for the $6.7 trillion agency MBS market more broadly.”
These are just morsels of how Wall Street has gone berserk, to the point where the Fed, after having caused all this, is fretting about it. Hence, their urgency to taper their money-printing binge. But they’re even more afraid that the house of cards they built will collapse if they taper. They got a taste of it. When the Fed heads were merely mumbling about tapering earlier this year, the hot air started to hiss out of emerging market debt, their currencies went haywire, mortgage rates jumped in the US, Treasuries and other bonds dove, junk bonds swooned, and bond funds took a serious licking.
Yet the Fed hadn’t actually done anything. They’d just palavered. And when they got scared and backed off, the entire world saw that they were marinating in their artfully concocted pickle. And none of this has anything to do with consumer price inflation – but with asset price inflation.
In Japan, the money-printing binge by the central bank has caused another problem: “The JGB market is dead,” announced with finality the chief bond strategist at Mizuho Securities, one of Japan’s 23 primary dealers that have to bid on government securities. It had been “sacrificed” by the BOJ, said another industry heavyweight. Read…. Bank of Japandemonium Killed And “Sacrificed” The JGB Market.
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.