The Fed’s Legacy: Asset Bubbles and Lost Confidence

For most experts, failure is a learning experience that leads to a search for new methods. That’s not true for central bankers. When their policies fail, they try more of the same in the vain hope that quantity will make up for the lack of quality in their ideas.

In the past seven years, major central banks have created over US$15 trillion of new money, mostly through purchases of government bonds.

These money printing and bond purchase programs have been called QE1, QE2 and QE3 in the US, Euro-QE in Europe and QQE (quantitative and qualitative easing) in Japan.

All of these programs and exotic variations such as ‘Operation Twist’ have failed to achieve self-sustaining growth anywhere near former trends, and have failed to achieve the 2% inflation targets of those central banks.

When investors ask, ‘Where’s the inflation after all this money printing?’ my answer is, ‘Don’t look at the supermarket shelf; look at the stock market’.

In other words, we have not had much consumer price inflation, but we have had huge asset price inflation. The printed money has to go somewhere. Instead of chasing goods, investors have been chasing yield.

Part of this asset bubble inflation has to do with a flawed theory of bond/equity ‘parity’. The theory says that once you adjust for credit risk and term premium, bonds and stocks should yield about the same. Right now, safe ten-year Treasury notes yield about 1.65%.

Many stocks have dividend yields of 3% to 5%. Investors know that stocks are riskier than safe bonds, but how much riskier? Under the parity theory, investors can keep bidding up the price of stocks until their dividend yields get closer to 2%, leaving a small margin over bond yields to cover ‘risk’.

There are many flaws in this theory — including the fact that companies go bankrupt all the time, and boards of directors can and do cut dividends in recessions. But one of the biggest flaws is the complete disconnect between what’s driving bond yields in the first place.

If bond yields are falling because deflation is ruining the Fed’s plans to reflate the economy, is that a reason for stocks to go up? If bond yields are signalling recession, should you really be bidding up stock prices to extreme levels based on a theory of yield ‘parity?’ This behaviour defies common sense and economic history, but it’s exactly what we’re seeing in the markets today.

At some point, probably sooner than later, the reality of central bank impotence and looming recession will sink in and stock valuations will collapse. The drop will be violent, perhaps 30% or more in a few months. You don’t want to be over-allocated to stocks when that happens.

This analysis applies to more than just stocks. It applies to a long list of risky assets including residential real estate, commercial real estate, emerging markets securities, junk bonds and more.

It only takes a crash in one market to spread contagion to all of the others.

The inability of central banks to deal with crisis and the complete loss of confidence by investors in the efficacy of central bank policy.

The last two global liquidity panics were 1998 (caused by emerging markets currencies, Russia, and Long-Term Capital Management) and 2008 (caused by sub-prime mortgages, Lehman Brothers and AIG).

Another smaller liquidity panic arose in 2010 due to problems in Middle Eastern and European sovereign debt — caused by Dubai, Greece, Cyprus and the European periphery. In all three cases, central bank money printing combined with government and IMF bail-outs were enough to restore calm.

But these bailouts came at a high cost. Central banks have no room to cut rates or print money in a future crisis. Taxpayers are in full revolt against more bailouts. Governments are experiencing political polarization and there’s political gridlock around the world. There is simply no will and no ability to deal with the next panic or recession when it hits.

Consumer inflation expectations have fallen to the lowest level since late 2010 — not long after the last crisis — and the trend is clearly down, toward levels not seen since the depths of the panic in 2008: With central banks around the world doing everything possible to cause inflation (QE, ZIRP, NIRP, helicopter money, currency wars, forward guidance, etc.), what does it say about confidence in central banks that inflation expectations are falling, not rising?

The systemic dangers are clear. The world is moving toward a sovereign debt crisis because of too much debt and not enough growth. Declining productivity is the last nail in the coffin in terms of countries’ ability to deal with the debt.

Inflation would help diminish the real value of the debt, but central banks have proved impotent at generating inflation. Now central banks face the prospect of recession and more deflation without any policy options to fight it.

The impact of deflation and the strong dollar have caused a shortage of liquidity around the world.

Since private debt has expanded faster than central bank balance sheets, a dollar shortage has arisen as debtors scramble for dollars to pay back debts. This raises the prospect of a new liquidity crisis and financial panic worse than 2008.

Persistent low rates have not caused inflation, but they have caused asset bubbles, which threaten to pop and unleash a financial panic on their own — independent of tight financial conditions.

When this new panic hits — either from a liquidity shortage or bursting asset bubbles — investors will have no confidence in the ability of central banks to limit the panic. Unlike 1998 and 2008, the next panic will be unstoppable without extreme measures — including IMF money printing, lockdowns of banks and money market funds, and possible martial law in response to money riots.

You should have gold and other hard assets to weather this storm.

But you want to own gold now, before the next crisis strikes. It could be here much faster than you think.


Jim Rickards,

Strategist, Currency Wars Trader

From the Port Phillip Publishing Library

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James G. Rickards is the editor of Strategic Intelligence, the newest newsletter from Fat Tail Investment Research. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.

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