2000. 2007. 2011.
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world’s emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world’s emerging economies certainly have started to worry about what happens if all the hot money flowing into their economies and markets suddenly starts flowing out. “As long as the world exercises no restraint in issuing global currencies such as the dollar,” Xia Bin, an advisor to the People’s Bank of China said, “then the occurrence of another crisis is inevitable.” (For more about reaction to the Fed’s policy see my post http://jubakpicks.com/2010/11/04/everybody-loves-bens-600-billion-at-least-in-the-short-term/ )
I think some degree of worry—less than full panic but more than polite concern—is appropriate at this stage. And that worry should play a role in shaping your investment strategy as the decade advances. In today’s post I’m going to lay out the Whoops, the Fed’s done it again scenario. In a Friday post I’ll tell you what I think you can do about that danger.
In 2000 I’d say the sin was one of omission. The Fed sat on the sidelines aware that a stock market bubble was building but it did nothing to head it off. Remember then Federal Reserve chairman Alan Greenspan talked about “irrational exuberance?” Well, it was all just talk. The Fed, which had the power to try to moderate the bubble by tightening credit on Wall Street, believed that trying to manage bubbles was futile. All a central bank could do was watch from the sidelines and then help clean up the wreckage.
And quite a bit of wreckage there was. The NASDAQ Composite Index peaked at 5048.62 on March 10, 2000 and it bottomed at 1114.11 on October 9, 2002. That was a loss, top to bottom, of 77%.
Eight years after the October 2002 bottom, the NASDAQ Composite is up handsomely—131% from October 9, 2002 to November 5, 2010.
But ten years after the bear market began in March 2000 the NADAQ has barely recovered half its losses. From a high of 5048.62 the market has clawed back to 2578.98 at the close on November 5. That means the NASDAQ Composite Index is still down 49%.
I’d put the Federal Reserve’s role in the financial and economic crisis set off by the U.S. mortgage crisis in a different class. The sin here was one of commission. The Fed played an active role in creating this global meltdown and in making it as bad as it was. (Or maybe that should be “is”?)
To clean up the wreckage from 2000, the Federal Reserve lowered short-term interest rates. At the height of the NASDAQ in March 2000, the Fed’s benchmark rate was 5.73%. The central bank kept rtes above 5% for another year—the benchmark rate was at 5.47% on March 7, 2001—but then it began to cut—and fast. By March 6, 2002, short-term rate were at 1.74%, and by the end of 2002 they were just 1.23%. By July 2003 the Federal Reserve had cut them even lower to 0.96%.
And there they stayed. For too long, the Fed now admits. A year later on June 30, 2004, short-term interest rates were just 1.11%.
That marked the turn in the cycle. Finally. In July the Federal Reserve began to raise interest rates, even if very slowly. By the end of the year they were at 2.27%. By November 2005, they had finally reached 4% again. And by June 2006 short-term rates crossed the 5% barrier.
But by that time, the low interest rates that had been intended to help clean up the wreckage of the bear market of 2000-2002 had set off their own real estate and lending bubble.
In the fourth quarter of 2002 when short-term interest rates were 1.23%, the real median price of a house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005 the real median price was up to $262,634. That’s a 33% increase in the median price of a house in just three years—without inflation. That’s extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. Possible to buy and flip for a quick profit. Refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn’t ask questions about your income or credit record.
By 2006 this price appreciation had peaked. The median real price of a house that year ranged between $250,000 and $263,000. But by the second quarter of 2007 it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That’s a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (Since the house they live in is by far the most valuable asset most families own and since home ownership rates in the United States are much higher than stock ownership rates, a 36% drop in housing prices is more devastating for most families than a 77% drop in stock prices.)
That track record suggests that “What me worry?” isn’t a reasonable response to the Federal Reserve’s two rounds of quantitative easing. The first round, that ended only this spring, saw the Fed buy $1.7 trillion in Treasuries and mortgage backed securities. The new round announced last week would add an additional $600 billion of Treasury buying to the total.
The dangers of these two programs to the U.S. economy are scary enough. The Federal Reserve is buying all these debt instruments on the cuff. The Fed doesn’t actually have the money to pay for these purchases. Instead it is creating dollars out of thin air—printing them, figuratively at least—and at the same time creating a huge liability on the Fed’s own balance sheet. Of course, the Fed may be able to pay off that liability by selling the bonds back to the market some day, but you’re entitled to wonder where the buyers for $2.3 trillion in U.S. debt and mortgage-backed debt are going to come from.
If you’re the kind of person who worries when they see a big debt and no obvious way to pay it off, then the Federal Reserve’s current balance sheet undoubtedly worries you.
But even if you shrug off the Fed’s balance sheet, the Fed’s current course presents, what shall we call them? challenges for the U.S. economy. That $2.3 trillion in quantitative easing is potentially inflationary: pumping that much money into the U.S. economy will, eventually, push up the pries of things and assets. (Which in the short run is what the Fed wants as long as the gain in prices is no more than 2% annually. Good luck fine-tuning that one.) Putting $2.3 trillion new dollars into the world weakens the U.S. dollar making imports more expensive and driving down the U.S. standard of living. At some point that $2.3 trillion also drives up U.S. interest rates because you’re got to pay people (mostly overseas people who are already holding a lot of U.S. dollars) more to take all those dollars and those higher interest rates will reduce the growth rate of the U.S. economy.
But those aren’t the possibilities that worry me most or that have overseas central bankers screaming in protest. The big problem is what happens to that $2.3 trillion in dollars created by the Fed. They certainly don’t all stay in the United States, of course. Would you, if you were a self-respecting dollar stay here earning 0.12% (the yield on the three-month Treasury bill) or even 2.53% (the yield on a 10-year Treasury bond) when you could go overseas and earn 10.75% on Brazilian debt, or 6.5% in Turkey, or 4.75% in Australia? Would you stay home buying real estate in a market that’s barely begun to show a quiver of life or plunk yourself down in Hong Kong or Mumbai or Rio? Would you stay loyal to U.S. stocks, knowing that the U.S. economy is growing at 2% a year or go cavorting off to join the fast company in China or Brazil or India?
Yes, indeedy the really big asset bubbles that the U.S. Federal Reserve may be creating now aren’t at home but overseas in the stock markets of Indonesia, in the real estate markets of India, in commodity prices in Australia. Everywhere the flood of dollars created by the Fed might wash up next.
And since many of these asset markets aren’t anywhere near as liquid as those in developed economies $2.3 trillion can create a huge problem. India is thinking of slapping on currency controls because so far in 2010 the country has seen a record inflow of $25 billion in overseas cash from stock funds into Indian equities.
$25 billion? When the Fed is talking about $2.3 trillion?
Part of the reason that overseas central banks are squawking so loudly is that it’s not clear what they can do about the problem. The flood of dollars is creating dangerous inflation of 8.5% in September so the Reserve Bank of India raises interest rates to slow the Indian economy? Besides the hardship that visits on the poor of India who need the jobs that faster economic growth provides, raising interest rates just makes your country a more attractive destination for all those dollars looking for a home.
The nightmare, of course, is that those dollars could flow out as quickly as they flowed in. That’s exactly what happened in the Asian currency crisis of 1997. Most of the world’s developing economies are in better shape and less dependent on external cash flows than in 1997 but these economies certainly aren’t immune to disruption.
And even if they don’t go the way of Thailand in the 1997 crisis, a huge outflow of hot dollars would send asset prices plunging with who knows what effects on national financial systems and capital markets. Look what the mortgage crisis did to Lehman Bros., remember them? The mortgage crisis caused what were comparatively liquid and large markets to freeze tight. Financial and non-financial companies couldn’t raise even overnight operating capital.
No wonder that someone like Brazil’s finance minister Guido Mantega said with resigned anger: “Everybody wants the U.S. economy to recover, but it does no good at all to just throw dollars from a helicopter. You have to combine that with fiscal policy. You have to stimulate consumption.”
Fiscal policy? From a U.S. Congress? I wouldn’t hold my breath. Congress punted on fiscal policy decades ago. Even the Clinton administration’s vaunted (and real) budget surplus was achieved by a deal between the Secretary of the Treasury and the chairman of the Federal Reserve. If the politicians in Washington were capable of conducting fiscal policy, the Federal Reserve wouldn’t be implementing policies like quantitative easing. Ben Bernanke and company know exactly how dangerous this course is. But what’s the choice?
In another post on Friday, I’d take a whack at figuring out what you and I, mere investors, can do to protect ourselves if the Fed is indeed doin’ it again.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/