U.S. capital markets are experiencing all-time highs across the board, the result of the longest sustained economic expansion in modern history. As with any long-running bull market, signs of froth have multiplied over time. The market is in the midst of an unprecedented “bull market in everything.”
Yet, the Federal Reserve, the authority responsible for moderating the business cycle and combating asset bubbles, has thus far proven unable unwilling to acknowledge the proliferation of warning indicators. In fact, the Fed appears to have become a chief contributor to the asset bubble.
Blowing bubbles
In late 2018, the bull market seemed to be running out of steam. At the time, most observers concluded that the Fed would attempt to pull off a “soft landing” for the economy, which is no easy feat. But, as trade war headwinds threatened to tip the U.S. economy into recession in early 2019, the Fed came under intense fire from President Donald Trump, who attacked Fed chair Jerome Powell’s more hawkish approach to monetary policy.
Cowed by Trump, the ostensibly independent Fed chair bent the knee to political pressure. Interest rate cuts followed soon after, reinvigorating the tiring bull market. Powell’s Fed has embraced its freshly dovish stance with gusto, injecting more than $400 billion into the financial sector via the repo market in an effort to boost liquidity. The Fed’s various actions have resulted in the growth of its already bulging balance sheet by roughly 10% in the fourth quarter of 2019 alone.
The Fed’s actions to inject liquidity into the market is, in effect, a renewal of the quantitative easing strategies employed by Powell’s predecessors during the course of (and carried on long after) the Great Recession. Yet, even if the Fed’s latest actions have managed to help juice up stocks and re-energize positive investor sentiment, such interventions – even big ones – can at best only keep the proverbial music playing for so long.
Blind to bubbles
Have the Fed’s massive liquidity injections really contributed to the inflation of an asset bubble? The answer to this question is an unequivocal yes, according to Michael Howell, managing director of CrossBorder Capital. Last month, Howell claimed that the U.S. central bank was responsible for creating the “bubble in everything.” On its face, it seems like a hard charge to deny, yet the Fed has tried to do just that.
The Fed does not deny all responsibility for the charging bull market. Last month, New York Fed president Bill Dudley made the case that equities and other asset classes have shot up as a result of broad economic strength (with, perhaps, a helping hand from lower interest rates), not liquidity injections. Thus, the rise in values are not the sign of a liquidity-driven bubble, but rather the natural continuation of a fundamentals-driven bull market.
Neel Kashkari of the Minneapolis Fed has echoed Dudley’s argument, as well as expanded upon it. On Feb. 11, Kashari argued that interest rates are only slightly accommodative and thus unlikely to deliver much of a boost to capital markets. Moreover, he downplayed fears about the risk of an asset bubble, opining that it is “hard to know in advance if you are in an asset bubble.”
Bubble trouble
While the Fed’s arguments are well made, they seem to fly in the face of observable reality. The claimed domestic economic strength is anything but certain. By Kashkari’s own admission, the Fed will likely return to cutting interest rates within six months. Yet, rate cuts are tools for bolstering a flagging economy. The fact that they may soon be necessary once again implies that the economy is not in such good form as the likes of Dudley and Kashkari claim.
There are few glimmers of hope outside the U.S. either. China’s economy has been hamstrung by the new coronavirus scare, and Japan’s is on the brink of recession. Claiming that the real economy is doing great under such circumstances is a tough sell.
Ultimately, despite all of the Fed’s protestations to the contrary, liquidity injections have effects on asset prices that are both observable and predictable. In virtually any circumstance, adding liquidity into a market will juice up asset prices. The Fed has done just that, and asset prices have climbed in response. But, as CrossBorder’s Howell has explained, liquidity injections tend to cause an exuberant high, as well as a painful hangover:
“A rising tide of liquidity floats many boats, but we know from experience that liquidity-fuelled asset markets usually end badly, as they did in 1974, 1987, 2000 and in 1989 in Japan. In this regard, the scale of recent Fed interventions needs to be understood. Last year, US markets enjoyed their biggest effective inflow of liquidity in more than 50 years, by our measures.”
Bubble fit to burst
While liquidity injections can push up asset prices and shore up market confidence for a time, their power to postpone an economic reckoning is not infinite. Unfortunately, it is not possible to know when the crash will come, only that it will.
With so many danger signals flashing, investors might be well served following the lead of such companies as Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), which has built an enormous cash reserve amidst the broader market hubbub.
Invest with caution!
Disclosure: No positions.
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