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This Is Not a Rally... It's a Credit Bubble of Epic Proportions

April 08, 2013
"An explosive rise in asset prices always generates concern that a bubble may be developing and that its bursting might lead to broad and deep economic distress."

– Fed Governor Frederic Mishkin, August 2007

On Friday, the Bank of Japan ushered in a new era of monetary stimulus.

Under new governor Haruhiko Kuroda, and under massive pressure from new prime minister Shinzo Abe, the BoJ promised a $1.4 trillion debt monetization program.

This will start next year and will double the country's monetary base (currency in the hands of the public plus commercial bank deposits at the Bank of Japan).

Following the news, the Nikkei 225 ended the session up 1.6%. The yen fell more than 2% versus the dollar, and 4% versus the euro. And the yield on the 10-year JGB hit a record low.

We are in uncharted territory regarding monetary easing. We are living through a giant academic-led monetary experiment – the largest in history by far – that is being pursued without regard for the potential for nasty unintended consequences.

The central banks of the "big three" developed economies – the U.S., the EU and Japan – are now committed to doing "whatever it takes" to keep bond yields low. They have no choice. If yields go higher, stock market gains will evaporate and rising interest costs on sovereign debt would put huge pressure on governments. We would see another giant asset bubble deflate and have no monetary "ammo" in reserve to ease the pain it would cause.

Relative to the size of its economy, the BoJ's stimulus plan is now even more intense than the Fed's. As Japan bond bear Kyle Bass points out, "The BoJ is now monetizing at a rate around 75% of the Fed on an economy that is one-third the size of the U.S."

What many don't understand, or don't want to see, is that in Japan (and in the U.S.), this stimulus is not reaching "Main Street" by way of bank lending. Although the monetary base is rising, wider measures of money supply have been flat or are falling.

This means that credit easing ends up exclusively boosting asset prices (most notably, equities) by way of cheap leverage, margin buying and "carry trades."

But the fundamentals are not keeping up. As former Reagan budget advisor David Stockman pointed out in a recent piece in The New York Times, "State-Wrecked: The Corruption of Capital in America":

"Since the S&P 500 first reached its current level, in March 2000, the mad money printers at the Federal Reserve have expanded their balance sheet sixfold (to $3.2 trillion from $500 billion). Yet during that stretch, economic output has grown by an average of 1.7% a year (the slowest since the Civil War); real business investment has crawled forward at only 0.8% per year; and the payroll job count has crept up at a negligible 0.1% annually. Real median family income growth has dropped 8%, and the number of full-time middle-class jobs, 6%. The real net worth of the "bottom" 90% has dropped by one-fourth. The number of food stamp and disability aid recipients has more than doubled, to 59 million, about one in five Americans."

Of course, Stockman's views have gone down like a lead balloon in the corridors of power and in the mainstream media – which abhor his hard-money views and which cling to a painless Keynesian solution to the 2008 credit collapse.

What should you do in the current environment? Exercise extreme caution. Try to think independently of the crowd. And remember your history...

As barometers go, stock markets, under conditions of high levels of margin borrowing and other forms of leverage, are less than perfect. Otherwise, the much-feted 1929 rally would not have happened – a full year after commodity price deflation had set in.

Fast-forward to 2013, and we see that the three best-performing sectors in the U.S. equity rally are the anti-cyclical and defensive health care, consumer staples and utilities (with an average year-to-date gain of 14%). The three worst-performing sectors are the highly cyclical and growth-sensitive materials, tech and energy (with an average year-to-date gain of less than 3%).

This is not a rally. It's a credit bubble of epic proportions.


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