by Ron Rimkus, CFA
There are lots of reasons that a bubble might occur. One often suggested reason is that animal spirits are to blame. As humans, sometimes we investors simply can't resist the temptation to participate as an asset's price starts moving upward. Can this explain market phenomenon like bubbles? It's possible. But it is far from the only explanation.
An important question to ask, let alone answer, is: How much of a bubble is caused by "irrational exuberance," and how much is caused by government intervention? Because government intervention into markets distorts the natural balance between supply and demand, it is an obvious place to start. So, any serious discussion of bubbles must ultimately separate investor behavior from government intervention. Importantly, government interventions into the economy distort price signals that market participants need to make decisions about where and how much to invest. So, much of what is blamed on animal spirits is really rational response to market information.
Of course, bubbles also get buy-in from market participants. In almost all cases, these participants buy into a kernel of truth, making the case for the upside plausible. For instance, at least in terms of recent history, Bubble 1.0, the dot-com bubble of the 1990s, had the wave of productivity unleashed by the adoption of the Internet. Bubble 2.0, the U.S. real estate bubble, had steadily rising U.S. housing prices creating the allure of an upside, with limited downside. And today's QE bubble holds that massive government monetary intervention (known as quantitative easing, or QE) is reflating the economy and strengthening financial markets.
Despite their many recent successes in averting market collapses around the world, today's central banks seem to act is if they had no hand in creating the market excesses that caused each crisis — and more recently, that there are no undesirable consequences to their easy money policies. While it is true that the government interventions of the past few years indeed avoided a massive debt deflation cycle, it is also true the these interventions themselves are changing the fundamental structure of the economy, as well as the expectations of its participants. In addition, maintaining interest rates near the zero boundary only encourages an arbitrary amount of debt creation and money supply growth — beyond what the market would do absent such intervention. Without getting into all the diffuse avenues of the global credit system, suffice it to demonstrate that a reduction of interest rates merely expands the demand for credit as illustrated below.
As illustrated in the graph, the equilibrium level of interest rates determined by free market supply and demand is demonstrated by i1. When central banks, like the Federal Reserve, reduce interest rates to, say i2, then the lower rate enables greater levels of demand to be satisfied in the market place. So, the quantity of credit increases from Q1 to Q2, with the difference being "excess credit." This excess credit then flows into demand for things like housing (through mortgages) and into financial assets through global trading platforms.
Money is like water: it goes where it wants to go, and you can never completely control it. What's different about this bubble is that it is not only larger than the previous bubbles, but also much more diffuse. The liquidity is now flowing into a much wider array of asset classes and geographies. Unlike the dot-com bubble or the U.S. real estate bubble before it, this bubble doesn't seem to have a single primary target — making its identification even more challenging.
The centerpiece of Bubble 3.0 is the Fed's massive QE3 campaign, in which it purchases a total $85 billion of U.S. Treasury, agency, and mortgage bonds per month (just over $1 trillion per year). Of course, there is recent speculation that the U.S. economy is improving and that the Fed will begin to taper their massive money printing.
To be fair, driving the value of the U.S. dollar down has indeed improved the current account balance in the U.S., reducing it to approximately 3.1% of GDP in 2012 from its peak of 6.1% of GDP in 2006. Moreover, the shale oil revolution in the U.S. will help mollify the impact of imported oil, thereby easing pressure on the current account deficit further going forward.
Nevertheless, the Fed's low interest rates are inducing the economy to ramp up debt — thereby increasing, not reducing, systemic risk. Of course, the Fed's actions do not stand alone. The Bank of Japan, the ECB, and the Bank of China have each unleashed a massive flood of liquidity as well. Collectively, these four central banks have increased their balance sheets by over $8 trillion since before the crisis of 2008. And many more central banks around the world are playing along to protect their export markets. So, where has all this liquidity gone? Let's follow the clues.
Of course, the U.S. government has famously bailed out a multitude of institutions and financial markets — dramatically escalating government debt in the process. Total U.S. government debt is rapidly approaching $17 trillion as illustrated in the graph below.
Sources: CFA Institute, St. Louis Fed.
In the last five years, the U.S. federal government has increased debt outstanding by $7.4 trillion dollars (ending in 1q-2013). Clearly, the Fed's massive ongoing purchases of longer-term Treasury, agency, and MBS securities gives investors the wherewithal to purchase these securities knowing that the Fed will be buying — if and when they choose to sell.
Today's zero interest rate policies and negative real interest rates make low-risk saving nearly impossible. Consequently, investors have to pursue more risk to achieve adequate returns on their savings. So, with the Fed buying so many government bonds, many investors have likewise bought government bonds knowing that the incremental demand by the Fed will push bond prices up in the short run. The trade-off is that these investors must also absorb greater horizon risk than they otherwise might in order to get adequate returns.
U.S. consumer debt is below where it was in 2008, confirming that the housing market is still not healthy — though that is almost certainly changing with the recent improvement in the housing market. Corporate debt is, however, considerably higher today-- more than $1.5 trillion over its nadir in 4q-09.
Nowhere has this risk-shifting corporate trend been hotter than in junk bonds. Strong demand for junk bonds has pushed yields down from more than 20% during the heat of the crisis to a low of just above 5%. Credit markets are showing increased volatility lately, so the yields have bounced a bit in the past few weeks. Although spreads are not quite at all time lows, the massive intervention in Treasuries has probably expanded the spread materially from what it would be in the absence of intervention. In other words, yields on Treasuries are lower from the intervention, while yields on junk bonds are probably free market based, thereby keeping spreads wider than might be warranted. Lastly, fund flows into junk bond funds have been increasing as well.
Sources: CFA Institute, St. Louis Fed, Merrill Lynch.
Of course, the Fed's massive purchases of securities is distorting the collateral markets as well. Recently, repo rates in money markets have again turned negative on a nominal basis. This is extraordinary. In effect, some money market funds are paying banks to borrow money, because the funds need collateral. This odd situation is clearly a direct result of the Fed's intervention.
In addition, U.S. real estate markets are currently experiencing a strong rebound. Prices in the U.S. are up about 10.9% year over year. There are also stories of financial firms making large investments into real estate — particularly in formerly depressed markets like Phoenix and Las Vegas. Now financial firms like BlackRock are sweeping in and buying large amounts of foreclosed homes and bidding up prices. The question isn't whether it is good or bad for BlackRock to do this. In a free market system, they should be able to make investment choices they deem worthwhile and then live with the success or failure that ensues. The question is: Would they being doing it if the Fed did not keep interest rates so low?
Lest you think this is just a U.S. phenomenon, think again. The QE-conomy is global. Not only is the U.S. real estate market reflating, but real estate markets around the globe are getting expensive. Clearly illustrated in a graph from a study by the Organisation for Economic Cooperation and Development, the median home-price-to-income ratios reveals the most expensive markets studied (in order) are:
- New Zealand
- The United Kingdom
This data compares the current price-to-income ratios to each country's own historical average. Among smaller or developing markets, some of the most expensive are:
- Hong Kong
Both Hong Kong and Singapore have enjoyed a meteoric rise in their real estate prices in the past 5 years with current price-to-rent ratios that would place them on par with Belgium and Norway. With the excess credit created by the central banks over the past several years, is it really any surprise that we see so many markets with expensive real estate?
Of course, many of us have heard about China's massive ghost cities. And yes, Chinese real estate prices are high by any standards. Nevertheless, there is a chance that they will avoid a real estate crisis so long as disposable income is growing more quickly than home prices — which has in fact been the case over recent years. However, if and when their economy stops growing or growth in disposable income cools, the housing sector will collapse.
Within Europe, the stronger, northern economies of Finland, Germany (especially Berlin), and Norway are attracting money from throughout the eurozone. So, global real estate markets are enjoying strong credit-fueled demand.
Consequently, investors have moved headlong into higher yielding asset classes like high-yield debt (junk bonds), asset-backed securities, emerging market debt, and greater financial leverage to improve returns. In short, investors are forced to take on more risk than they otherwise would and it is permeating a seeming endless list of markets. All over the world. This is Bubble 3.0 — the QE-conomy. If a bubble were truly a mass delusion of investors — driven by animal spirits — why is it happening at the same time in so many different countries and in so many different markets around the world?
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