About this week’s show:
- What is a credit bubble?
- How misallocation of capital distorts market pricing
- What you can do about it
About the guest: Doug Noland served as senior portfolio manager of Federated Prudent Bear Fund, Federated Prudent DollarBear Fund and Federated Market Opportunity Fund. With more than 20 years of investment experience, he leads the nine investment professionals who comprise Federated’s Alternative Equity Management Team. Before joining Federated, Doug was employed with David Tice & Associates, Inc. where he served as an assistant portfolio manager and strategist.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We are talking about the stability of the global financial system. We are talking about confidence in the heart of money and credit. And the thought that we can go out and endlessly inflate trillions of dollars of credit – and these are just basically electronic IOUs, that’s all they are, they’re just journal entries – and pretend that that is real wealth, again, history will not be kind.”
– Doug Noland
Kevin: Our guest today, Dave, Doug Noland. It’s rare for us to have a guest on two weeks in a row, and this is week one of a two-week show.
David: I have a confession, and that is that I do keep secrets. This particular secret is Doug Noland. We don’t talk about the Credit Bubble Bulletin all that often because the resource is so valuable to me. I almost treat it like my precious little source of data analysis (laughs).
Kevin: So when people say, “So Dave, you came up with that yourself?” You don’t want to have to tell the truth.
David: If they ask directly, I’ll be more than happy to, and I’ve given him credit, saying Doug Noland says this and such, without connecting all the dots back to the Credit Bubble Bulletin.
Kevin: Sure, even last week.
David: The Credit Bubble Bulletin comes from a certain background. Doug began as a CPA and Treasury analyst, and then went to work in the hedge fund industry for about nine years with Gordon Ringoen in San Francisco, with Bill Fleckenstein. He did some writing with someone who is very well known, I think, in the credit space, and that is, Dr. Richebacher. And then he spent 16 years with David Tice, where Doug managed the Prudent Bear funds, both in Dallas, and then ultimately with Federated in Pennsylvania. That was then, this is now.
Shorting has been his expertise going back to the nine-year experience with Gordon Ringoen in the hedge fund space. So he thinks like a CPA, he thinks like a Treasury analyst, he thinks very analytically about all the things that serve as signs and indicators of a change in the marketplace which is relevant to a trigger point when he should be short the market.
Kevin: I think we probably ought to bring up, for the listener who is not familiar with shorting the market, that’s just a way of saying, “Look, I think the market is going to go down. I want to make money on the downside, not necessarily on the upside.” This has been an area of specialty of Doug Noland’s, virtually, his entire career.
David: It means that you have a sensitivity to fragilities. It means that you have an eye for dislocation. It means that you have a nose for things getting out of line relative to history, and relative to what an economy can sustain. So, yes, it is a valuable resource for me, the Credit Bubble Bulletin, it’s worth reading. I used to go to the Prudent Bear website every day, and I don’t go to the Prudent Bear website at all anymore because…
Kevin: Doug’s not there.
David: Doug Noland took the value of going there every day with him because he was the value, in my humble opinion.
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David: Just as a bit of background, maybe you could share with us, you’ve been doing the Credit Bubble Bulletin since the turn of the century?
Doug: 1999.
David: 1999. Okay, so just before. Tell us a little bit about your theoretical framework. Explore, if you would, the lens through which you see things.
Doug: Sure, and thanks a lot for having me, David. It’s a treat to be here with you. My framework goes back to the early 1990s. I was working for a hedge fund out in San Francisco, a bearish hedge fund manager. We were professional bears. My first year in the industry was 1990. We had just phenomenal success. We were the geniuses. We had it all figured out, the economy was going into recession, bear market, we were going to be rich.
Then you had 1991, all of a sudden the markets rallied, and I started to try to understand how an impaired banking system kind of morphed into this new age financial system, driving not only the prosperity in the 1990s, but this phenomenal bull market. So for me, it was an obsession. It really was an obsession to try to understand what was going on in finance, what was changing to fuel the boom. My attention went to asset-backed securities, mortgage-backed securities, Fannie and Freddie, and we were totally changing finance, we were moving away from the traditional banking system and bank lending driving finance to Wall Street finance. I just thought that this was an incredibly interesting period of time, interesting development in the markets.
And then we started to have this wild financial volatility, we had the bond market, bear market in 1994, Mexican collapse, Southeast Asia. And then in 1998 you had Long-Term Capital Management and the collapse in Russia. These were spectacular booms and busts and I was convinced that this new finance was fueling these booms and busts, yet there was very little talk about any of this. The talk was still that only banks trade money, that banks drive credit, that the Federal Reserve controls all of this, and I was saying, “No, no, it’s completely different than that.”
So that’s why I started writing my blog, I thought there was just this historic evolution in finance, this transformation that was getting very little attention. I started my blog, I was trying to title it, and then I decided, The Credit Bubble Bulletin, and I’m just going to chronicle this, and I thought maybe that Bubble would be in the title for a year or two. In 1999 I was convinced the bubble was about ready to burst. That bubble did burst, but then we had a new bubble, and in 2002 I started warning about the mortgage finance bubble, but never did I imagine we’d be in 2016 and I would still have the bubble in the title of my blog, and I would still be calling another bubble.
David: And Janet Yellen, as recently as April of this year, has said that our economy is on a solid course, it is not a bubble economy. So clearly, there is a contrast between the glasses through which she sees the world and the glasses through which you see the world.
Doug: Absolutely, and I remember the same comments in the 1990s – the new paradigm, this is an age of financial stability. We certainly heard a lot of that during the mortgage finance bubble period, that policy-makers were enlightened and that they had created a more stable environment. I just look at the situation as, we have this huge, huge bubble in securities, the biggest bubble ever, and it only appears stable because the central banks now are completely back-stopping it, with zero and negative interest rates, with QE, which is, essentially, money-printing. We have over two trillion annualized QE in the world today. So, to me, it is a very unstable system that central banks, so far, have been able to sustain, and they are only sustaining it by making the bubble larger.
David: That is a reminder that there is a huge presumption, on their part, of control. What would you say that they can control versus what they think they can control?
Doug: If this gets back, even to the 1990s, in the early 1990s the banking system was impaired. At Citigroup there was talk of it being insolvent. Part of what happened is, we had this non-bank credit growth – Fannie and Freddie and mortgage-backed securities, etc. – and the Greenspan Federal Reserve encouraged this growth because the banking system was impaired, and this securitized finance kind of got away from them. So they can only control it by incentivizing the hedge funds to leverage, to incentivizing money to continue to flow in today to bond funds, even though the yields are so low.
So they’ve been able to control market expectations, and how they do that, we saw that in 2012 when Draghi came forward and said that the ECB would do whatever it takes, but actually, he wasn’t speaking for the ECB, he was speaking for central bankers all over the world. And now we’ve seen the Bank of Japan, we’ve seen the Bank of England, we’ve seen the Chinese Central Bank, we’ve seen the Fed, basically say, “We will do whatever it takes to ensure there is not a crisis, to ensure there is not a bear market, to ensure there is not a recession.” And so far the participants in the market believe that’s true, and believe that QE goes on indefinitely to levitate the markets.
David: Is it the understanding of your average market practitioner that there are no negative consequences from that, or do they not care because the future is the future, and the present is the present, and it’s only worth trading dollars in present terms, let the future sort itself out?
Doug: Yes, I think it is short-termism, everywhere. I think most people in the market know this is an unhealthy dynamic with the central banks, but the focus is performance that month, performance that quarter. In the financial markets, if you perform poorly, you don’t have much of a career. So we see that for investors, portfolio managers, financial advisors, hedge fund managers. Everyone has to play the game today or they have to find something else to do with their careers. It’s a very unhealthy dynamic, but that’s how it has evolved.
David: It seems odd to me – we’re now in 2016, we had Ben Bernanke talking about an exit strategy for the Fed from their extraordinary policy measures back in 2011, and as an add-on to that last question, why don’t market participants seem to care about the reliance on monetary policy experimentation in order to maintain the status quo? Are you boiling it down to self-interest? Is it that there is an outside faith in the Fed, that is they’ve done this, clearly, they’ll do even more if called upon? I don’t understand the rationale because it seems like it’s one desperate measure to the next and market participants aren’t seeing them as desperate measures at all.
Doug: Yes, it’s all become normal, I guess. Back in 2011 the Fed made public a very detailed exit strategy, and I think at the time they planned on winding down their balance sheet growth, normalizing interest rates. But at the point, and I archive all my old articles, and I titled one of my bulletins “No Exit” because I thought it would be impossible for them to shrink their balance sheet that had grown to 2.1 trillion dollars. But I’ll tell you, in 2011 when I wrote “No Exit” I did not imagine the balance sheet instead of going back below a trillion was on its way to 4½ trillion.
If you stand back and look at what has happened, it has been unimaginable that these central banks have inflated credit this way, and we’re at a point now where the bubble is so big, and at least the sophisticated operators, a lot of the hedge fund managers, know the bubble is so big, they know central banks are trapped and they have no choice but to back-stop the markets and to continue to inflate securities prices. So that’s enough to keep players playing the game.
There can be a lot of money to be made at the end of a speculative bubble. We can think back to 1999. That’s the way these bubbles work. It gets crazy at the end, people lose a lot of money, but in the meantime some people can do pretty well, and if you don’t participate, you’re in trouble.
David: It’s like the alchemists of old which dreamed of creating gold, or money, from dirt. You have modern central bankers who have done one better. They can take modern money or credit – they can create it from nothing. It doesn’t even require the dirt.
There is a certain set of ideas that are popular among central bankers. I spoke to one British central banker six months ago who casually said, “Look, you can expand credit, you can expand your balance sheet indefinitely. It’s not a precursor to inflation because it will be sterilized.” So this idea that somehow what they’re doing does not have a consequence because they have a mechanism or a tool to take away the bad consequences – is it realistic?
Doug: I think future historians will be unkind. It will be very difficult to comprehend how this happened. As I said, in 2012 things turned – let’s just say crazy, where central banking completely took over global markets. For me, I mentioned I thought the tech bubble burst back in 2000-2001. In 2002 I had to change my tune, and that’s when I began warning of the mortgage finance bubble. Why? Because the Federal Reserve, specifically, was targeting mortgage credit to reflate the whole economy after the bursting of the tech bubble. I knew this was going to lead to pricing distortions in mortgage credit, housing inflation, and self-reinforcing speculation in the markets, especially mortgage credit.
When that bubble burst in 2008 I thought it was over. Well, in 2009 I had to change my tune again. I think it was April 2009 when I first started warning about the potential emergence of what I called the global government finance bubble, which to me was very troubling, because mortgage credit, it was dangerous to distort mortgage credit the way it was done, with all the government back-stops. What central bankers were doing, the Bernanke doctrine, basically, wanted to inflate security market prices, wanted to inflate central bank credit, wanted to inflate government debt.
So this bubble has gone, not only global, because we’ve exported these types of excesses, it has gone to the heart of money and credit. What we have been doing is inflating central bank credit, government debt, the heart of the credit system, the heart of money, what people in the past have trusted, and for me, that’s the most dangerous type of a bubble. If you have a bubble in, let’s say, junk debt, that can be problematic. You can have a boom there. But you get to a point where that credit is risky, the market knows it’s risky, there is a limited demand for that type of credit, that bubble will not turn systemic. The mortgage finance bubble was much closer to money, people trusted the GSE credit, they trusted mortgage-backed securities, they trusted that government would back this debt.
So that bubble ran for years, went to incredible excess, became very systemic, in fact, in much more of the whole economy. The global government finance bubble, as I said, has gone to the heart of the money and credit, it has gone global, and I fear when this bubble bursts, the consequences are immense, they are enormous, profound. Because if people don’t trust central bank credit, don’t trust government debt, then they are not going to trust finance generally. That’s the type of credit crisis that could be global. The excesses in China have been extraordinary. So this bubble is much more troubling to me. I was very nervous in 2007 – much more nervous today. That any central banker can talk about this type of credit expansion not having consequences is really hard for me to listen to, to believe.
David: So we’re talking about the global government finance bubble, and it would appear that bubble dynamics don’t disappear. With intervention, they simply move up the food chain. When you have gotten to the government finance bubble, what comes after the government finance bubble? Are we at the top of the food chain?
Doug: Yes, that is my fear, and there is a lot of interesting theory with bubbles. They can go on for a long time, and that’s where we are today. The bubble has been going on for 25-30 years, so of course, after that long of a period it seems like it can go on forever, but when you get to the end of the line, when you’re inflating government debt and central bank credit, again, not only when that bubble bursts is there an inevitable crisis of confidence, how do you get the next bubble? Because for each bubble to reflate the collapse of the old bubble, it has to be bigger.
I don’t know how the next bubble is bigger. Not only have we gone to the heart of money and credit, we’re going to probably have three trillion dollars’ worth of credit growth in China this year. The fact that the global bubble went to China and the emerging markets – they were the global locomotive for the recovery after the collapse of the mortgage finance bubble back in 2002, 2008, 2009. So it’s very difficult for me to see where the inflationary fuel can come from for the next bubble, which leads me to believe we will have QE almost indefinitely until the markets just lose faith in that type of credit.
David: It’s almost like financial rules don’t exist. You look at the bubble dynamic in government finance and the game-changer in the last couple of years has been seeing central banks take zero rates, which being at the zero bound was pretty impressive, and then all of a sudden we went negative. Now you have the Financial Times reporting over 13 trillion dollars in negative-yielding paper. Again, it’s like financial rules don’t exist. If you think you understand the limits of a bubble, then all of a sudden the rules are changed, rates don’t have to be positive, they can be negative. Now the question might be, how negative can they go?
That is a question I have for you. How negative can rates go before you begin to distort investment perceptions of the paper they’re investing in, and change their behaviors, in terms of why they would want to own that paper anyway?
Doug: Yes, another excellent question, David. Part of this new finance that I began chronicling back in the late 1990s was asset-based finance. This is new credit going specifically into the asset markets – mortgages, stocks, bonds. That is very seductive credit because when the mortgage goes into those inflating assets, the higher asset prices leads to more credit growth, the more credit growth leads to higher asset prices, more wealth creation, the economy grows, and it almost seems miraculous. Actually, it does seem miraculous. But this type of credit is very unstable. We saw how this works with tech stocks. It doesn’t work well in reverse.
We saw how it worked in 2008/2009, when all of a sudden you have a contraction in credit, you have falling asset prices, and it is self-feeding on the downside. How is that rectified? Zero rates that have turned negative, the QE going into the market directly and purchasing bonds, it started off in sovereign bonds, it has gone to corporate bonds, it has gone into equities, at least in Japan. And these negative yields, really, are just an inflated price for all of these bonds, and that keeps this credit game going. The problem is, if you have a reversal in the bond market, and I think there is an enormous amount of leverage that has built up in the bond market, then you have an immediate problem.
So right now, central bankers are trying to eliminate the possibility of higher yields, lower bond prices, and this de-risking, de-leveraging dynamic, but all this has done is to create a much larger speculative bubble, and now I think we’re seeing enormous distortions that these negative interest rates are causing, distortions in the derivatives markets. Keep in mind that interest rate derivatives are the largest derivative market in the world. You literally have hundreds of trillions of dollars in interest rate derivatives, and I think there is a huge underlying dislocation in that market.
I think it has caused a lot of leverage to be created, a lot of liquidity being created in the derivative markets that has now fed into the emerging markets, it has fed into the corporate debt market, it has fed into equities, so these negative interest rates are causing huge distortions, a dislocation in the government debt markets, derivative markets, and just a bigger securities bubble that has gone global, it’s gone into basically all asset classes, and it is now deeply systemic, unlike any bubble we’ve had in history.
David: We see this change in investor expectation as the bedrock of finances has shifted, people buying stocks for yield, not for capital gains. You have people buying bonds for capital gains, not for yield. And a confusion of priorities in terms of what goes into a portfolio and for what purpose. They’ve had to change their expectations because of central bank tinkering with the economy. You look at the Chinese, and you’ve seen massive interventions in the marketplace, you have the biggest sectors in the economy controlled by the government.
The question I have is, if you change the nature of the economy to a Chinese version of capitalism, with command and control dynamics as dominant features, can you manage the consequences of credit excess? Is there an end to it, when you control the media, when you control the SOEs – through the state-owned enterprises you can also create new special purpose vehicles and take all the garbage that is collecting in terms of bad debt, bad promises, bad businesses, just wrap it all up into a toxic waste dump. We did a little bit of that with Maiden Lane I and II, but the Chinese seem to be experimenting with it on an even grander scale. Who is to say that the new version of capitalism doesn’t have these command and control dynamics and we just have to get used to the new world?
Doug: (laughs) I’ll say right up front, I hope I’m way too dire, I hope this analysis proves laughable. I would love to be wrong on this. As a macro-analyst of money and credit, I look at what has unfolded in China, and I’ve been following this closely now, documenting this for years, I am in awe of what has unfolded there. The Chinese used to speak, not that many years ago – they really studied the Japanese experience and the Japanese bubble, and they used to comment publicly that they had learned a lot of valuable lessons from Japan, that they would not repeat those mistakes. Well, their bubble got completely away from them, at the end of the day they learned nothing, the excesses started to grow, and then they pushed the panic button back in 2008-2009, had a massive inflation, a 600-billion dollar stimulus, I believe, and they haven’t been able to turn back. Several times they have recognized the excesses in real estate and credit. They’ve gone in, carefully tried to rein in excess, and the longer a bubble unfolds and inflates, the more aggressive the reining is that is necessary to end the bubble. They were not willing to take hard action and it got completely away from them.
There is some belief that they can manage their situation, they can recapitalize their banks, they can take the bad loans off the balance sheets of the banks, set up these new entities. There is a massive growth in their off-balance sheet, wealth management vehicles. Well, at the bottom line in a credit bubble, China needs three trillion dollars of credit this year to sustain this distorted economy, to sustain inflated asset prices, to sustain the bubble. That three trillion of credit this year is going to be very, very unsound. You cannot inflate your way out of a bubble like this. And I would argue – I call it the terminal phase of excess at the end of the bubble and that’s when policy-makers get cautious because they don’t want to pierce the bubble because the risks are more obvious.
That is exactly when you need aggressive intervention because your systemic risk grows exponentially because you are growing credit rapidly, and the quality of that credit is deteriorating rapidly, so it’s a very dangerous situation where you can really destroy your credit system in a relatively short period of time. In the 1980s Japan basically destroyed their credit system in about three-and-a-half years. After doing miraculous things for a few decades they destroyed their system in a few years. We saw a trillion dollars’ worth of subprime mortgage CDOs in 2006, which almost destroyed the financial system. So I do not believe, at all, that this is under control in China, that they have a model that they can manage these types of risks. In fact, this is the most dangerous bubble in history unfolding in China right now.
David: Is there anything to suggest that, at this stage of the game, the stakes are so high, and politicians have not been willing to make the hard fiscal choices along the way, and have allowed for excesses to increase, and for monetary policy to be used as a primary tool to try to meet the challenges of the day, is there something from history that suggests that at this point we see political solutions, not financial and economic solutions? Let’s say, designating a loss. You’re the chosen loser today.
Doug: Yes, and I was going to reference the ex Dallas Fed President. Richard Fisher used to talk about the law of holes. If you find yourself in a hole the first thing you do is you stop digging. For me, a solution right now is to try to end the impairment of money and credit, try to get the governments, the central banks, out of the markets, to quit distorting the debt markets and equity markets, and that would cause a significant dislocation in the market and in the economy, but we’re on a path right now where we’re going to have a crisis of confidence in all of credit. So you need dramatic steps right now to try to at least get us on a more sustainable path. I certainly don’t see that coming from politicians. This is an argument that goes back a couple of hundred years as far as, do you want discretionary central banking or do you want rules? The debate early on was, the problem with discretionary central banking, monetary management, is that one mistake will inevitably lead to more mistakes because there is not an acceptance of previous mistakes, and central bankers will try to inflate their way out of the problem, which only compounds the problem, and that is where we are today. This is just compounding problems that have been developing for decades.
David: So if you find yourself in a hole, stop digging. Fisher’s law of holes (laughs). I like it. I’ll tell you, this opinion is certainly in contrast to a discussion we had with Richard Duncan a few weeks back in which he would say, we need an expansion of credit to the tune of about 2.2% at net of inflation in order to avoid recession. And if we don’t continue to feed the credit machine – you mention the Chinese need three trillion dollars in new credit to sustain the bubble, well, that’s more of a global issue. Looking at just the domestic problem here in the United States, we need to expand credit, whether it is private, corporate, or governmental, to these numbers, or we see recession. Fisher would say, “Listen, if you’re in a hole, stop digging,” and you would say, “Look, you’ve got to wrap your arms around the problem, not keep on adding to it and pretending it doesn’t exist.”
Doug: Right. And there needs to be some discussion of what the stakes are. We are talking about the stability of the global financial system. We are talking about confidence in the heart of money and credit. That needs to be protected. The thought that we can go out and endlessly inflate trillions of dollars of credit – and these are just basically electronic IOUs, that’s all they are, they’re just journal entries – and pretend that that is real wealth, again, history will not be kind. You have to wean your system off of this type of credit addiction, this dependency. To throw out a couple of numbers, back in the 1990s, and there were excesses in the ’90s, but the U.S. economy depended on 600-700 billion dollars of nonfinancial credit growth. We needed that amount of new financial claims to drive that economic structure. By the time you get to 2006, even 2005, that credit dependency is up to almost 2½ trillion dollars. Why? Because you inflated asset prices, you inflated incomes, you inflated corporate profits, you distorted your whole economy to where you have to keep feeding it with new financial claims. In China, as we mentioned, they’re up to 3 trillion.
The problem is, you cannot continue to inflate financial claims in that environment and expect those financial claims to be sound in the marketplace, inevitably. That’s what we have to start thinking about and protecting and immediately reduce the amount of credit in the economy, reduce the distortions. There is no alternative than a really difficult recession, unfortunately, because the economy will not respond well to less credit – here, China, or elsewhere. But again, if we want to get onto a sustainable course going forward, that is how it has to begin, is to reduce the credit addiction, because again, that is the financial inflation, the credit inflation, that will come back to haunt the system when people do not trust that credit.
David: So what you’re really talking about is a confidence game, and there has been a tremendous amount of confidence that has been assumed in the world of money and credit, and that confidence, to some degree, has been abused following the end of the Bretton Woods agreement, going back to 1971, where for the first time in world history we had a money system which was devoid of any real, tangible anchor. And now you have an entirely free-floating money system that has allowed for the expansion of credit and credit as money to grow exponentially, without bounds. You layer into that what you described earlier as a sort of morphing of the markets in the 1990s, moving away from bank finance to Wall Street finance.
And it seems like we’re accommodating, and accommodating, and accommodating, these unhealthy changes. But on the one hand, it has given us more economic activity, more economic growth, but it has come at a cost, a future cost, because that’s was debit is, right? Something that you have to pay in the future. We’ve had a certain economic advantage in the present, but there is a price to pay for that, that is, the stock of debt which has to ultimately be paid back.
Doug: That’s right.
David: Now, you have the assumption by central bankers and governments that it doesn’t matter how much debt you go into because you can always inflate it away. So you have at odds what is in the interest of the people, and the interest of central bankers, which is, we would prefer stable prices, not inflated prices, and yet they know that they can abuse the system of finance, creating excess credit, not worried because eventually they will inflate it way. And now they are in this strange scenario where, attempting to create inflation, they are unable to. What do you think keeps central bankers up at night as they try to create inflation, and haven’t been able to thus far
Doug: I think they stay up late at night because they know they’re in an experiment, there has been nothing like this in the past, and it has not worked as they expected. Again, they were talking exit strategy in 2011 and here we are today.
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Kevin: Dave, as we said in the beginning of the show, we’re going to have a second show where we’re probably going to be a little bit more recommendation-oriented. Listeners oftentimes say, “Okay, well, that’s fine, I understand the economy is in wicked bad shape, but what do I do now?” And Doug has always been able to come up with some overall macro-economic solutions to a portfolio.
David: That’s right. We’ll continue the conversation from this week, and hopefully explore some of the practical elements of investing in this environment.
