Oct 30, 2009

Big Crash Coming?

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In More Like A Depression Every Day, I described strong deflationary pressures in the American economy despite the Shock & Awe fiscal & monetary stimulus being applied. The flow of free money is supposed to counter deflation by boosting both asset values and government spending. Economist Nouriel Roubini, otherwise known as "Dr. Doom", notes that this "wall of liquidity" is inflating asset values, not just in the United States, but all over the world.HTML clipboard

One important consequence of the Fed keeping interest rates low and its quantitative easing has been a weaker dollar. The world's reserve currency has depreciated 14.6% relative to a basket of other currencies since March 5, 2009 as measured by the U.S. Dollar Index (DXY). The depreciating dollar, combined with the Fed's stated intention to keep interest rates low for an extended period to come, has prompted investors to short the dollar—bet that the value of the dollar will continue to fall. Investors short the dollar via what is called the carry trade (and Figure 1 right).

...In absolute (2005 chained dollars) terms, real GDP is down 9% year-over-year, even after you throw in the "cash-for clunkers" program which gave an artificial boost to personal consumption expenditures.

A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That's another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Putting a compounding computer to this 1.3% annual out-performance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or $15 trillion – one year's GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner's platform.

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There's a huge bubble, because we have zero rates in the U.S, zero rates around the world and a huge carry trade. Everyone is borrowing at zero interest rates in dollars and getting a capital gain because the dollar is weakening, so they are borrowing at negative rates. And then they invest in risky assets:commodities, equities, credit. We're creating a bigger bubble than before [Lehman].HTML clipboard

It's going to go crashing down, in an ugly way. That's the basics of the argument.

Roubini believes that continued low interest rates are inflating asset values beyond what the fundamentals dictate all over the world—a new global bubble. He argues that when the Fed finally does raise rates and the dollar strengthens, as it eventually must, there will be another resounding crash in the global economy...

....There are improving fundamentals. There is a global recovery. But that justifies oil going from $30 to maybe $50. I think the other $30 is all speculative demand feeding on it—speculators and herding behavior. Last year, when oil was at $145, that killed the global economy. I worry that oil is going to go up above $100 for reasons that have nothing to do with the fundamentals of supply and demand.

Oil at $100 would have the same negative effects on the global economy as oil did at $145 last year.

I have made many of the same points in several columns, most recently in It's Not Black Or White. Unwarranted oil price inflation is certainly a threat to a global economic recovery in the next year, but another real danger lies in the renewal of systemic risk in global finance.... Read more from EnergyBulletin