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Friday, 4th August 2017

How the Bubble Was Created  

In our previous two posts, we explained why we think stocks are in a bubble and what a bubble means for gold. In fact, we believe all financial assets are in a bubble created by Fed policy, especially QE.

How did Quantitative Easing (QE) create a bubble in financial assets? In QE, the Fed purchased assets using newly created base money in the form of bank reserves and currency. This base money at the time it was created paid zero interest. The result was to drive down all interest rates and push stocks higher reflecting their dividend and earnings yields. The base money was used to purchase securities. Every time someone got rid of zero-interest base money by buying a riskier security paying a higher-than-zero yield, the seller would get the base money. The seller in turn would seek a return and the cycle would repeat until every asset was priced to deliver future returns near zero.

This is how sovereign debt yields have fell to the lowest level in history and junk debt spreads collapsed. This is how leverage has come to exceed every historical measure. This is how stock market valuations have become so extreme that, according to Dr. John Hussman, it will take zero or even negative average annual nominal total returns in the S&P 500 over the next 10-12 years just to get this index back to historical levels of valuation. Remember that the most iron clad of all market laws is reversion to the mean.

As Hussman points out, by creating zero-yielding base money, the Fed essentially created financial hot potatoes; the holders of base money are incentivized to look for better returns by tossing the money to others. Thanks to the Fed paying interest on excess reserves, the return on much of the base money is no longer zero. But the base money never disappears. It continually reappears in the hands of sellers. The only way base money is reduced is if the Fed itself absorbs and cancels it by selling securities it owns into the market, which the Fed has promised to begin doing later this year. What happens when the holders of base money decide not to reach for yield, preferring instead to reduce their risk by contining to hold base money? The speculative game collapses because rates have strayed so far from real risk-weighted economic returns.

Why has the credit-financed bubble not boosted the economy? The probable answer, as Steve Saville points out, is because of where the Fed's money went. In the financial crisis of 2008-9, the Fed channelled many hundreds of billions of dollars directly into financial institutions to keep them afloat and to ensure that their largest creditors suffered no losses. QE followed. When the Fed created money via QE, the funds once again went first to financial institutions, mostly the Primary Dealers. The Primary Dealers in turn purchased bonds (in effect front running the Fed), meaning that the next recipients of the new money were bond investors. These investors then used the money to buy securities. When the Fed creates money, it typically moves around among the accounts of financial-market players, only slowly leaking into the real economy.

In previous bubbles, the new money was loaned into existence by the commercial banks. When commercial banks lend money into existence, the new money goes first to individual and corporate customers of the banks and it therefore boosts the economy. But in the current bubble, most of the new money was created by the Fed and it went to financial players who used it for speculation. The Fed knew this would happen, as we have subsequently learned from statements by Messrs. Bernanke and Fischer. Chairman Bernanke explained that higher financial market valuations were expected to boost the economy via a 'wealth effect' in which the holders of financial assets would feel encouraged to spend more. This purported benefit of record low interest rates has never materialized in retail sales data perhaps in part because older savers have lost most of their interest income. What was stimulated was a growing disparity between those who own financial assets and those who do not.