The Mephisto Polka

Is monetary tightening leading to a last ditch investment frenzy before the bust?
July 20, 2017 Updated: July 20, 2017

In her recent set-piece testimony before Congress, Janet Yellen made clear that she is determined to repeat the sort of ‘gradualism’ in raising rates that proved so disastrous after the Tech bust. In other words, that she will not so much boil the frog slowly as to encourage him to go out and make a further raft of foredoomed, highly-leveraged investment decisions before he realizes he’s been cooked.

Lest you doubt his willingness to do so, be aware that our increasingly hot-under-the-collar amphibian is already taking out a record proportion of cov-lite loans; is flirting once more with the dubious delights of the CDO; has pumped private equity ‘dry powder’ up beyond 2008 levels; and has poured $1 billion-a-day into equity ETFs alongside $300 million into the bond equivalents over this past twelve months. He is also increasingly being tempted by doubly-, even triple-leveraged versions of these latter, Greater Fool vehicles.

Mark Carney’s BOE, meanwhile, is beginning to fret that the UK’s notoriously spendthrift consumers are borrowing too much and that the corporate bond market has become subject to the same kind of systemic weaknesses which proved so disastrous to the banks a decade ago. Nowhere is there any recognition that the Old Lady’s own policies have contributed to – if not actually occasioned – these two potential problems, or that a yawning current account gap, an indisciplined Treasury, and a household sector actually running down their savings in cash terms might be causally connected amid a long spell of BOE-engineered, negative real interest rates.

Europe and Japan

The ECB is in its usual, biblical ‘House divided against itself’ mode, with Chief Macromancer, Peter Praet, pleading for ‘patience and persistence’ – i.e., for allowing him to hit the saloon drunks another shot – and with the Italians riding roughshod over the banking bail-out rules. Across the Rhine, by contrast, Klaas Knot warns of ‘getting very close’ to the point where the conditions which were so conducive to the outbreak of the last crisis have been fully restored and Jens Weidmann calls forlornly for having the ‘resolve’ to ease ‘off the gas pedal.’

Industrial production may be at post-Crash highs after rising at its fastest clip in six years. Real estate might be bubbling up nicely – not least in the epicenter of that last madness, Ireland, where residential property prices have risen 50 percent in the past four years, culminating in a jump of close to 20 percent year on year in the most recent showing from the fancied areas of the south-east. But none of that is sufficient to wean the Council off its trillion-euro fixation with still-subdued inflation ‘expectations’ and that hoary old ‘fausse idée claire’, the Phillips Curve.

Over in Japan, with employers running out of workers – job:vacancy ratios are back at 1980 Bubble highs – and with ‘soft data’ Tankan survey readings and manufacturing turnover ‘hard’ ones both up to three-year highs and with the BOJ officially categorizing a 12-year record, six out of nine regional economies as ‘expanding’, you might think the central bank could ease back on its vast programme of stimulus measures there, too.

But, no. Not a bit of it!

Hemmed in by its pledge to ‘control the yield curve’ – i.e., to hold long rates at ‘around zero’, come what may – the Bank was again pumping furiously last week as the global bond rout threatened to drive local security rates up beyond this arbitrary threshold.

When this policy was introduced last year, it was widely seen as a disappointment by those who can never have enough inflation.  At the time, we begged to differ, pointing out that this was a veritable tripwire – one, moreover, which was linked to a nuclear-scale device when this deliberately open-ended commitment is combined with the Bank’s coincident proposals to allow CPI to overshoot enduringly in order to bring the long-term average – and not just the prevailing –  rate of growth in the index back up to the desired level of 2 percent.

Even before we see if this will really be tried in earnest, it should be noted that the monetary base (whose expansion is the direct result of the BOJ’s purchases of JGBs and the like), has been rising at a rate in excess of $3 billion a day since March, the largest scale of such addition on record.

In case you think the asylum walls are impregnable and that this insanity can remain solely a Japanese concern, consider that the domestic press is carrying stories that, denied any scope for the local exercise of their talents by this excess, the giant banks are now seeking alternative outlets abroad: in the US securitization market, for one, in what – with more than a nod to the experience of the 80s as well as to that of the 00s – bodes well to be a singular test of Santayana’s famous dictum about the fateful repetition of a wilfully forgotten history.

No Deleveraging in China

As for China, for all the arm-twisting exerted upon the insurers and for all the ‘macro-prudential’ suppression of the housing bubble, credit growth can hardly be said to be flagging. So far in 2017, new renminbi loans amounting to $1.2 trillion have been issued – equivalent to $6 1/2 billion a day and to getting on for $5 million a minute – and this in a period when ‘deleveraging’ has been the official watchword from on high.

Amid all these infusions of spendable means, it is no surprise that stock prices around the world have hit new cyclical, if not absolute, highs. Nor have the wilder reaches of fixed income been reluctant to join in the fun. Indeed, as evidenced by lesser credits’ notable reluctance to sell-off as rapidly as have the government bond benchmarks via which they are priced – financial conditions everywhere remain highly – nay, irresponsibly – accommodative.

Perhaps inevitably, there is no shortage of prophets of doom to croak their displeasure as every new uptick results; each of these long-stopped clocks painfully eager to qualify for a ‘They DID See It Coming’ Award to add to their LinkedIn entry after the next crisis erupts (sorry, Janet, but there will inevitably be another crisis!). The main thrust of the argument of these birds of ill-omen is, they contend, that with such endemically elevated levels of outstanding debt, it will only take a modest increase in interest rates to render it utterly unserviceable to a large subset of borrowers and then – well, Lehman, you know!

Thus, the counsel of despair shared both by those demanding endless stimulus and those who never wanted it administered in the first place, is that the dependence on easy money now poses far too great a risk to break. Damned if you do, damned if you don’t, is the gist of their complaint.

But, given the proclivity of our esteemed monetary guardians to err on the side of laxity – to possess not the slightest trace of Weidmann’s metaphorical ‘resolve’ to lift the pedal from the metal – we would tend to the opposite opinion: namely, that our ruin will be all the more assured and all the more complete the longer these ‘Madmen in authority hear voices in the air’ urging them to join Monsieur Praet’s perilous pursuit of ‘patience’ and ‘persistence’ and so to allow increased moral hazard and a progressively ingrained feeling of invulnerability to lead the world’s Movers and Shakers to stray ever closer to the abyss.

I wonder if good, ol’ Chuck Prince – Citigroup’s notorious former CEO who, in his own words, kept dancing right up until the music stopped in 2008 – is again quietly practicing the polka in the privacy of his back parlor?

Sean Corrigan is the principal at investment advisory Cantillon Consulting.