Economic and market themes: 2014-06-27 Fed will trigger the next crisis

The title here is a bit provocative I know. But it is really something I stole from an article about Stephen Roach’s view that I will use as a jumping off point for my Friday review. I also want to note that I have noticed all the typos creeping into these daily posts and have to apologize because this is happening despite my spell check because of time constraints in my posting process. I will try to smooth that out in the coming days. So bear with me. Now let’s dive in.

Credit bubbles. Here’s what the Roach article is saying.

The U.S. Federal Reserve’s “wildly accommodative” super-low interest rates and bond-buying program risk triggering the next world financial crisis, market veteran Stephen Roach has warned.

“Monetary accommodation, to the point of ignoring the stresses and strains of financial stability and what they mean for asset markets and credit markets, is something that needs to be seriously rethought,” the Yale lecturer and former chairman of Morgan Stanley Asia told CNBC.

[…]

”Now we have such distance from the depths of the events in the aftermath of Lehman Brothers that we need to be thinking about the next crisis again,” said Roach.

“As long as the Fed remains as widely accommodative as a $4.25-4.50 trillion dollar-balance sheet would suggest, there is good reason to question the Fed’s commitment to financial stability and there is good reason to believe that we could, in the not too distant future, find ourselves in another mess.” 

I like Stephen Roach’s worldview. In his recent book, Unbalanced, about the unbalanced US – China relationship, Roach wrote about the need for the US to increase saving and rely less on debt accumulation to maintain growth. What he is saying is that the Federal Reserve gears US policy toward an asset-based model that can only work via its extraordinary easing. And those easing efforts invariably lead to bubbles and crisis. So, rather than thinking of the Fed saving the US economy from recession by easing to maintain growth, we should think of the Fed promoting financial instability that leads to the next financial crisis.

It is not the Fed’s role to buy financial assets to support growth. Quantitative easing was a measure used effectively to help the Fed act as a lender of last resort in dislocated markets in 2008 and 2009. And even then it violated the Bagehot rule of lending freely against good collateral at a penalty rate. Now, QE is just an additive that creates risk-on sentiment and will lead to credit bubbles. It is dangerous and that’s why it is being unwound. Zero rates, however, remain in place, telling markets that risk-on is still the way to go. When this episode ends, I believe we will have credit bubble. And the aftermath of that bubble will be very negative for the financial sector and lead to a crisis.

Inflation. Now, getting to the real economy, we have seen inflation metrics tick up in a number of countries. Here, the US and Japan are the most notable. US inflation is the highest in 18 months, whereas Japanese inflation is the highest in 30 years! Even Chinese consumer prices are again rising at a faster rate with the CPI hitting 2.5%. I am not alarmed by any of this and do not believe inflation alone is a pretext for raising rates in the US or elsewhere. Labor markets and capacity utilization are not showing signs that the economy is overheating. Quite the contrary, I believe the lack of wage growth means the US economy remains somewhat fragile. Moreover, low productivity numbers — rather than actual wage gains for households —  are driving the uptick in unit labor costs in the US. Meanwhile, in the UK, inflation is at the lowest level since 2009. And the Eurozone and the rest of Europe is also dealing with disinflationary trends. In short, inflation is not a problem and should not be the reason to raise rates. The reason to raise rates in the US is because they are artificially low, with real interest rates negative at the short-end and in the belly of the curve. To the degree inflation picks up, it’s the decline in real interest rates as a signal for risk-taking in credit markets that I am most concerned about.

Oil. On the other hand, when it comes to Iraq, we do have to be concerned about the impact higher oil prices could have in emerging markets. I don’t see the situation in Iraq as having any real measurable global economic significance. This is mostly a political conflict. However, if we saw a real spike in oil prices, there would be cause for alarm. Since the end of Bretton Woods, every global recession has been associated with a steep rise in oil prices except the recession after the TMT bubble. We saw this in 1973-75 after the first oil shock. We saw the same again after the second oil shock in 1979. The Gulf War saw oil prices rising and serious economic turbulence from Scandinavia to Britain to the US, all as the Soviet empire was collapsing. And then again as the global housing bubble was imploding, oil shot up to $147 a barrel.

While the energy intensity of developed economies has receded, a rise to the $147 level would be a major tax on consumption that I believe would be a major drag not just on consumption but on credit demand. So, that is one problem. However, the serious problem with an oil shock for me is in the emerging markets. The mini-crisis in EM this winter revealed imbalances and fragility in a number of economies that would be negatively impacted by an oil shock. Moreover, China is a major oil importer whose growth slowdown is what precipitated the EM crisis. With Chinese growth ramping back up, an oil shock would have a pass-through effect from China to the emerging markets, which could trigger another round of panic there, especially in view of the Fed’s taper.

I spoke about this earlier in the week on Boom Bust. But the FT had a good piece on this yesterday with a nice graph on net energy exports as a percentage of GDP.

The markets to be concerned about are the ones with high current account deficits, high inflation rates and macro instability. I would be particularly worried about Ukraine, Thailand, Indonesia, and Turkey on this score. Russia, now suffering due to the Ukraine crisis, would benefit on net from a rise in oil prices, something that has to play into their geo-political strategy in the Middle East now that Iraq has become an issue again.

The Wall Street Journal also had a good chart on oil intensity in Asia.

Using this metric, you now see Thailand popping up again. But the other big economies I am concerned about here would be India, China and Indonesia.

The bottom line: I would be more concerned about Emerging Markets from an oil shock than developed markets. And if we did get an oil shock from Iraq, it would strengthen Russia’s hand, weaken the US hand, hit Chinese growth, worsen current account imbalances in emerging markets and make another round of EM bloodletting a distinct possibility. 

On the oil score, As rebels have seized a key oil refinery already, I recommend reading the Diplomat’s article on China’s vulnerability in Iraq and the geopolitical implications. Also see the Telegraph here.

That’s it for today. Have a good weekend.