Credit Super Cycle Endgame

“Credit expansion is the governments’ foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.

If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders.

The final outcome of the credit expansion is general impoverishment.”

Human Action – Ludwig von Mises (1883 – 1973)

After an extraordinary period of excessive credit creation, and financial engineering of staggering proportions we have now entered a new phase of the credit super cycle. Confidence is fickle and unpredictable, but more than likely the market turbulence of the last two months heralds a new and possibly chaotic period for the markets.

Many will argue that if the markets seem stable and well behaved that all is well. However, it is important to distinguish between short term palliatives, providing the appearance of stability, and deep seated issues that have gone well beyond the point of a quick fix. At this stage the credit super cycle changes character.

The cumulative build up in credit makes the continued management of the business cycles much harder and increasingly prone to much greater instability. In short this is point at which the credit super cycle has reached the endgame.

We can not know the future, and there are still many forks in the road, but if we are going to be at all prepared for the most dangerous phase of the credit super cycle, we need to understand the historic nature of our current predicament and have some comprehension of the scale of the issues. We also need to realize that policy options are now very limited and extremely difficult to execute effectively.

Understanding our source of Chaos

First of all we need to understand how we got here to begin with. Very few investors (and I mean almost none) have a clear understanding of the workings of the Federal Reserve, the central bank.  

The bottom line is that our monetary system is biased to create excessive money supply, uses a very blunt instrument to execute policy, and has no natural anchor. It is well worth making sure this statement is well understood.

With an objective of maximizing long term growth, and a consensus that both recession and deflation are regarded as unacceptable, it is hardly surprising that monetary policy, through any cycle, is likely to be biased in favor of growth rather than stability. If policy is going to be wrong it is highly dangerous to make it too tight for too long, and risk the possibility of triggering a recession, or worse, deflation. In this way policy needs to be biased on the easy side through any interest rate cycle. So, over any cycle there is always a tendency to create excessive money supply.

Very often the monetary excess through the cycle is substantial. One reason for this is that monetary policy is executed with only a very blunt instrument. The central bank controls only the price and quantity of money. Given the difficulties of making accurate macro econometric forecasts, with uncertain leads and lags and only a crude policy tool to use, one should hardly expect monetary policy to achieve any significant degree of precision.

Over time, the monetary excess created by each cycle begins to have a cumulative impact. The monetary excess from one cycle is never mopped up and the imbalances and distortions continue to expand cycle after cycle. Most people just become used to the distortions and regard them as just part of the way things are. As long as the central bank can manage the cycles within acceptable limits no-one seems to care about the long term cumulative impact.

So, in as far as the central bank is successful in avoiding adverse economic impacts through each cycle, the population becomes accustomed and accepting of any “quirks” that seem to occur. For example, there seems to be little penalty in borrowing a little more each cycle. Poor investments go relatively unpunished, so they can be kept and even further increased. So extended is this process that the population becomes conditioned to expect this behavior to be rewarded indefinitely.

Indeed, this process can continue for a very long time. The monetary system is entirely independent of any natural limits. Fiat money creation is almost costless and the only limit is confidence of participants in the system. However, once confidence breaks it is very hard to restore.

Ultimately, the apparent stability of the system masks an increasingly unsustainable background. As the level of debt and dependence on “successful” economic management grows, remarkable imbalances develop and expand through each cycle as the government and central bank have to become increasingly active to achieve their objective.

This situation is clearly demonstrated in the chart below, which shows the astonishing progression of household debt to income, which has now doubled since the 1970s. You will also notice that this chart is accelerating through this period.

In order to believe that this chart is sustainable you would have to believe that there is no limit to the speed of debt accumulation relative to income and the extent of debt levels relative to income.

If you think that this chart is remarkable you have not seen the chart below. Not only has the growth in derivatives been astonishing in recent years but the growth in credit derivatives defies superlatives. Now the amount of derivatives outstanding is a multiple of the size of the US economy!

Make no mistake, all derivatives are on someone’s balance sheet, so this represents another astonishing form of debt, or money creation.

Now What?

Since credit booms depend on ever-larger doses of credit to sustain themselves, what happens if credit creation lurches into reverse? Control of credit creation then becomes highly problematic. This is where we find ourselves now. The chart below shows how dramatically credit booms can reverse.

The lenders are simply refusing to lend, which is why the commercial paper outstanding is plummeting. In a perfect world, asset-backed entities, known as "structured investment vehicles" (SIVs), borrow short-term money in the commercial paper market, then invest the proceeds in debt instruments like mortgages, credit card receivables and collateralized debt obligations (CDOs). But the borrowing part of this formula has dried up completely. The asset-backed issuers of commercial paper cannot find any lenders to finance their toxic cocktails of lousy mortgages and "new math."

Over the last six weeks, the (formerly) $1.2 trillion U.S. asset-backed commercial paper market has contracted by a whopping $245 billion dollars. In other words, one fifth of this market has simply disappeared. Unfortunately, the SIVs still need the $245 billion that nobody will lend them. Without the money, they must liquidate their illiquid portfolios of subprime mortgages and credit derivatives.

So far, the slow-motion crisis in the commercial paper market is unfolding behind the veil of institutionalized obfuscation. But the American financial system is not merely an "SIV problem," it is also - and more importantly - a financial system problem. In addition to the $250 billion of short-term financing that has already disappeared form the asset-back CP market, another $300 billion will come due before Thanksgiving.

Even then this is nowhere near the full extent of the credit problems. The housing market is still under considerable pressure from high inventories, high debt from home owners and rising mortgage payments well into next year. There are other problem areas with excessive debt that we have not even discussed, but hopefully by now you should begin to understand the scale of these problems.

So how can monetary policy save us?

The short answer is with great difficulty. Not only are the problems immense in scale but we should also realize that the starting point for monetary management has now become highly problematic:

1.     Today the current account deficit is hovering around 8% of GDP, and this massive deficit puts continuous pressure on the US dollar.

2.     Gold and other commodities are now in an uptrend, which is signaling an inflation problem. Higher interest rates would make credit management much more difficult.

3.     Total credit market debt to GDP has continued to rise to 330%. This is the highest level ever and exceeds the level reached in the 1920s just prior to the great depression.

4.     Debt growth averaged 4% per annum in the 1990s, but it has been averaging 10% per annum since 2002. How can economic growth be sustained at much lower levels of debt growth?

5.     Credit risk problems are far more widespread than they have been in the past. They are no longer isolated at just a few institutions or just one type of institution. Credit extension has become so pervasive that current problems have come to influence confidence in the entire monetary system as a whole. This is demonstrated by the record interest rate spreads of Libor over similar maturity government bills.

With this background it should be apparent that managing the current credit situation has become extremely precarious, and with this there is an unusually high probability that this will lead to unstable conditions.

Put very simply there are essentially only three alternatives to monetary policy. The first option is for credit growth to continue to accelerate at near its recent remarkable pace. However, in the current environment the appetite for substantial credit growth has clearly diminished, and even if it were possible this level of credit extension would just make the sustainability of policy even more problematic as it would further extend record levels of credit.

The second monetary policy choice would be to allow a credit contraction, to restore the level of credit to more normal and sustainable levels. This would amount to a huge negative shock to the economy, which is already showing signs of weakness, so it likely to be actively avoided as no one would vote for this scenario.

The third option then becomes the only realistic option, and that is to try to keep credit extension in line with moderate growth levels, to give the economy enough liquidity, credit and time to recover, without making the situation any worse in the long term. This is easy to say, but in the current predicament a highly challenging balancing act.

The lack of any easy or attractive options is why we have now entered the endgame for the credit super cycle.

 

What do you do?

While there will be many casualties at the end of a credit super cycle, there are also many actions that can limit the damage to your own finances, and it is also just possible that you could prosper in an environment where most people will feel completely lost:

1. We need to take greater care of counterparty risk. When credit is growing at a rapid rate balance sheets become naturally leveraged and can also contain a high level of complex financial engineering products. If we are entering a period where it is going to be much more difficult to expand credit, and the price of credit may be much higher, then there are many balance sheets that suddenly become much more vulnerable.

2. Investment choices will depend crucially on the growth of the money supply. As there is no constituency favoring a credit contraction, it is highly likely that money supply will continue to grow at a rapid rate. After all it is the only tool available in our current monetary system. How well this works, how far they will be able to lower interest rates, how much additional credit appetite there will be are all unknowns, but the bias is clearly in favor of continued rapid money supply growth. Not only are we just over a year form an election, but Bernanke has been very clear about his bias in favor of excessive money supply growth as we have discussed before.

In this situation investments should favor real tangible assets. The key characteristic of real tangible assets is typically scarcity. At a time when money supply growth is likely to be substantial, scarce assets will maintain their purchasing power. However, financial assets may well be substantially constrained by a higher cost of capital. There are always exceptions and special cases but investors need to reconsider how they can maintain their purchasing power in the current environment.

3. An environment of excessive money supply can lead to highly volatile markets. Yet the alternative of holding cash can also become highly problematic. Americans are increasingly becoming aware that their dollars are losing purchasing power. In order to just defend your purchasing power it becomes necessary to diversify your assets away from cash deposits. Scaling into appropriate assets over time and adopting an effective risk management system can help a great deal in managing volatility.

4. The current problems are to great degree US domestic issues. In many other countries around the world the situation is a great deal different. As a result diversifying into some international markets is also an appropriate strategy.

Summary

The intention of this note is to raise awareness of the current state of monetary policy in the US. In my experience very few investors understand either the Federal Reserve or how monetary policy works. So far this does not seem to have mattered a great deal. However, as we move in to the endgame of the credit super cycle this will leave most investors dangerously exposed to a new set of circumstances.

The endgame of the credit super cycle is not something that most investors have ever experienced. Without becoming a student of the history and theory of monetary policy how could anyone be prepared for this new environment?

More than likely we are now at a point where stagflation seems like the best option. Growth will probably remain weak as the real value of debt falls with sustained higher levels of inflation. As Hyman Minsky once said, “Stagflation is the price we pay for the success we have in avoiding a great or serious depression”.

 

 

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