Could the Next Crash Happen This Month?

In late August of this year, Federal Reserve chair Janet Yellen began hinting that the Fed might raise interest rates some time in September. Speaking at the annual meeting of central bankers in Jackson Hole, Wyoming, Ms Yellen said that “in light of the continued solid performance of the labour market and our outlook for economic activity and inflation, I believe that the case for an increase in the federal funds rate has strengthened in recent months.”

screen-shot-2016-09-11-at-11-34-59

Fed chair Janet Yellen recently hinted that the Fed Funds Rate might be raised in September.

While there was a stock market reaction to the announcement, it was fairly mild, with the S&P 500 falling by just 0.16%. Tellingly however, the bond market was much more severely hit, with yields on two-year US government bonds rising by 6.8%, and on 10-year US government bonds rising by 3.6%. This speaks to the way in which the easy money policy which the Fed has been pursuing since the last crash, has inflated a bubble in the value of government debt, particularly in the current low-rates climate, where it’s seen as one of the few safe ways to see a return on your savings. (For more about how central banks have been inflating a dangerous government debt bubble, see my recent article for the Mises Institute.)

So why might a Fed rates hike start the next crash? Essentially, the low interest rates, quantitative easing, and general “money-printing” which central banks have been pursuing since the last crash, has allowed investors to bid asset prices higher than they otherwise would have been, and governments to borrow at lower cost. As illustrated by the Austrian Business Cycle Theory, not only does the cheap cost of borrowing enabled by artificially low interest rates allow for the inflation of unsustainable asset bubbles, but it also encourages businesses to borrow money to invest in more risky projects. The problem with this is that it gives the illusion of profitability to projects which would not have appeared profitable if interest rates had been allowed to naturally reflect the state of real resources in the economy.

When a central bank, such as the Federal Reserve, forces interest rates lower than they otherwise would have been, it distorts the signals businesses have available to them, concerning the state of real resources the economy has at its disposal. An artificially low interest rate signals that the economy has more saved up resources than it actually does. This makes certain, long-term investments appear as though they’re going to be profitable, when actually there aren’t enough real resources in the economy to see them all through to completion. Eventually, in order to avoid hyperinflation, the central bank will have to cease its money printing and allow interest rates to rise again, at which point a whole host of these projects across the economy are suddenly revealed to have been unprofitable all along, with the resources invested in them having been wasted. Bankruptcies ensue, and the crash begins.

Furthermore, to illustrate the way in which central bank money printing has created a bubble in the stock market, I have stolen this graph from Lara-Murphy.com, which shows a clear correlation between the rate at which the Fed has been increasing the money supply, and the value of the S&P 500.

screen-shot-2016-09-11-at-12-39-30

The blue line approximates the total amount of money in the US economy, as controlled by the Fed, and the red line shows the value of the S&P 500.

The graph shows quite a striking correlation. Whenever the Fed has stepped on the gas and ramped up its quantitative easing – such as can be seen here between late-2012 and late-2014 – the stock market has boomed with it, and whenever it has hung fire the stock market has stuttered, as can be seen on the graph in late-2011. The extraordinary thing about this is that throughout almost this entire time period, Fed interest rates were close to 0%. The fact that, even during a time when borrowing was forced to be so cheap, so much of the stock market growth still seems to have been nothing more than a result of inflation, hints at just how little the US economy really has recovered from the Great Recession, even to this day.

A taste of the calamity we have in store for when this bubble finally bursts, was provided in December of 2015, when the Fed raised interest rates for the first time since 2006. Even that interest hike of a mere 0.25%, caused a dramatic downturn in the stock market, as can be seen on the graph above, and widespread speculation in January of this year that we were about to plunge into another recession. The massive downturn caused by such a modest rates hike then, gives an insight into the enormous degree of malinvestment which must be lurking under the surface of the economy, a bubble teetering precariously on the edge of bursting, kept there by low interest rates alone. When the Fed finally does have to raise rates more, and this stock market bubble finally bursts, I suspect that the similar bubbles throughout the economy – government debt, house prices, auto-loans, etc – which will come crashing down with it.

Even the mere suggestion of another possible rates hike has already caused a wobble in the economic house of cards the Fed’s easy money has propped up. The S&P 500 fell by 2.45% on Friday, its biggest decline since the Brexit shock, whilst the Dow Jones Industrial Average fell by 2.13% and the Nasdaq fell by 2.54%. The fact that these key economic indicators were so bludgeoned by even the faintest hint of a rates rise, lays bare the unstable, low rates fuelled bubbles which have been the source of so much of their apparent recent “growth”, and which now appear close to bursting.

So will the rates hike and crash really arrive this September?

While Ms Yellen’s remarks did initially spark concerns that this could be the case, prediction markets have now quieted down somewhat about the possibility of a September rates hike. According to the CME Group fed funds futures, the likelihood of a rates rise in September has fallen to just 27%. The consensus at this point is that the Fed will wait until after this year’s election before contemplating any further action, with the likelihood that a Fed Funds Rate hike will be agreed upon at the Fed’s final meeting of the year placed at 46%.

However, as much as I suspect a crash will follow any rates hike they do pursue, this delay is actually not necessarily good news. The longer interest rates are held low, the more malinvestments will be made before the crash comes, and consequently the worse the crash will eventually be. With interest rates having been at extraordinary lows since the start of the Great Recession, there’s no way of completely avoiding the fact that such a long period of low rates means malinvestments have already been made, the bubble has already been inflated, and so the crash is inevitably coming. It’s not within our power at this point to avoid the next crash altogether, because the mistakes which will cause it have already been made. But an early rates hike would at least get the recession out of the way before the bubble could inflate any further.

Sadly though, high rates in 2016 are scarcely more popular at the Fed than they are at the Bank of England. The likelihood that policymakers will be bold enough to raise rates enough to give us the short, sharp shock needed to rid us of this bubble and get the inevitable recession out of the way quickly, are rather slim.

My First Published Article

Screen Shot 2016-08-26 at 13.49.14

So this past Monday I had my first ever article published. It was put out by Mises Wire, the daily online publication of the Mises Institute in Auburn, Alabama, where I recently spent a week studying Austrian Economics at their ‘Mises University’ summer programme.

In the article, I discuss the little clues which have come to the surface in the British economy since the new Bank of England interest rates cut, and what they might point to for the future of the world economy.

You can read the full article at this link:

https://mises.org/blog/bank-england-turns-more-easy-money

More to come soon, on both this blog and hopefully over on Mises Wire again. Stay tuned…

Could post-Brexit Credit Downgrades save Britain from the next Crash?

v2-bank-of-england-pa

After last Thursday’s decision by the British public to leave the European Union (a decision which I endorsed and stand by), reports emerged in the press almost immediately of the imminence of a downgrade in the UK government’s perceived creditworthiness. And sure enough, several downgrades have occurred in the days since the referendum. First to act was ratings agency Moody’s, who assigned a negative outlook to Britain’s Aa1 rating on government debt the day after the referendum. Shortly afterwards, Standard & Poor’s downgraded the British government’s creditworthiness from AAA to AA+, while Fitch went even further, downgrading the government’s credit rating to AA. Significantly, S&P has also, in the past few hours, downgraded the credit rating of the EU itself from AA+ to AA.

Grim sounding stuff, upon a cursory glance, and certainly perfect headline content for the many doomsayers and pro-EU commies of the fourth estate. However, the long-term implications of such downgrades might not be as negative as we’re all being led to believe. Indeed, increasing doubtfulness of the government’s creditworthiness could help to cushion the blow for Britain somewhat, when the next crash inevitably arrives.

First of all, these downgrades theoretically make it more difficult for the British government to sell bonds to private investors, and hence more difficult for it to borrow money, which to me at least makes the downgrades a positive, almost regardless of their other consequences. With UK public sector debt at over 80% of GDP and Osbourne still failing to achieve even his own lax targets for reducing the deficit, I’m pretty sure that if fire rained from the sky and Beelzebub ascended from hell to eat Mark Carney’s legs, I would still hail the event as a positive if it made it more difficult for the government to borrow money. One might argue that the downgrades actually won’t affect the total amount that the government can borrow, because even if they dissuade private investors from buying government bonds, the Bank of England can theoretically pick up the slack by simply buying government bonds with money created out of thin air. However, with interest rates at record lows since 2009, the threat of high inflation might prevent the bank from completely offsetting a reduction in demand for government bonds, and so it’s possible that the total amount of money the government can borrow may indeed decrease.

However, far more important is the fact that these downgrades may help to deflate the government debt bubble which we are currently living through, and which will in all likelihood be the cause of the next crash. In the aftermath of the Dot-com crash of 2000-2001, central bankers’ pursuit of artificially low-interest rates encouraged speculation and a scramble to borrow and invest, during a time in which the economy should have been allowed to readjust and learn the lessons of the crisis it had just been through. Instead of allowing the Dot-com bubble to fully deflate so that the economy could start building on a solid foundation again, they merely rolled the bubble over into another section of the economy: housing. The reason why housing became the area of the next bubble was because it was seen as an extremely safe area of the economy, with  relatively predictable rates of expected return, and only a small chance of failure. When the housing bubble finally did burst, central bankers made all the same mistakes again that they had in 2000, sledgehammering interest rates into the earth’s mantle and consequently causing a scramble to invest in the area that had replaced housing as the universally accepted “safest” investment in town: government debt. However, with Puerto Rico facing an historic debt default just this very week, and many other countries not far behind, the signs are beginning to emerge that the government debt market of today is just as “safe” as the housing market of 2006 was.

If the above is true, and if we really are on the verge of a government debt crash that will dwarf the housing crash just as much as the housing crash dwarfed the dot-com crash, then we should all be thanking the ratings agencies for trying to steer UK investors away from becoming more heavily invested in government debt. Will it completely shield us from the effects of the crash? Absolutely not. But we can at least assume that, come the crash, the British public and its institutions will likely find themselves at least somewhat less heavily invested in the failing government bonds than they would have been, had they retained their unimpeachable AAA ratings.

So thank you again to the British public for voting for Brexit, and thank you to Moody’s, Fitch, and S&P for downgrading your assessment of our government’s creditworthiness; in exchange for a little short-term uneasiness, you may have put Britain in a stronger position to weather the coming storm, perhaps without even having realised it.

It’s Time To Leave, and Take Back our Ancient Liberties.

Screen Shot 2016-06-23 at 09.32.38

Before we all vote today, I think it’s important to remind ourselves of what it is that we’re actually directly voting on, particularly after a campaign with this many misdirections and red herrings. This referendum on our membership of the European Union has no direct impact on trade or economic policy, it has no direct impact on immigration, and it certainly has no bearing whatsoever on wishy-washy concepts such as “co-operation” and “fellowship” with Europeans. What we are directly voting on today is whether or not laws should be imposed upon us by 28 European Commissioners whom no one has ever elected, and whom none of us will ever be able to vote against. It’s as simple as that. When you find yourself with the ballot paper in front of you later today, you should at least be aware of exactly what concrete thing it is that you’re giving your moral seal of approval to. If you put your X in the remain box, understand that you’re not voting for “tolarance”, or for trade and co-operation with Europe, or against any unsavoury types you might find on the other side. The real, concrete thing that you’re actually consenting to is the idea that supreme legislative and executive power over 64 million Britons should be combined in the hands of 28 people who no one ever voted for. Really think about that when the ballot paper is sitting in front of you. Trade, immigration, defence, culture: these are all secondary issues which we can argue and re-argue, decide and re-decide another day. Today, however, is our one chance to stand up for our democracy; to stand up for the principle which previous generations laid down their lives for, back through the World Wars, the English Civil War, Magna Carta, and even beyond. Will we turn our backs on our legacy of democracy today, or will we pass it on safely to our children, and generations yet unborn? Today is our one chance. Don’t let yourselves down. #VoteLeave