Nouriel Roubini on Fed Pullback

For days, stock and bond markets have gyrated leading up to today’s end of the FOMC’s two-day meeting, as traders positioned and repositioned themselves on every comment, interview, and letter by Federal Reserve members and other government officials.

Market bears suspect overheating equities will prompt the Fed to announce a reduction in bond purchases. Market bulls point to gradually rising bond yields as reason for the Fed to postpone bond reductions until early next year, given the Fed’s commitment to keeping rates low.

In their 8-page paper for Institutional Investor, economists Ian Bremmer and Nouriel Roubini – known the world over for their decidedly pessimistic views on the states of world economies – candidly express that it really makes no difference what the FOMC decides today or at any other meeting.

In their view, the U.S. and global economies could soon be in for another 2008 shocker.

“Dangerous Illusions”

Over the past 4 years since the financial crisis bottomed in March of 2009, investors have been on the ride of their lives.

Equity markets keep rising, recouping their 2008 losses and setting new all-time highs. Bond markets have kept rising too, with capital gains offsetting shrinking yields. GDP, though slow, has been steadily positive. Unemployment has fallen from the high 9% to the mid 7%. And gear-stopping deflation has been averted.

But Bremmer and Roubini detect complacency. “The sense of crisis has lifted,” they note, “encouraging some to see in the changed landscape a sustainable ‘new normal’, a period of painfully slow but predictable economic progress” with “many investors willing to bet that a surge in liquidity in the U.S., Europe and Japan makes for a more robust way forward”.

To the two economists, “these are dangerous illusions”, because “the deeper questions that created the recent convulsions have not been answered.”

“That’s why the uncertainty and volatility of the past half decade is far from finished, and is almost sure to trigger new crises,” they forewarn. “Be sure your seat belt is securely fastened, because nothing has really come to rest. We have entered the ‘New Abnormal’, a period in which … the wise investor is prepared to be surprised.”

Continued Easing Likely

One of those unanswered questions that still lingers from the last crisis is the still unacceptably high levels of risk-taking among institutional and private investors alike. Over-leverage is what led to bank bailouts and outright bank failures all over the world, as banks were taking on too much risk for the amount of capital they had.

Since then, banks have been in a prolonged process of deleveraging and increasing their capitalization to strike a sound balance between risk and assets.

Unfortunately, while the current task of “deleveraging is ongoing, and structural reforms needed to boost competitiveness are delayed,” Bremmer and Roubini believe economic growth will remain “anemic for many more years to come, and unemployment rates will stay high”.

This expectation for slow economic growth convinces the two that “very aggressive monetary policy – quantitative easing, credit easing, zero policy rates and bold forward guidance – will thus continue for a little while longer.”

Given even the slimmest chance of bond tapering announced today by the Federal Reserve, we can continue to expect stimulus and low interest rates for quite some time.

Blowing Bubbles

Yet it is this same low interest rate environment that started the whole mess back in the early 2000s. Low interest rates back then forced banks to take on more risk to make up for lost interest revenues, in turn inflating equity and real estate bubbles, which imploded together in 2008.

Bremmer and Roubini are convinced that today’s ultra-low interest rates, deleveraging, and recapitalization are forcing banks to divert funds away from loans into equities and high-yield/high-risk bonds, slowing the economy and creating 2008-style bubbles.

“The days of high returns on capital based on excess leverage and slim liquidity buffers are gone as the screws of tighter regulation and supervision start to tighten … Higher capital and liquidity ratios will reduce returns, slow credit creation and hamper growth.”

Deleveraging and recapitalization is forcing banks to hold on to the money they are getting from their central banks. As banks tighten up their lending (really, what bank wants to lend at just 3% per year?) money does not circulate through the economy as it should. Instead, the low velocity of money results in cash being parked in stocks and bonds, prompting the two economists to warn:

“With falling velocity, anemic credit growth and weak [economic] growth, such monetary easing will not cause goods inflation, though it may lead to asset inflation in credit and equity markets.”

While consumer prices have not yet been hit by inflation, equity and credit/bond assets sure have been bubbling up.

As a result, central bank policies are recreating the risks of 2008 all over again, the economists explain:

“The Fed’s liquidity injections are not creating credit for the real economy but rather boosting leverage and risk-taking in financial markets. It may be too soon to say that many risky assets have reached bubble levels and that leverage and risk-taking in financial markets is becoming excessive, but the reality is that credit and equity bubbles are likely to form in the next two years owing to ongoing loose U.S. monetary policy.”

Breaking Up is Hard to Do

The warning that all these measures together – low interest rates, stimulus, deleveraging, recapitalization, and the low velocity of money – are causing more harm than good is echoed by a growing number of economists, analysts, even Federal Reserve members. This is one reason many expect the Fed to announce stimulus tapering today – or to at least promise to reduce it soon.

But Bremmer and Roubini stress that it may already be too late. There are only two ways to remove a band-aid: quickly or slowly – and either way is going to be painful.

“The exit from the Fed’s QE and zero-interest-rate policies will be treacherous,” they caution us, reminding us to brace ourselves for the band-aid’s removal. “Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system.”

As already noted, the slow velocity of money (the reluctance of banks to circulate their money via loans to businesses and consumers) is hampering economic growth. If they end QE too quickly, the truth of how weak the underlying economy really is will become painfully apparent.

Remember, stock valuations are higher than they should be right now because of stimulus. Remove stimulus quickly and everything will crash, as the real economy underneath all those stocks is not yet strong enough to support their lofty valuations.

But neither is removing QE slowly going to be any easier, as the economists reiterate:

“A slow exit risks creating a credit and asset bubble as large as the previous one, if not larger.”

The Likely Crash-Landing

The pair of economists then draw on history to project what course of action the current Fed will likely take when the time comes to unwind its stimulus. And the results are not expected to be pretty.

“When the Fed starts to raise interest rates, it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate.”

Indeed, the U.S. Federal Reserve has already stated numerous times that it will not begin to raise interest rates until unemployment is at least 6.5%, with additional readings pointing to a stable economy. Indications have also been given by the Fed that when rates do begin to rise, they will do so slowly.

So what can go wrong with that? Much, according to Bremmer and Roubini:

“From 2001 to 2004 interest rates were too low for too long, and the subsequent rate of normalization was too slow, inflating huge bubbles in credit, housing and equity markets.”

Yet the two believe it will be even worse this time around:

“This time the unemployment rate and household and government debt are much higher. If financial markets are already frothy [now], consider how frothy they will be when the Fed starts tightening [likely in 2015] – and then when the Fed finishes tightening [likely in 2017-18].”

As Roubini predicted in an earlier interview with Business Insider, “this might lead to a generalized credit and equity and asset bubble in the next year or two, followed by a crash”.

Cautious Investing

As investors brace themselves for turbulence in the markets, whether over the short-term on the back of today’s FOMC announcement, or over the longer-term extending to the painful tearing off of the stimulus band-aid, Bremmer and Roubini offer a piece of advice to help investors weather the storms:

“… commercial diversification. Investors in a country’s stability are concerned, and rightfully so, with the diversity of the goods and services it produces. Yet those most likely to weather this crisis-prone global order also benefit from a diverse set of trade and investment partners.”

It is a caution we have heard many times before, and with good reason. Portfolios that are diversified across multiple companies, sectors, markets, and even countries will sustain less damage during the rough times ahead.

Joseph Cafariello

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