Yellen's Statement Ignores Reality

Recently in London, the Chair of the Federal Reserve, Janet Yellen said she doesn't believe we will see another financial crisis in our lifetime. This statement is really quite amazing considering the massive levels of leverage within our economy, the record levels of global debt, the rising default rates and the complete disconnect between risk and reward within our economy.

The Federal Reserve has done an amazing job of pricing fear out of the markets. Implied volatility levels have never been so low. The market feels very confident that everything is under control. A common measurement of fear, the VIX, has been hanging around the 10 handle for a significant periods of time as of late. Something that was unheard of before the Fed pumped trillions of dollars of quantitative easing in order modify the behavior of the markets. There is a strong belief on Wall Street that the Fed will backstop any sizable decline in the future. Why fear risk when you think the Fed will do what is necessary to stem losses. This is the source of market confidence and as likely the source of Janet's own confidence. Her statement only goes to further enforce this belief. The head of the Fed has said she doubts there will be a financial crisis in the future.

 Recently the Federal Reserve openly considered Quantitative Tightening, as a means of unwinding a part of their $4.5 TRILLION dollar position, as a means of further appeasing the markets. The logic goes that if the Fed "normalizes" monetary policy they must believe the economy is no longer weak. The further away from the near decade long emergency stop gap policies by the Fed the better people should feel about the economy as a whole. The problem is the economy has not recovered, beyond the temporary impact of massive debt injection and market manipulations by the Fed. That being said the likelihood of quantitative tightening occurring without popping the debt bubble is slim to none.

The reasons are many, but they come back to weak economic growth and massive levels of debt. Corporations have taken on a record level of debt. The consumer is also carrying record levels of debt while the savings is at an all time low, Wall Street investment margin is at an all time high. Many pension plans are at the brink of collapse, while many private capital funds are leveraged to the hilt. What could possibly go wrong? With actual levels of risk soaring you would expect much higher values in the VIX, instead it is trending at extremely low levels. The markets are priced like there is almost no risk. This is where the centrally planned market manipulation has brought us.

Some might say I am being overly pessimistic and not all is bad. Mortgage debt levels are much lower now than in 2007. This is true, but if you looks deeper you will notice house ownership levels were much higher back in 07 compared to today. Today many Americans are carrying huge debt without even owning a home. They rent and carry huge debt on their credit cards and car loans. Consumer debt delinquency rates are climbing at an alarming rates, while subprime auto loan delinquency rates are raising many red flags. Student loans are at record levels, while tuition levels have skyrocketed, crippling the purchasing power of new graduates for many years to come. Many consumers can barely make the minimum payments on their debt. They are maxed out and there isn't even house to back up any insolvency.  None of this adds up to a brighter future.

Homeownership Rate for the United States
Source: US Bureau of the Census

Source: Real Investment Advise, Zero Hedge

Source: Bloomberg, Zero Hedge

Source: TransUnion

Corporations are also loaded up with debt. They utilized the extremely low rates, not to expand their operations or invest in to capital assets. No, instead they used the new source of near free money to buy back stock. This action does create the illusion that a business is doing better. As the number shares outstanding decline, the earnings per share increase. This all looks good on paper to the average guy pouring his hard earned money into the markets. How could it not be good when companies have stellar EPS growth? In the long run the actual business is not better off just because there are fewer shares outstanding, especially when debt levels are off the scale and the capital equipment is aging, while the rest of the world innovates. That brings us to the main issue at play here. As interest rates go higher those inflated earnings will face some serious downward pressure, as more and more money will go to servicing that debt. The fact that corporate America is levered up to record levels does not bode well for the future.

Source: Thomson Reuters, Credit Suisse

Business inventory levels are at record highs due to a lack of sales and over capacity, which is reflected by bankruptcies of many major retail chains. Auto inventory is also becoming a big problem, at the same time as the debt market is becoming saturated. Annual auto consumption has slowed, driving up the numbers of unsold vehicles. Auto production is starting to fall in response.

Source: Bloomberg

Unfortunately the central banks have become major players in the capital markets. The world debt markets continues to be flooded with centrally planned capital injections. These Keynesian policy makers drive the markets to push the financial apparatus to pump out as much debt into the economy as possible. Then have the gall to call it stimulation. As if carrying more debt is a good thing.  America is drowning in debt. It's pure desperation by a debt addicted Federal Reserve. Each dose of capital injections needs to be bigger than the last just to get that tiny economic push. With the miracle of fractional banking the available cash through debt financing has exploded. Global debt is now at $217 Trillion, which is 327% of GDP.

Governments, nations, cities, states have all lined up at the trough and are now feeling the effects. The problem with excessive debt is it is impeding future growth. No one likes to talk about austerity, but this is where we are headed. Debt is simply spending future earnings today. In essence we are living off of our children and grand children's future. This is something that is mostly ignored by almost all politicians and media. I guess spending is more fun than thinking about who pays. Savings is the true measurement of wealth, but is a thing of the past in the United States. The Federal Reserve has a long standing policy to discourage savings.

So as the the economy struggles to manage record levels of debt, at a time that the Fed considers quantitative tightening, there are many factors that indicate the current debt bubble is leaking air and is in significant jeopardy. The real question is when this current debt bubble does pop and markets begin to correct downwards what will the central banks do? How does Janet expect to stop the next crisis? They have painted themselves into a corner, where they have little to no room to lower rates. The ECB and BoJ are already at negative rates and continue to manipulate markets with further quantitative injections. If a correction hit them tomorrow they would have nowhere to go, beyond throwing up their hands and saying "We're out." The action of endlessly printing money and monetizing debt is one of a bankrupt state. 

The Fed has a very short runway before they run out of room. The alternatives would be very limited at that point, which might partially explain the Fed's recent rate increases in the face of weakening data. If things turn ugly some very difficult choices will be forced on those in charge of monetary policy. A very possible reaction will be a complete 180  in policy with a brand new series QE. Printing massive amounts of new money to further manipulate the markets and monetize debt would put serious downward pressure on the dollar and weaken the economy.

Janet's statement was in all likelihood a further attempt to instill confidence in the market as she prepares to remove the primary supports holding up the debt bubble. The bottom line is this debt bubble will not end well and will be far worse than 2008/09. The largest financial crisis under the watch of the Federal Reserve is approaching, regardless what Janet says.