Aftermath (Part 1): Consequences of a Massive Debt Bubble

The dark financial clouds are forming and the likelihood of a storm hitting is pretty certain. The question is what will be waiting for us once it hits.

The Fed has manufactured the largest debt bubble ever seen and there are signs that this bubble is starting to lose air. Subprime auto loan defaults are on the way up. Major retail chains are shutting down as business inventory continues to climb. Many very large pension funds are deep underwater with no hope of recovering.  Commercial real estate is showing weakness. Consumer debt is climbing through the roof and is on a unsustainable path, while home ownership rates are at extreme lows. Student loan debt has become a major issue. Government debt is at extreme levels, approaching 20 BILLION DOLLARS, surpassing 104% of GDP, with absolutely no plan to resolve it moving forward. Unfunded government liabilities are ignored by government and mainstream media, but is without a doubt a massive ticking time bomb. I guess its not a worth worrying about until its too late. I suppose if they pointed out the fact that millions of Americans who thought they had a nice pension waiting for them, will not be getting it, it might cause people to get upset. So it is best we sweep that under the rug for a later date. Three cheers for ignorance.

The elements for a serious fiscal collapse are stirring. Once the markets begin to topple, there will be a significant drop off in market liquidity. The major force that has kept pushing markets higher (ie: central bank purchases) will be greatly reduced, if things go as planned. The Federal Reserve has given up on expanding its quantitative easing for now, and is openly considering quantitative tightening.  The ECB is starting to consider reducing its market manipulation through asset purchases. The Bank of Japan is still gleefully chasing failed Keynesian policy with nothing to show for it. After over a decade of epic failures they still haven't figured it out yet. None of this central bank "stimulation" has revived the global economy. It has just created the largest debt bubble ever. The markets are just starting to grasp this concept. The central banks are feeling pressure from those questioning when the decade old "emergency measures" will lead to a recovery.  So far its been little more than a big fat nothing burger.

Oh sure 15.1 TRILLION DOLLARS of central bank manipulation have driven asset prices sky high. There is no denying the fact that the stock markets and bond markets are at incredible highs. Throwing over 15 TRILLION DOLLARS and still growing (over 2 TRILLION DOLLARS a year a of additional artificial manipulation) at the markets will do that. For those questioning where the inflation is, might want to check asset prices, but that is for a different blog post on another day.

Now lets hope nobody in there right mind actually puts much weight in these market prices. Yes they look good on paper, but they do not reflect true price discovery. Its market manipulation. These prices are reflecting what prices are after massive central bank infusion. These prices are all part of the temporary scheme set forth by central banks to make the world feel richer, or at least those lucky enough to be holding assets. This has been their strategy all along and they have been open about it. Yes the central banks of the nations which were once the pinnacles of free markets are now bureaucratic sloths embracing central planning. Nothing says efficient markets like socialized support.

It all reminds me of when a little kid gets tired of walking at the amusement park. His parents pick him up and carry him for a while. Suddenly they start moving faster through the park and it takes so much less energy for the kid to get where they were going. The central banks have replaced the free markets and are carrying everyone along for the ride. Now of course if the central banks were ever forced to reinstate free market price discovery things would look much different. There would be a major correction once the manipulation was priced out of the markets. I am not just talking about equity markets, but the much larger bond and treasury markets, where interest rates has been kept near or below zero since 2009. The price for a decade of malinvestment and mass expansion of debt will likely make the 2008/09 market crash look like a simple day in the park.

Yet Janet Yellen and friends seem to think this is a tiny price to pay for a decade of slow to stagnant growth. The growth rate over the past decade has been so weak that we have not seen anything like it since the 1930's, during the great depression.

The last 10 years have matched the great depression

The access to endless amounts of nearly free money, which has been multiplied many times over through fractional banking, has seen the burden of debt cripple the economy while we have also seen spectacular amounts of speculation through the economy on questionable businesses, risky projects and even pure lunacy. Governments have gone on a binge like never seen before. It is one gigantic mess.

When this Fed bubble finally blows there will be wide spread panic in the markets. There will be nobody buying into a crashing market. The highly levered private equity funds will not wait around before they begin to pull the trigger, lest they are forced to unwind. The same goes for the record levels of margin in the New York markets. The passive money in index funds will be jumping off the bandwagon and on to the sell button as endless streams of selling hits the markets. The bond markets will become a bloodbath if risk premium shoots up. Now that the Fed is out of buying game, there is very little support in the bond markets at these levels. Of course if rates begin to rise to reflect actual risk, we will see major issues sprouting up across the economy. Higher rates would be very damaging across the board. Many governments are so deep in debt that seeing interest rates climb to normal levels would be a severe blow to their finances and force some very painful decisions. Many governments are already feeling the strain, even at these extremely low rates. Illinois is the latest state to sound the warning bells.  The record levels of debt is not sustainable. When rates normalize the broader economy will begin to buckle under the weight of massive debt.

Once the market reaches this point the Fed will be at a fork in the road. In essence there will be two primary paths they can choose:

A)  They can admit that the recovery was never real and the economy requires endless amounts of QE to sustain itself and then proceed to print many more trillions of dollars as a means of keeping the market from collapsing and further monetize debt, while driving the dollar into the ground. The QE debt bubble was the subscribed solution last time (actually 3 rounds of QE) and the world believed them, so why not try again? Once the investors realize the Fed is willing to sacrifice the dollar to support asset prices and monetize US debt they will lose confidence in the US dollar. International investors will likely start pulling their money from US denominated securities, which would end up pushing rates higher.

B) They can accept their previous policy actions of monetizing debt and manipulating markets have been an abysmal failure. Instead they could choose to allow the free markets to work through the debt bubble they made by creating the conditions where true price discovery is reached. It won't be pretty either way, but they could look at protecting the weakening greenback by allowing rates to normalize slowly. This action would likely see the debt bubble further collapse and see the markets move further towards a correction, but you can't undo the largest debt bubble in history without feeling it. Once we are through the correction period we can look at building a sustainable economy based on balanced fiscal policy and stable monetary policy.

Given these two scenarios and considering the historical preference of the Fed to use debt bubbles as the "solution" of choice to "save"a systemic failing economy, it is a good bet that the Fed will double down on the printing press option and go with the first alternative, at least initially. By further utilizing their failed policy it will look to extend the market's and Washington's limited confidence in the failed institution of academics. How long the markets buy into endless amounts of money printing is questionable, but it hasn't stopped Japan from this "solution" policy.