Is a replay of September ’08 on the horizon?
There has been a bit of buzz of late about the notorious yield curve, that seemingly prophetic differential between the yields of long- and short-term debt instruments of what we are to assume to be of equal credit quality. It looks like it’s flattening–the yields on long-term bonds are lowering relative to those of short-term bonds. One would ordinarily expect the interest rates on long-term debt to be higher than those of short-term debt as they compensate investors for putting their money at risk over a longer time horizon, thus subjecting their investments to the market and economic conditions of a future too distant to assess at the present time. If long-term yields are falling, it’s because investors are buying up more long-term bonds, thus bidding up the prices of those bonds and decreasing those yields. A big reason why investors would start increasing their purchases of long-term debt would be that they are attempting to lock in today’s rates for the long haul, as they assume that interest rates will soon be falling.
And why would they assume a decrease in interest rates at a time when the Fed has been incrementally raising them? One reason would be that they fear a seismically disruptive downturn in the markets. The times that those long-term yields have dipped below those of the short-term bonds in the past–when the yield curve has inverted–have been followed by severe market downturns and recessions. In fact, the Federal Reserve Bank of San Francisco says that an inverted yield curve has preceded every major recession of the past sixty years.
But now you may be asking why these investors are being so pessimistic, even with all this talk that the economy is going great guns like it hasn’t in over a decade or so. (Which is not to say that there haven’t been any naysayers.)
I’ve already mentioned the reason, about two paragraphs up–the Fed is raising interest rates.
You may recall–or maybe you don’t, it all seems like such a distant lifetime ago already–when everything melted down in September of 2008, what I like to call the Great Financial Sh*t-Show of 2008. There was this steep sell-off in the markets that folded companies and financial institutions like houses of cards, the sell-off being largely of debt securities creatively collateralized by mortgage obligations.
The U.S. Congress passed a major bail-out package, the “Emergency Economic Stabilization Act of 2008,” which President George W. Bush signed within hours of its passage. The legislation had already been in the works for several months prior to the September ’08 crash, largely under the direction of then Treasury Secretary Henry Paulson, a former chairman and CEO of Goldman Sachs. Both major party presidential nominees at the time–then Senators Barack Obama and John McCain–bolted from the campaign trail and pretty much raced each other back to D.C. to vote for the bill, which created the $700 billion Troubled Assets Relief Program (TARP) to purchase the newly devalued assets clogging up Wall Street’s balance sheets. Of that $700 billion, $250 billion was spent on purchases of the preferred stock of financial institutions through what was called the Capital Purchase Program (CPP). But even before the passage of the bail-out bill, the Fed was already pumping liquidity into the markets through low-interest loans made through its discount window, and had put out more than $7.5 trillion by the spring of 2009.
To put it more succinctly, the Congress and the Fed created just about the greatest corporate welfare program in U.S. history. The American people were told that if they were not compelled to compensate for Wall Street’s losses, the Great Depression 2.0 would overcome the land, followed by a plague of locusts and a thousand years of darkness, turning us all into beggars thrust into tent cities on the streets for the rest of our lives.
What preceded that crash was a raising of interest rates by the Federal Reserve, after a considerable period of time during which they had kept interest rates pushed down. Take a step backwards from the inversion of the yield curve, and you notice this rather curious pattern:
The above charts the growth and reduction in the “True Money Supply” against periods of economic recession. This approach to getting a grip on the actual supply of money was formulated by the economists Joseph Salerno and the late Murray Rothbard, which in turn is largely based on the concept of “money in the broader sense” as it was developed by the Austrian school economist Ludwig von Mises.
It’s positively eerie how the Fed’s expansion and contraction of the money supply coincides with the periodic booms and busts of the economy. It almost makes you wonder if there’s some kind of inherent causal relationship.
America’s central bank has of late been selling off assets that it has been carrying on its balance sheet since the ’08 crisis. In selling off assets, they are therefore reducing the money supply, which is how they effectively implement interest rate hikes. So if the pattern I identified above continues to hold, what does this portend? Another massive sell-off and a crash, perhaps?
So, to sum up: Step 1), The Federal Reserve massively expands the money supply with asset purchases, lowering interest rates, and then, Step 2), eventually sells off those assets to raise interest rates again, which is usually followed by a crash, or a panic, or whatever you want to call it.
And in an attempt to remedy the crash, they then go back to step 1 and repeat the process all over again, leading to the same kinds of results as before.
It almost seems as if the very basis of our entire banking and financial system is inherently flawed, as though it naturally leads to unsustainable booms and busts. Who knows how much real wealth it destroys in such a process?
Nah, that can’t be right.
That’s crazy talk.
Originally published at kaerchexicon.com on July 13, 2018.