It's
Looking A Lot Like 2008 Now...
Did
today's market plunge mark the start of the next crash?
by
Chris Martenson
2
February, 2018
Economic
and market conditions are eerily like they were in late 2007/early
2008.
Remember
back then? Everything was going great.
Home
prices were soaring. Jobs were plentiful.
The
great cultural marketing machine was busy proclaiming that a new era
of permanent prosperity had dawned, thanks to the steady leadership
of Alan Greenspan and later Ben Bernanke.
And
only a small cadre of cranks, like me, was singing a different
tune; warning instead that a painful reckoning in our financial
system was approaching fast.
It's
fitting that I'm writing this on Groundhog Day, as to these veteran
eyes, it sure has been looking a lot like late 2007/early 2008
lately...
The Fed's 'Reign Of Error'
Of
course, the Great Financial Crisis arrived in late 2008, proving that
the public's faith in central bankers had been badly misplaced.
In
reality, all Ben Bernanke did was to drop interest rates to 1%. This
provided an unprecedented incentive for investors and institutions to
borrow, igniting a massive housing bubble as well as outsized equity
and bond gains.
It's
worth taking a moment to understand the mechanism the Federal Reserve
used back then to lower interest rates (it’s different today). It
did so by flooding the banking system with enough “liquidity”
(i.e. electronically printed digital currency units) until all the
banks felt comfortable lending or borrowing from each other at an
average rate of 1%.
The
knock-on effect of flooding the US banking system (and, really, the
entire world) in this way created an echo bubble to replace the one
created earlier during Alan Greenspan’s tenure (known as the
Dot-Com Bubble, though 'Sweep Account' Bubble is more accurate in my
opinion):
The
above chart shows the Fed’s 'reign of error'. It began with the
deeply unfortunate sweeps program initiated at the end of 1994
(described below), proceeded to the echo bubble that itself broke in
2008 with even greater damage done, and all of which has led us to
where we are today.
Note
the twin panics of 2016 on the above chart. Panic #1
occurred when our current bubble threatened to burst -- that
scared the living daylights out of the Big 3 central banks: the Fed,
the ECB and the BoJ. So they colluded to juice the
markets and boy, did they succeed. Panic #2 was the surprise
election of Donald Trump. So much thin-air currency was created
and dumped into the markets after that unpredicted event that we got
that the markets have pretty much gone vertical ever since (note the
protractor in the chart above).
When
this current bubble pops, the one that I've repeatedly described
as The
Mother Of All Financial Bubbles,
the ensuing damage will be many multiples of that caused by the
bursting of the bubbles that preceded it. That’s the nature
of these things: you either take your lumps when you should, or you
pay a far steeper price later on.
So
far, we've done all we can to postpone any consequences as far into
the future as possible. Someday, maybe someday very soon, those
consequences will arrive. And, at our unprecedented extremes in
(over)valuation, the price we will have to pay then will be very
steep indeed.
Swept Away
One
of Greenspan's biggest sins while at the helm of the Federal Reserve
was allowing the banks to implement “sweep accounts” for retail
deposit accounts.
Banks
are required to hold some of your deposited money ‘”in reserve”,
commonly around 10%, to act as a cushion against insolvency risk.
This means that if you have $1,000 on deposit at a bank, it's
supposed to have $100 of that in cash on hand in case you
unexpectedly walk in and demand some of your money back.
Since
it’s only during a bank run that everybody wants 100% of their
money back, the Federal Reserve only required banks to keep just 10%
of depositor money on hand at any given time. They rest can be loaned
out. (That's why this is called 'fractional reserve lending').
Banks
don’t make very much money by holding onto your money. They
want to “put it to work". Through the miracle of
fractional reserve banking (at 10% in reserve) your deposited $1,000
can be turned into $9,000 of new loans.
Instead
of offering you 0.5% on your savings while getting 1.5% on a Treasury
bond (booooooring!)
and pocketing the 1% spread, banks would prefer to lend out 90% of
your deposit to a homeowner while charging 4% and pocketing a
whopping 3.5% spread.
In
Scenario A the banks make $10 from their 1% spread on $1,000. In
Scenario B they make $355 in net interest profits on your same $1,000
deposit. That's a big difference.
But
what if even that’s not enough to sate the banks' hunger for
greater profit? What if the banks feel overly hamstrung by that pesky
10% reserve requirement? What if they only had to hold 5% in
reserve?
Well,
then $20,000 in loans can be made against your $1,000 deposit.
If we call this Scenario C (again at a 4% loan rate,) then banks can
make $755 in net interest profit on the back of your $1,000 deposit.
Now that’s more exciting!
But
how to get around that pesky 10% reserve requirement? This is
where Alan Greenspan stepped in back in 1994. Facing unwanted
tightness in the corporate bond market, an effort was made to inject
more liquidity into the system. Greenspan's solution for where that
new money should come from was to allow the extension of sweep
accounts into retail banking.
Now,
what's a sweep account? Good question.
If
you have a checking account with a bank, you very likely also have a
corresponding sweep account (also in your name) that you probably
never knew was there.
Each
night, right before the bank's reserve snapshot is taken, all of the
money in your checking account is briefly "swept" into a
special sweep account which has no reserve requirements. So, when the
reserve snapshot is taken for your bank, presto!, there's
no money in your checking account -- so, as far the regulators are
concerned, your bank need not hold any money in reserve for that
account.
And
right after the reserve snapshot is taken, presto
again!,
your money is swept right back into your checking account.
Sounds
crazy or, at least, illegal -- right? But it's real.
From
the Federal Reserve itself we get this description of sweep accounts:
Since January 1994, hundreds of banks and other depository financial institutions have implemented automated computer programs that reduce their required reserves by analyzing customers' use of checkable deposits (demand deposits, ATS, NOW, and other checkable deposits) and "sweeping" such deposits into savings deposits (specifically, MMDA, or money market deposit accounts). Under the Federal Reserve's Regulation D, MMDA accounts are personal saving deposits and, hence, have a zero statutory reserve requirement.
(Source)
The
result of this program effectively removed reserve requirements
altogether, allowing a flood of new lending to proceed. Sure, that
fixed the corporate bond market tightness; but it also gave rise to
the massive stock bubble of the late 1990s (see the red arrow
pointing upwards on the above chart).
So
why focus so much on the creation of the sweep accounts program?
First:
this was the original error that the Fed has been responding to ever
since, just as a drunk driver responds to a skid by
oversteering this way
then that way
with the skid, over-correcting too much each time. If you want
to understand today’s dilemmas you have to know this little bit of
history.
Second:
this was the beginning of the “We’ll
just change the rules when it suits our needs”
regime that has now so utterly infected the regulatory apparatus of
the US financial system. As a result, for all practical purposes,
there really aren’t any iron-clad rules we can count on anymore.
The
corollary to this is that creating a lot of easy money is fun and
exciting for a while, but then make things far worse in the end.
Why
is that? Because you can't print prosperity. Money
printing only steals prosperity from the masses, and most especially,
from future generations -- that’s all the central banks really ever
can do.
But
theft isn't a sustainable form of governance. The central banks reign
of error(s) will continue and compound until we, the people, finally
rise up and demand something different.
What
will it take to create enough public outrage to trigger this? Well,
how about another massive financial crisis, one that may make 2008
look tame in comparison?
Look,
bubbles always burst. And there are very worrying signs that the
current Mother Of All Financial Bubbles is ending right now.
What
most has my attention are spiking interest rates and oil prices
threatening to head above $70/bbl. These are twin shocks that
our extremely over-indebted and over-leveraged economic system simply
can't withstand for long before breaking down.
It’s 2007/2008 All Over Again
The
warning signs in 2007 were abundant and, for most, completely obvious
in hindsight. I was writing about them extensively at the time
and, today, I see too many parallel features for comfort.
It's not that conditions are exactly the same, but they're so similar
that we’d have to quibble to separate them.
Whereas
in 2007 people were borrowing heavily against their rising home
prices, today we have record household debt, record auto loan
balances (in terms of both payment schedule length and amount),
record corporate debt, and record sovereign debts.
In
2007 the Fed was carefully raising rates to see if they could build
up an interest rate buffer. Today, we also have rising
rates and declining market liquidity due to reduced
central bank QE activity:
Note
that "raising rates” today isn't exactly the same as it was in
2007, save that that borrowing money costs you a little more. So,
yes, auto loans and mortgages all cost a little more than they did a
few months ago.
But
unlike the mechanism the Fed used in 2007, today it's not driving
interest rates higher by withdrawing liquidity. Instead, it's
doing so by simply offering a higher rate of interest to banks on
their excess reserves (IOER), and that drags the overall rate of
interest up.
Why?
Because if you're a bank and you have the choice between either
lending overnight to another bank or lending money to the Fed (which
is completely risk-free), then you're going to take the best deal.
Right now, the Fed is offering pretty sweet terms.
This
chart explains why and how the Fed has been able to raise rates
without draining liquidity:
Without
this little feature, unwisely authorized by congress in 2008, the Fed
would have to drain many hundreds of billions of dollars from the
system to hike interest rates. Instead, now they can just set the
IOER higher, as if it were a magic dial that sets the price of money.
It’s
a cool trick. But it's newness prevents us from looking to past
interest hiking cycles for clues as to how this current one will play
out. The dynamics are totally different.
Now,
the Fed is starting to drain liquidity from the system, too. It's
using a process it refers to as ‘reducing its balance sheet.’
On
that front, we see that the Fed has allowed some $30 billion of
Treasurys to ‘roll off’ its balance sheet. This simply means that
when these instruments matured, the Treasury Department returned the
principal to the Fed (thus 'retiring' the bonds), instead of seeing
the Fed replace the bonds by printing up more money to buy more of
the same securities at the next Treasury auction:
While
the above chart may look dramatic, it’s not really. It won't really
impact things much as long as the ECB and the BoJ continue to print
and dump more new digital currency into world markets. (Although,
they've publicly committed to tapering these purchases in the future
-- so far that’s not really in the data unless we squint hopefully
at the last little wiggle in the chart below):
But
what really matters is this next chart, which shows the combined
stimulus across all the major central banks. Since the financial
system is truly global now, it matters less what any one central bank
is doing and instead we have to look across them all.
When
we do, this is what we see:
Anything
above the zero line means that central banks are still dumping money
into the system. So they are not collectively ‘tightening’
yet, which would technically mean they would be removing money from
the system -- as they are slated to do somewhere around the beginning
of 2019.
However,
the world’s debt levels and stock and bond prices are all so
massively stretched and elevated, that simply even doing less money
printing may have the same effect as tightening. Believe it or not,
we’re coming off of the largest year of money printing in all of
history in 2017.
Think
about that for a second…nine years into the ‘recovery’ and the
central banks printed the largest amount of emergency money ever.
Which
is it? Are we still experiencing an emergency of historically
unprecedented magnitude? Or are we years into enjoying a robust
"recovery", as our media and elected officials have been
telling us?
Of
course, we've been writing here at PeakProsperity.com for years that
our global economic and financial systems are dramatically more
tenuous than we're being told
In
my calculation, the markets cannot withstand any reduction
in stimulus. If the projected tightening actually occurs, asset
prices will begin to fall violently in response. When that occurs,
all the central banks' promised plans will be tossed in the trash
can. The ensuing rescue efforts will unleash a tidal wave of
liquidity that will dwarf the efforts of the past decade, and very
likely destroy the remaining purchasing power of the world's major
fiat currencies.
But
first, the markets will need to fall hard, in order to give the
central bankers enough political air cover for such drastic action.
Expect to see days where the Dow closes down between 500 - 1,000
points in a single day.
Just
like today...
Assume The Crash Position
So,
is the top in? Are the markets in the process of rolling over?
In Part
2: Is This It? we
examine the congregating perfect storm of crash triggers -- rising
interest rates, a fast-weakening dollar, a sudden return of
volatility to the markets after a decade of absence, rising oil
prices -- and calculate whether today's 666-point drop in the Dow is
the start of a 2008-style market melt-down (or worse).
Make
no mistake: these are sick, distorted, deformed and
liquidity-addicted markets. They've gotten entirely too dependent on
continued largess from the central banks.
That
is now ending.
After
so many years of such extreme market manipulation finally gives way,
the coming losses will be staggeringly enormous.
The
chief concern of any prudent investor right now should be: How
do I avoid being collateral damage in the coming reckoning?
Click
here to read Part 2 of
this report (free
executive summary, enrollment required
for full access)
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