Hedge Fund CIO: "Like 2000 And 2008, This Too Is An Asset Bubble But It Differs In A Fundamental Way"

Submitted by Eric Peters, CIO of One River Asset Management

Anecdote

Central banks have created yet another asset bubble that will lead to a deflationary collapse just like 2000 or 2008, explained the famous investor.

And I agreed that there’s an asset bubble, but this one differs in a fundamental way. The previous two asset bubbles created a powerful wealth effect. In 2000, the stock bubble made people feel wealthier. They spent more, saved less. When asset prices collapsed, consumption retrenched because the wealth they’d been spending evaporated. Only the debt remained. The same thing occurred in 2008 but with housing. Part of why growth has been comparatively anemic in this bubble is there’s been no discernable wealth effect.

After two painful collapses in wealth, the consumer caught on to the Fed’s game and refuses to be fooled a third time. The Fed refuses to repeat this painful cycle too. So they’ve committed to a gentle tightening, and a gradual balance sheet reduction, terrified that aggressive action will trigger a third deflationary bust. It is this fear that ensures the Fed will remain behind the curve.

But while this expansion is now finally generating inflation, the next market bust is unlikely to spark a deflation like the previous two -- because unlike those booms, today’s inflationary impulse is not caused by the wealth effect. Prices are accelerating today in the absence of the wealth effect. Their rise is fueled by expanding deficits, tariffs, tax cuts, anti-immigration, de-globalization – all coming at a time of record low unemployment.

These things are new features in the economic landscape, introduced by politicians who were elected to address voter anger over wealth inequality, income insecurity – not just here in the US, but throughout Europe, Japan too. And these new features ensure that this cycle’s turn will look profoundly different from the 2000 and 2008 deflationary collapses.

Modern Central Banking:

“Historical tenets for how monetary policy impacts inflation aren’t functioning,” said St. Louis Fed CEO, James Bullard. “The Phillips Curve has disappeared and neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure.”

Given the uncertainty, Bullard argues the Fed should use financial market signals in deciding monetary policy – specifically the yield curve slope. In his estimation the Fed was wrong to ignore the flattening curve in 2000 and 2006 when tightening policy.

I wanted to ask Bullard if monetary policy changes this decade (dot plots, quantitative easing, yield curve control, negative term premium targeting, etc.) might be distorting the yield curve. In that context, is it correct to compare today’s yield curve to previous decades? Given these interventions, how would one begin to separate central bank action from market signal? Is there not a risk of treating the direct results of your own actions as an independent variable to further validate your actions? But Bullard wasn’t taking questions.

The Whole Isn’t The Sum Of The Parts:

“One of the great difficulties in convincing believers that neoclassical economics fundamentally misunderstands capitalism is that, at a superficial and individual level, it seems to make so much sense…. At an individual level, the basic economic concepts of utility-maximizing and profit-maximizing behavior seem sound…. Since they seem to make sense of the personal dilemmas we face, it is fairly easy to believe that they make sense at the level of society as well. The reason this does not follow is that most economic phenomena at the social level – the level of markets and whole economies rather than individual consumers and producers – are ‘emergent phenomena’: they occur because of our interactions with each other – which neoclassical economics cannot describe.”

– Steve Keen, Debunking Economics

Outlier:

At this week’s inflation conference, the questions were predictable, the analysis uniform, orthodox, and the singular conclusion was that inflation will be 2% over almost any horizon. Tariffs were treated as one-offs -- short-term deviations from a stable trend. I was the outlier, suggesting a different perspective: What if what we see today is all connected? Instead of looking from the bottom up, at the tariff, look top down at the reason for the tariff. American nationalism, Brexit, Italian elections, (among others), do they reflect a secular shift?