Home » Economy » The Bubble is Back, Part 1: “A Sense of Complacency”

The Bubble is Back, Part 1: “A Sense of Complacency”

by John Rubino on August 12, 2013 · 19 comments

Just when you think it can’t get any stranger, the U.S. economy – measured by the declining number of full-time jobs, lower household incomes and below target inflation rate – seems to be weakening, while the most speculative asset markets lurch back into full-tilt bubble mode. Home prices in Vegas, Silicon Valley, and Miami are above 2007 levels, equities are near all-time highs, and bank stocks are once again dominant in the S&P 500. It’s as if 2008/2009 never happened. And now this from Bloomberg, about the return of junk bonds:

Bond Hubris Overwhelms Fed in Riskiest Credit-Market Sectors

Bond investors trying to divine when the Federal Reserve will reduce its unprecedented monetary stimulus are increasingly looking to the riskiest parts of the debt market, which are booming like before the financial crisis.

The amount of loans made this year that lack standard protections for lenders exceed the all-time high set in 2007, and only one other time have investors pumped more money into funds that buy lower-rated loans than they did last week. Bonds rated in the lowest category of junk accounted for the greatest percentage of speculative-grade offerings last month since 2011.

Funds that purchase speculative-grade, or leveraged, loans in the U.S. attracted $2 billion last week, the second-biggest inflow on record, according to Charlotte, North Carolina-based Bank of America Corp. Companies will raise as much as $360 billion of the debt this year, Barclays Plc said Aug. 9, up from an earlier estimate of as much as $250 billion.

Lacking Safeguards

The market for so-called covenant-light loans that lack typical lender safeguards such as limits on debt has already soared to $155 billion this year, beating the record $96.6 billion in 2007, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.

Junk-bond sales rose 24 percent to $235.3 billion through Aug. 9 compared to the same period a year ago, according to data compiled by Bloomberg. Those securities and leveraged loans are rated below Baa3 by Moody’s Investors Service and less than BBB-at S&P.

Sales of payment-in-kind, or PIK, notes, which allow borrowers who can’t meet interest obligations to pay with additional debt, total more than $6.5 billion this year, on pace to top the $8.1 billion issued in 2012, Bloomberg data show.

Corporate bonds in the lowest rating tier of CCC made up 10.3 percent of the $22.4 billion in high yield sales in July, the most since 2011, according to JPMorgan Chase & Co.

Corporate default rates, at about 3 percent, are near historic lows, according to Moody’s, generating a sense of complacency among investors.

‘Pattern’ Detected

Fed Governor Stein said in a February speech that investors in company debt had been engaging in “a fairly significant pattern of reaching-for-yield behavior.”

At 7.4 percent, the jobless rate remains above the Fed’s 6.5 percent target, while the rate of inflation is below 2.5 percent, levels policy makers said would trigger a reduction in its bond purchases.

Speculating ‘Serpent’

Investors convinced the Fed is going to keep interest rates low through 2016 are more willing to take risk and add leverage, forcing the central bank into a balancing act to encourage lending while preventing bubbles, according to Lawrence McDonald, senior director for credit, sales and trading at Newedge USA LLC.

“If you’re too accommodative, the serpent in the market will come back and start speculating really quickly, and that’s what’s happened to some extent,” he said in an Aug. 5 telephone interview. “They’re watching that like a hawk.”

Some thoughts
Let’s start with some of the more amusing quotes from the above article:

“Corporate default rates, at about 3 percent, are near historic lows, according to Moody’s, generating a sense of complacency among investors.” By now we should have learned that default rates are always low at the peak of a bubble because when money is freely available, almost no one has to default. But as soon as the cash tide goes out, to use Warren Buffett’s turn of phrase, you quickly find out who’s been swimming naked. So a low default rate in a speculative sector points to a high default rate a year or two hence.

“Fed Governor Stein said in a February speech that investors in company debt had been engaging in ‘a fairly significant pattern of reaching-for-yield behavior.’” Which is exactly what Governor Stein’s organization has been trying to engineer. By forcing interest rates down, the Fed hopes to cause everyone from retirees on fixed incomes, to young families saving for their kids’ college, to municipal pension funds, to move way out on the risk curve, speculating in stocks, junk bonds and derivatives. To the extent that it’s working, it is doing so by sacrificing a whole generation of unsophisticated investors who are in completely inappropriate investments and will be crushed when those markets turn down.

“If you’re too accommodative, the serpent in the market will come back and start speculating really quickly, and that’s what’s happened to some extent …They’re watching that like a hawk.” Yes they’re watching, and they’re relieved to see speculation finally breaking out in the junkiest sectors of the economy. The Hail-Mary strategy is to get the animal spirits going and hope it translates into sustainable growth – despite the fact that the junk bond bubble of the 1980s, the tech bubble of the 1990s, and the housing bubble of the ‘00s all failed to do so.

Anyhow, that speculative markets are looking like 2007 while the velocity of money is at record lows is truly fascinating, and raises the question of how those markets will behave if normal velocity returns. But it’s okay, the experts are watching it like a hawk.

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  • Willy1964

    Another misconception: “The FED determines interest rates”. No, that’s done by a force called “Mr. Market’. And the FED always follows “Mr. Market”.

    • bill Hope

      you can bet your old jeep on that…..in no way did the Fed “adjust” the ten year from 1.7% to 2.6% last month on purpose. They have some influnence, but when it gets away from them, things can get real wild real quick

    • Bruce C

      I agree, but only to a limited extent. The “market” is pretty pathetic by any measure that I can glean. To me it reflects only the most base sentiments: greed, fear, obedience, gullibility, evasion, hypocrisy, pragmatism, idolatry, cynicism, immaturity, etc. The market may occasionally stumble into seemingly rational or proactive behavior but it is usually motivated by one of the baser emotions instead of rational conviction.

      The FED invokes “perception management” so even though sometimes the FED has to adjust to the market’s waywardness it is usually the market that follows the FED’s lead. The slogan, “Don’t fight the FED” is akin to “City Hall propaganda.”

    • Sueychop

      Mr. Market’s about to whack the Fed big time.

  • Chris

    It is unconscionable of Fed to leave interest rate that low for so long as it will force retirees or anybody with money in the bank to move them into risky financial products. It is not going to end well. As money had gone into unproductive areas like junk bonds and the stock market, there is little improvement in the productive area that generates jobs. The next failure would be in the bond market and might even affect sovereign bonds. The bonds sitting in central banks are not reserves but worthless IOUs of bankrupt countries. If Japan goes bust, it will start off a chain reaction in the financial world like a swinging wrecking ball, knocking down one bond after another. We know that the assets that Japan central bank has, like the US bonds, cannot be sold as selling them will cause the price of US bonds to plunge. As bonds have counter party risk, some central banks have gold in their reserves. The mortgage crisis in 2007/8 was due to banks and insurance companies owning CDOs and CDSs which have counter party risks that nearly brought down the world economy. In this coming crash, it could be the sovereign bond starting with either Japan or EU. The rush by central banks into reserves with no counter party risk will cause them (eg gold) to shoot up to the moon. Sovereign bonds will fail because of its risk free status is being abused to the point of being risky. Just like the invincible CDOs were also abused by sub prime loans, etc, to the extent of being risky. Inflation in consumer items is high but bearable and ruled as low. But asset inflation is astronomical and unsustainable. The money Fed put into the economy is finding their way to the wrong areas like junk bonds and stock market, and Fed is keeping an eye on the wrong area like jobs. Junk bonds, housing and stock markets are already in dangerous territory and more money will only make them worse. The poor retirees who wanted to put money in the bank but were forced to put money into the stock market will be badly hurt when the market change direction.

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  • Steve

    Very Ultra Low Risk is Gold/Silver. Where else can you buy $100 bills for $10 dollars???

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  • Bruce C.

    There seems to be as many reasons to be complacent these days as there are reasons not to be. For every article, data point, statistic, and trend line that indicates the worst is over and blue skies are ahead, there are just as many that say the opposite. Furthermore, just the natural reaction to so many heightened concerns for so long now – none of which have happened – can give rise to complacency out of sheer exhaustion and capitulation.

    For how many decades have we been hearing about threats to Israel, Iran’s imminent nuclear capabilities, instabilities in the Middle East threatening a third world war, local skirmishes getting out of hand, and oil supplies being cut off? The 2009 “suckers” stock market rally, the demise of the EU and the euro, China this, China that, Japan is going to crash, Fukashima may be a world-wide disaster, the US dollar is going to crash, interest rates are sure to rise, gold and silver are going ballistic, gold and silver are in bubbles, gold and silver may crash, debt is the problem, debt is not the problem, debt doesn’t matter, when the Fed stops QE things are going to crash, the Fed will never stop QE, if the Fed doesn’t stop QE things are going to crash, corporate profits are rising, corporate profits are falling, stocks are overpriced, stocks are under priced, the US is becoming fascist, the US is experiencing an entrepreneurial renaissance, there is an energy and manufacturing boom in the US, there is no recovery in the US, everybody wants to come to America, America is in decline, unemployment is falling, real unemployment is rising, the Fed won’t let the markets go down much, the Fed can’t keep the markets up indefinitely, central banks are buying gold, central banks are selling gold, there is a shortage of gold, there is no shortage of gold, the gold price is manipulated, the gold price is not manipulated, interest rates are rising, interest rates are falling, inflation is low, inflation is higher than it seems, inflation is really not as high as it seems, Europe is starting to grow again, Europe is stagnating, Europe is getting worse, the developed Western economies are in decline and the East is growing, North America is experiencing a revival, the developing economies are declining, the US stock market is the place to be, anyone still in stocks is going to regret it, bonds are in a bubble, bonds are still the safe haven, junk bonds are safe because of all the corporate cash, junk bonds are signaling trouble, mining stocks are the most undervalued of all, mining stocks are poised to go higher, mining stocks still have further to fall, mining stocks will fall if the overall market falls, mining stocks are a hedge against a market crash, the demand for oil is growing, the demand for oil is falling, the demand for oil is flat, fracking will make the US a net energy exporter, fracking will fail to live up to its hype, consumer consumption is rising, consumer consumption is falling, wages are rising, wages are falling, the glass is half full, the glass is half empty.

    • bill Hope

      great post Bruce, thanks for verbally diagraming our collective schizoid financial consciousness. I have often thought the reason this market hasn’t imploded is that so many expect it, anticipate it, and bet that way….that it can’t happen. Of course I thought that in 2006-7 also

  • Bill197511

    The complacency, espoused by shills like Paul Krugman and Ben Bernanke is just propaganda to convince us that their phony recovery is going strong. In truth, they have thrown over 4 trillion $ into the banker’s pockets and the money resides there now. When that money finally makes it into the economy, the Fed will get the inflation they want and will continue to trash the dollar. Both of the above “men” are misguided liars.

    • Dan

      And so was Ricardo a liar too? You see free trade was sold to us too and now we are left with a over sized investment industry that produces nothing but debt and lives off of people who speculate in it with other people’s money. And that other people’s money is the money they gained from the workers productivity, as it rose, and their pay stagnated the last 30 years. It’s called supply side economics, I believe kicked off by the nother the infamous Reagan, Mr. Voodoo.

      Ricardo didn’t know what to say about what would happen if capital would leave the state of origination, probably because he didn’t think the people running the government would actually kill the goose that gave us the golden egg, the middle class.

      In the end it will be the government, no matter what the free markets types say, will be the one who steps in and ends this whole ponzi scheme, as it did in FDR’s time, and anyone who says markets will, is sadly a misled, or paid to say it by the people who are benefiting from it.

      It’s called the business cycle of death and destruction for anyone who gets in the way, most likely people who acutely work for a living

      • Bill197511

        Who is Ricardo?

        • Dan

          David Ricardo is a 19th century economist who came up with the theory of comparative advantage that economists like to point to when talking economics. Read the book Free Trade Doesn’t Work, by Ian Fletcher, a conservative economist who presents a logical well thought argument how it doesn’t work in the long run with proof. Free trade was tried and failed by Great Britain and ended it to late, as they had lost their comparative advantage, as we will too.

      • llowe888

        Well said. Read the ‘Road to Selfdom’ by Hayek regarding free market.. to some extent is a workable solution. Too much of it will generate.. eventually ‘free market’ speculation. I made money in the heydays of Thatcherism but now regretting my involvement in this degrading illusive market economy..

        I do think in the end, you can’t forecast herd mentality especially in the psychology of it. Even in a flocking herd of speculators, some(weakest link) will be pick out and eradicate by the risk invoked by extreme risks! Recently JP Morgan loses was an indication of such risk in derivitive.. a $30 mil blow out to 6+ billions

      • picomanning

        And when was the last time interest rates were subject to ‘free trade’?
        Markets in free trade are can be defined by individuals. Free trade is an historical anomally. Yet free trade is what best promotes economic growth.
        There are no contradictions.

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