Why Investor Irrationality Does Not Solely Account For Bubble Cycles

An academician recently suggested that the success of those who accurately identified and predicted the emergence and the impact of past bubbles had been a result of happenstance.

That's because allegedly, since it is human tendency to seek patterns even where there is none, which is known as clustering illusions, these patterns coincidentally played out favorably for those who made the seemingly prescient predictions.

The academic expert further claimed that bubbles signify as deviations from 'fundamentals'.

In other words, the bubble phenomenon has been largely blamed on irrational behavior or cognitive biases, in the perspective of the expert.

While we accede that cognitive biases have a major role to play in bubble cycles, we believe that irrational behavior is basically prompted by responses of the marketplace to the incentives shaped by displacements.

People just don't buy stocks or real estate out of mood or because today's horoscope column say so.

For whatever cognitive reasons for the transactional actions, they are facilitated by real forces such as easy access to credit, low interest rates and or other government policies that shape incentives such as subsidies, guarantees, distortive tax laws and etc...

Thus, while people can or will be herded into irrational behavior, such as impulsive buying, it takes money to drive up asset prices. And money functions like fuel that mobilizes a car-regardless of the intended destination of the driver [For all we know he can drive the vehicle off a cliff!].

And sound money based on real savings don't create nasty nationwide bubbles. That's because the ability to go on a speculative binge would be restricted or that the access to credit will be limited...in spite of one's irrationality.

On the other hand, credit expansion from money from thin air not only facilitate but magnifies such human frailty.

Besides, if bubbles are an outcome of people's irrationality and fundamentals are indeed the genuine basis to evaluate assets, then why is it that there has been no consensus or established formula on what defines as the winning fundamental metric for investing?

For instance, value investors differ from growth based investors. Moreover, even from the value standpoint, analysts have different approaches (e.g. Graham & Dodd and etc...). This would largely depend on the parameters (data points, reference points and disparate theories) used to interpret data and to arrive at value.

In short as with bubbles, the ambiguity of ascertaining the so-called scale of 'intrinsic' value of an asset largely depends on subjective appraisal.

This chart from Bespoke could be used as example.

The chart demonstrates the basic fundamental metric for analyzing global stocks. It shows of the Price Earning ratio PLUS GDP growth.
According to Bespoke (whose chart is shown above), ``In this regard, we have created "PEG" ratios for a number of countries using the P/E ratio of each country's main equity market index along with 2010 estimated GDP growth rates. Just as with stocks, the lower the country PEG, the more attractive. As shown, India has the best PEG out of the countries we analyzed. It has a P/E ratio of 26.19 and estimated 2010 GDP growth of 8%. While its P/E isn't as low as a lot of countries, its growth rate is very high. China ranks second with a PEG of 3.66. The US ranks in the middle of the pack with a P/E of 24.53 and estimated GDP growth of 2.6%. At the bottom of the list sits Switzerland, Italy, and the UK, while Australia, Japan, and Spain have negative PEGs due to either a negative P/E ratio or negative estimated GDP growth."

So in spite of the breathtaking 2009 run, the HIGH current PE ratios (left column) can be deflated by adding an input-GDP growth (mid column). For the others with low GDP the effects of overvaluation is apparently magnified. So an additional variable changes the entire assessment process.

Hence, as per the economic growth adjusted perspective, this would imply that many stocks markets from China down to Russia have yet ample room to climb (right column) without having to be labeled as bubble.

And conversely, nations with poor or relative lesser economic growth should underperform or become suspect to thriving bubbles (due to exorbitant PEG ratios), e.g. as Taiwan to UK, while those with negative PEGs as Australia, Japan and Spain would account for the worst!

I am not suggesting nor am I implying that this approach is the valid way to deal with the markets. In my view this would seem irrelevant, since policies have all been calibrated to bubble blowing dynamics.

My point is that people will anchor on anything that will reinforce their biases regardless of the instruments used.

From Asian Development Bank

And the story above will most likely change with additional inputs, such as expected inflation (see ADB chart), demographic trends, and etc.

Yet the more inputs, the less likely these models will reflect on the reality and the more likely these would reflect on the bias of the analyst.

Bottom line: If investor irrationality have allegedly been the primary factor to cause for bubble episodes, then in the same context, fundamental metrics are a function of cognitive dissonance from cognitive biases.

Investor irrationality aren't primarily the cause of bubble cycles. That's because markets reflect on the subjective appraisals of the incentive driven participants that are mostly likely shaped by government policies.

The Smoke And Mirror Game Of Politics: Pres. Obama's Proposed Bank Tax

This would seem like a good example of how politicians engage in the game of political "smoke and mirrors" to spruce up on their images.

Pres. Obama, who appears to be working to shore up his rapidly flagging approval ratings, recently took to task the banking industry and proposed that banks be levied to cover or redeem the cost of the spate of bailouts.

The New York Times quoted Pres. Obama who said that he wanted "to recover every single dime the American people are owed."

The articles continues with Pres. Obama's strident diatribe on these banks, ``“We’re already hearing a hue and cry from Wall Street suggesting that this proposed fee is not only unwelcome but unfair,” he said. “That by some twisted logic it is more appropriate for the American people to bear the cost of the bailout rather than the industry that benefited from it, even though these executives are out there giving themselves huge bonuses.”

``Mr. Obama continued, “What I say to these executives is this: Instead of sending a phalanx of lobbyists to fight this proposal or employing an army of lawyers and accountants to help evade the fee, I suggest you might want to consider simply meeting your responsibilities” — including by rolling back bonuses."

What else would seem as the most politically appealing way to pander to the uninformed public than to piggyback on the prevailing negative sentiment by taking on the lead role in bashing the sector!

However beyond the surface of the politically enticing rhetoric, there appears to be significant undertones.

Cumberland Advisors' Bob Eisenbeis scrutinized on the possible ways how such tax might be imposed and came up with this stirring conclusion.

From Mr. Eisenbeis (bold emphasis mine),

``Whether or not retribution is justified, the proposal from the Administration makes little economic sense. Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that may be exempted from the tax.

``If there is a desire to extract revenue-retribution from large institutions, it turns out that there is no easy way to do it. If one wants to punish management then the efforts should be directed towards taxing their bonuses and other compensation. But there are four problems with this. First, most of those responsible are no longer in their positions, so it will be the new management who will suffer, not those who caused the problems. Second, taxing bonuses won't prevent another crisis. Third, there are always ways around the tax, in terms of how payments can be structured. Finally, managers of foreign institutions that might be covered can escape entirely.

``If the objective is to levy the tax according to how government support was provided, there is the issue in the case of those TARP recipients that were "forced" to take the government support even though they didn't want it. It is not clear how one can rationalize imposing a penalty on those who took the funds to support the government's rescue policies, even if those policies were misguided. Furthermore, there is no justification from the taxpayers' perspective of excluding the auto companies or Freddie and Fannie from responsibilities for losses, as well."

Read the entire article here.

Aside from the above, which exposes that the said taxes will not exact the social retribution from which these have been meant for, the far more significant points emphasized by Mr. Eisenbeis is that big banks will likely skirt these taxes by employing tax avoidance schemes through the shifting of their "funding by booking liabilities off-shore" or by utilizing "off-balance-sheet mechanisms to duplicate the traditional loan-funding-by-liabilities process".

And the brunt of which will likely be borne by "institutions smaller then the top five or six, who are mainly the regional institutions whose main business is the lending and deposit taking upon which their profitability depends".

The other way to interpret this is that the interests of the big banks will likely remain unscathed or could even be protected, by having its competitive moats widen against aspiring rivals through such tax measures.

I understand this to be crony capitalism.

And those of the smaller units would likely serve as the political sacrificial lambs for Pres. Obama's approval seeking publicity stint.

Yet, the more important victim could be the customers of these smaller banking institutions or the small and mid scale enterprises which compose about half of the GDP and more than half of the employment of the US (wikipedia.org).

And what seems as a politically correct harangue may actually be of the reverse intent, another political poker bluff aimed to buttress select vested interests group/s.

Of course since the proposed taxes have NOT been finalized yet, all these would be speculation on our part.

The aim of this post is to show how these political manipulations happen even in the US which goes to show how susceptible countries like the Philippines is, given its highly fragile state of democracy (I would agree with Joe Studwell-it's more of manipulated democracy).

It’s Not Deleveraging But Inflationism, Stupid!

A popular analyst recently wrote in his weekly outlook that the underlying theme of today’s environment should be known as “It’s the Deleveraging, Stupid!”

Deleveraging is technically accurate if the argument is centered on the contracting credit activities of the private sector of the US economy.

But focusing on deleveraging isn’t correct, it’s misleading. That’s because the private sector isn’t the only part of the US economy.

On the contrary, since the crisis surfaced, US government’s share of the US economy has exploded.

From CFR.org

One must realize that even prior to the crisis that the trend of the US government’s contribution to the economy has already been expanding, albeit gradually.

The crisis only hastened the process.

From Business Insider

Well even in the labor market, government employment has now surpassed the private sector.

In short, it would be a terrible mistake to fixate on the private sector when government’s role in the economy has been capturing a fairly substantial share of the economic pie.

Laissez faire, anyone?

So is the US government also experiencing a "deleveraging"?

From Paul Kedrosky (March 2009)

Based on the overall credit picture of the US, the answer is clearly NO.

Total credit has surpassed 350% of the GDP of which the US Government’s leverage has virtually topped the private sector. And that was in 2008, at the height of the crisis! It should be more today.

Obviously, a bigger government translates to bigger spending.

From Heritage Foundation

This means that spending has to be financed by higher taxes, by borrowing or by printing money.

Since higher taxes won’t be politically appealing considering the frail state of the economy, then the palpable recourse is to borrow or let the printing press rip!

Yet speaking of government, until this point we have not seen signs of deleveraging.

From Heritage Foundation

But we are obviously seeing debt building up…leveraging by deficit spending and not deleveraging.

Of course, like many deflation proponents Japan’s lost decade has been made as a popular example of what the US outcome might be.

From McKinsey Global Institute

While everyone in the investing community seem to know that Japanese internal savings financed its debt burdens, what everyone don't seem to realize is that Japan’s policy priorities had been far different from the US.

Forget about Japan’s bubble bust as being “isolated”, the important difference is that Japan policies didn’t have to bother with much of the world.

The US, on the other hand, being the world’s primary foreign currency reserve, has had to deal not only with its own economy but importantly work to uphold its status as the world’s monopoly provider of the medium of exchange for international payment and settlement.

From Federal Reserve Bank of Atlanta

In short, the global banking system and its attendant liquidity required for most of its transactions, greatly depends on the US dollar (Federal Reserve), which has equally been dependent on its own banking system to facilitate this transmission.

Therefore, US authorities have had to face two competing priorities, particularly the banking system (its global seignorage status) or its economy.

They made a choice and it was to rescue the banking system-so it can provide liquidity to the world and retain the privilege of being the world's monetary hegemon.

Of course, US authorities has repeatedly justified that its banking system is a vital part of the US economy, if not THE economy.

And that’s the reason why the Fed lent, spent and guaranteed some $11.6 trillion (as of September 2009), to the sector.

This implies that resources had to be redirected to the banking system which have been drained from the real economy.

This massive act of redistribution epitomizes not deleveraging, but inflationism.

And as we said above, bigger spending requires financing from debt or the printing press, if taxes is the least available option.

But considering that its banking sector’s balance sheet had been stuffed with rubbish but labeled as 'AAA' assets during the days of delusion, a solution has to be made.

Hence Bernanke like a good student of the Great Depression resorted to what he deemed as the most effective strategy to deal with this problem. His solution is to use the magic wand, the nuclear or the Helicopter option.

So by the waving of his magic wand, this would now allow him to “hit two birds with a single stone”….

From the Federal Reserve of Cleveland

The quantitative easing program or what the Cleveland Fed euphemistically calls as the “Fed credit easing policy tools” is simply the printing press!

By buying assets of the banking system, the banks get a reprieve, aside from buying time to build up capital. By manipulating the mortgage and treasury markets (even possibly the stockmarkets) the banks earn from spreads. By pushing up asset prices the animal spirits are reanimated. People go out and borrow and spend again, hurray!

Central bankers once ridiculed Zimbabwe’s Dr. Gideon Gono but apparently his formula seem so chic these days, such that Dr. Gono must have felt exonerated.

So does this signify as “deleveraging”?

Again the answer is NO.

Credit Bubble Bulletin’s Doug Noland who recently dissected on the Federal Reserve’s 3^rd Quarter Flow of Funds has this to say, (bold emphasis mine)

``Once again, system Credit expansion was almost completely dominated by federal borrowings. For the quarter, federal government debt expanded at 20.6% annualized, down from Q2’s 28.2%, Q1’s 22.6%, and Q4 2008’s 37.0% SAAR. Domestic financial sector Credit contracted 9.3% SAAR, an improvement from Q2’s 12.5% contraction. Foreign sector U.S. borrowings expanded at a 14.9% rate, the strongest since Q1 2008….

``Over the past year, Treasury debt expanded $1.743 TN, or 30.2%, to $7.521 TN. Treasury borrowings were up $2.270 TN, or 43%, in just five quarters. And despite the contraction in overall mortgage borrowings, outstanding GSE MBS expanded $408bn, or 8.3%, over the past year to $5.30 TN. In the past eight quarters, GSE MBS expanded $1.057 TN, or 25%. For the quarter, GSE MBS expanded $481bn SAAR. In just five quarters, combined Treasury and GSE MBS expanded an unprecedented $2.810 TN. “Flow of funds” data continue to confirm the Government Finance Bubble thesis."

So yes, there is no quibble, the private sector has been deleveraging.

But NO, the government isn’t.

Instead what Doug Noland calls as “Government Finance Bubble thesis” alternatively means inflationism...again.

Bottom line: I hate to say this, but I’ll simply borrow or paraphrase the sarcasm imbued in the title used by the popular analyst, ``It’s not deleveraging, but inflationism, stupid!”

Global Science and R&D: Asia Chips Away At US Edge

Even in the field of science and engineering, Asia appears to be rapidly chipping away at the edge of the Americans.

The press release from the US government's National Science Board (NSB) underscores such concerns, (bold highlights mine, interspersed charts from NSB)

``The state of the science and engineering (S&E) enterprise in America is strong, yet its lead is slipping, according to data released at the White House today by the National Science Board (NSB). Prepared biennially and delivered to the President and Congress on even numbered years by Jan. 15 as statutorily mandated, Science and Engineering Indicators (SEI) provides information on the scope, quality and vitality of America's science and engineering enterprise. SEI 2010 sheds light on America's position in the global economy.

``"The data begin to tell a worrisome story," said Kei Koizumi, assistant director for federal research and development (R&D)in the President's Office of Science and Technology Policy (OSTP). Calling SEI 2010 a "State of the Union on science, technology, engineering and mathematics," he noted that quot;U.S. dominance has eroded significantly."

``Koizumi and OSTP hosted the public rollout at which NSB Chairman Steven Beering, National Science Foundation (NSF) Director Arden L. Bement, Jr., and NSB members presented SEI 2010 data and described a mixed picture. NSB's SEI Committee Chairman Lou Lanzerotti noted the good news for those in the S&E community about public attitudes, "Scientists are about the same as firefighters in terms of prestige," he said. His presentation focussed attention on NSB's Digest, also released today, higlighting important trends and data points from across SEI 2010.

``Over the past decade, R&D intensity--how much of a country's economic activity or gross domestic product is expended on R&D--has grown considerably in Asia, while remaining steady in the U.S. Annual growth of R&D expenditures in the U.S. averaged 5 to 6 percent while in Asia, it has skyrocketed. In some Asian countries, R&D growth rate is two, three, even four, times that of the U.S.

``In terms of R&D expenditures as a share of economic output, while Japan has surpassed the U.S. for quite some time, South Korea is now in the lead--ahead of the U.S. and Japan. And why does this matter? Investment in R&D is a major driver of innovation, which builds on new knowledge and technologies, contributes to national competitiveness and furthers social welfare. R&D expenditures indicate the priority given to advancing science and technology (S&T) relative to other national goals.

[It is competition that serves as a major pillar of innovation. R&D is only utilized only in response to needs of the market.-Benson]


```NSB SEI 2010 Committee Member Jose-Marie Griffiths discussed another key indicator: intellectual research outputs. "While the U.S. continues to lead the world in research publications, China has become the second most prolific contributor." China's rapidly developing science base now produces 8 percent of the world's research publications, up from its just 2 percent of the world's share in 1995, when it ranked 14th.'"

The above signifies as empirical evidence, which supports our earlier post, exhibiting how Asian high tech companies have rose to the occasion, using the recent recession, to mount a serious challenge on the leadership of Western companies. [see Asian Companies Go For Value Added Risk Ventures]

The other areas of concern as cited by the NSB.

-Cross Border R&D or the globalization of the Research and Development function [yes, R&D isn't a national standalone thing as misperceived by protectionists, it's being collaborated by different institutions worldwide.]

According to the NSB, ``Overseas R&D expenditures by foreign affiliates of U.S. multinational companies (MNCs) rose from $12.6 billion in 1995 to $28.5 billion in 2006. Europe’s share of these overseas expenditures fell from 73% to 65%, and Asia’s share increased from 15% to 20%. Foreign MNCs spent $34 billion in the United States in 2006, up from $15 billion in 1995. European-owned companies’ share of these expenditures was little changed at 75%."

-Patents

East Asia And The ASEAN Yield Curve

This is a sequel to our earlier post What’s The Yield Curve Saying About Asia And The Bubble Cycle?, but this time in graphs.

The idea is that steep yield curves emanating from central bank policies incentivize the market to engage in various interest rates arbitrages like carry trades, stock market speculations and other borrow-short-invest-long transactions which essentially fuels bubble cycles.

A reminder is that interest rate policies and the shape of the yield curves impact the asset markets with a time lag. Said differently, asset markets respond to rate curves belatedly.

As earlier shown, in the US yield curve has been extraordinarily steep which most likely implies strong support to her asset markets. Importantly, because the US government has reflating its banking system, the arbitrages are likely to support global markets more as investors seek to optimize returns at the long end.

This means that the US dollar carry trade is likely to inflate further. And carry trades aren't likely to be confined to the US dollar but diffused to major currencies which have all engaged in competitive devaluation via a combination of suppressed interest rates, fiscal spending and most importantly, quantitative easing programs.

In addition, because asset market reflect a time lag on the curve, credit systems hobbled by deleveraging (such as in the US, UK and parts of Europe) could probably see belated marginal positive responses or improvements but would not likely reach the level it had during the last boom.

It is in Asia and emerging markets where a credit fueled bubble cycle is likely to take place.

In Asia where low interest rates have generated more policy traction than in crisis affected Western developed economies, the yield spreads also remain elevated.

And as earlier pointed out, combined with the other policies all these have been manifested in asset outperformance.

Again the steepness of the yield curve in the region should lend support to the asset markets for the meantime. As local investors and speculators and the domestic financial institutions will be incentivized to take advantage of the wide chasm in interest rates.

The following charts are all from Asian Development Bank's Asianbondsonline.com.

China

Japan

South Korea

Singapore

IndonesiaMalaysia

Philippines

Thailand

Finally, it would be foolish for anyone to think that stock markets move in a straight line, because in reality they don't.

Nevertheless, any attendant weaknesses should be construed as countercyclical or temporary events because aside from many other factors, steep yield curves are likely to support credit activities that should work favorably for asset markets.

Emerging Market guru and Franklin Templeton's chief honcho Mark Mobius nails it when he recently wrote, ``what I said was that in a bull market as we are now experiencing, there will be corrections as the market continues to march upwards, and such corrections could be anywhere from 15 to 20%, or even 30%. We have to be ready for such short-term volatility. The markets in China, Asia, and Dubai have seen corrections of 20% or more during the recent crisis, so these kinds of corrections should not be surprising.I want to emphasize that I am not predicting any specific correction but I am just saying that we have to prepare for such corrections and that we not be alarmed by them given current market conditions. Overall, I believe we will continue to see markets rise in the long run." (bold emphasis mine)

In short, market operates in cycles.

What’s The Yield Curve Saying About Asia And The Bubble Cycle?

``What is being ignored is the more fundamental question of whether the Fed should be attempting to set or influence interest rates in the market. The presumption is that it is both legitimate and desirable for central banks to manipulate a market price, in this case the price of borrowing and lending. The only disagreements among the analysts and commentators are over whether the central banks should keep interest rates low or nudge them up and if so by how much.” Richard M. Ebeling, Market Interest Rates Need to Tell the Truth, or Why Federal Reserve Policy Tells Lies

What’s The Yield Curve Saying About Asia And The Bubble Cycle?

-The Ultimate Black Swan-Armageddon

-The Cyclical Nature Of Bubble Cycles

-Measuring Boom Bust Cycles Via The Yield Curve

-What’s The Yield Curve Saying?

-Bubble Cycles Do NOT Discriminate

The Ultimate Black Swan-Armageddon

WATCHING National Geographic’s ‘Apocalypse How’ made me realize how the world is so vulnerable to the exogenous forces of nature and how man could be completely helpless in the face of such overwhelming power.

Yes, you may forget the farcical anthropogenic climate change, because the forces of nature would be exponentially be way far far far far more powerful and potent than the outcome from any of our collective destructive actions.

Besides, as remarked by the scientists interviewed in the TV documentary program, like any part of nature, our world operates on its own cycle. This means that the “ice age” could be just around the corner in some thousands of years to come, while the sun will expire on its own, by running out of fuel to burn, in about 5 billion years, and that today’s “aging” earth, even without the sun’s demise, will likely meet its end on its own.

And the sad part is that there is nothing mortal man can do to stop it. Every species or anything else that is part of nature will cyclically become extinct.

While we have been made aware by media of these apocalyptic scenarios through a variety of science fiction movies that could or may occur; such as huge asteroid/s crashing on earth, super volcano eruptions, alien invasion, robot uprising and many more, there are other factors such as the black hole, gamma rays from an imploding star or the unleashing of a mighty wave of solar flares from our sun, that could send our world into oblivion, unpredictably and instantaneously.

This would be the ultimate black swan for us- a low probability high impact event- our Armageddon.

Even in nature we see the variances of applied risks:

-cyclical risks (demise of sun or earth)-which if we are lucky enough would allow the Homo sapiens species commodious time to prepare for such eventuality through technological innovations and applications that could enable our descendants to scour other parts of universe for relocation

- and the Black Swan risks, which I guess leaves us to get insured with the Almighty.

The good news is that cycles extrapolate that for every death means a new birth somewhere. It’s just that we won’t be appreciating it, since we can’t know everything even when we’re alive, and perhaps because it is least of our concerns- since it ain’t about us.

However, in the understanding of nature’s dynamics, as consolation, a new life is taking place…somewhere.

The Cyclical Nature Of Bubble Cycles

This brings us back to the markets.

The difference between dealing with the complex forces of nature and that with actions of human beings is that the cyclical risks factors appear much magnified in the latter than the randomness elicited from the former.

But in contrast to the presumptive fallacious assumptions of the self-righteous aggregatists, the less complexity of social science doesn’t translate to technocratic omniscience since social sciences remain fluid, dynamic and adaptive to the constantly changing environments. Importantly they aren’t mechanistic.

The reason is that human actions are based on incentives: People are guided by what they perceive as satisfying some ends by engaging in specific means as distinguished by the scale of values (marginal utility) and time preferences, which comes in two parts-a low and high preference. In the Austrian School, low time preference means long term while high time preference means short term.

Interest rates function as major incentives in ascertaining the allocative (savings, investment and speculation) decisions of economic agents. To quote Professor Ludwig von Mises on interest rates and its money relation, ``The final state of the market rate of interest is the same for all loans of the same character. Differences in the rate of interest are caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract. Differences in interest rates which are not brought about by these differences in conditions tend to disappear. The applicants for credits approach the lenders who ask a lower rate of interest. The lenders are eager to cater to people who are ready to pay higher interest rates. Things on the money market are the same as on all other markets.”

In other words, in a laissez faire environment, creditors and debtors have essentially the same incentives as with buyers and sellers- both parties compete with their own class to serve the other parties or to satisfy the market, whereby both seek the price levels which satisfy their interests. Therefore, the rates of interest are determined by the demand and supply of credit through time preferences.

Unfortunately we aren’t in laissez faire environments where central banking has usurped the function of free markets in an attempt to perpetuate boom cycles via interest rate manipulation.

In Making Economic Sense, Murray N. Rothbard describes the boom bust cycle from monetary expansion primarily from interest rate controls (bold highlights mine), ``Inflationary bank credit is artificial, created out of thin air; it does not reflect the underlying saving or consumption preferences of the public. Some earlier economists referred to this phenomenon as "forced" savings; more importantly, they are only temporary. As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level. Only a repeated injection of inflationary bank credit by the Fed will keep interest rates artificially low, and thereby keep the artificial and unsound economic boom going; and this is precisely the hallmark of the boom phase of the boom-bust business cycle.

``But something else happens, too. As prices rise, and as people begin to anticipate further price increases, an inflation premium is placed on interest rates. Creditors tack an inflation premium onto rates because they don't propose to continue being wiped out by a fall in the value of the dollar; and debtors will be willing to pay the premium because they too realize that they have been enjoying a windfall.”

So in contrast to the myopic mainstream, which sees the market as operating in some ‘randomesque animal spirits’, interest rates mold the public’s mindset (not just capitalists or speculators but also workers, housewives and everyone else) as to how money gets allocated.

In short, boom bust episodes don’t come by haphazard chance; they function like nature, they are cyclical. Importantly, inflationism also reflects on the conditions of money.

Measuring Boom Bust Cycles Via The Yield Curve

Figure 1: Steve Hanke, stockcharts.com: Austrian Trade Cycle And The 2003-2008 Bubble Cycle

Where interest rates have been distorted to create a false impression of the abundance of savings via central bank injected money from thin air, the allure to invest in long term projects becomes relatively more compelling (see figure 1, left window).

That’s the reason why Americans and many bubble economies of the world had been seduced into the real estate bubble trap in various degrees.

Cato’s Steve Hanke describes how the process evolved (all bold underscore mine), ``An artificially low interest rate alters the evaluation of projects – with longer-term, more capital-intensive projects becoming more attractive relative to shorter-term, less capital-intensive ones.

``Austrian theory played out to perfection during the most recent boom-bust cycle. By July 2003, the Federal Reserve had pushed the federal funds interest rate down to what was then a record low of 1%, where it stayed for a full year.

``During that period, the natural (or neutral) rate of interest was in the 3-4% range. With the fed funds rate well below the natural rate, a credit boom was off and running. And as night follows day, a bust was just around the corner.”

As you can see in the right window of figure 1, during the dot.com bust, the US Federal Reserve hastily pared interest rates that pushed up or sharply steepened the yield curve (spread between 10- year and 2- year spreads-blue trend line).

Since interest rates always impact the markets with a time lag, the S & P responded and began to rise in 2003, or about 2-3 years after.

Then the US Federal Reserve began to lift policy rates in June 2004, thereby reversing the monetary easing as shown by the flattening trend of the yield curve.

The flattening of the yield curve subsequently led to the peak of the US real estate industry in 2005 (more than a year after), again with a time lag, as shown in our charts in China And The Bubble Cycle In Pictures, and eventually crashed in 2006 (see here for Case Shiller update).

The aftermath similarly had the US and global stockmarkets belatedly react by gradually unraveling in 2007. The culmination of which was manifested by a spectacular collapse that had been heralded by the infamous Lehman spectacle of September 2008. The crash proved to be the capitulation or the turning point for the markets.

What’s The Yield Curve Saying?

So where’s the yield curve now?

Figure 2: stockcharts.com: Skyrocketing Yield Curve

This noteworthy observation from moneyandmarkets.com’s Mike Larson, ``We just saw the spread between 2-year Treasury Note yields and 30-year Treasury Bond yields widen to 379 points. That’s the highest in almost three decades of record-keeping. And the 10-year TIPS spread I’ve highlighted on multiple occasions blew out to yet another 18-month high of 246 basis points earlier this week.” (emphasis his)

This means that the incentives to profit from the yield curve arbitrage have never been as compelling as before. Investors will likely be tempted to borrow short and invest long.

Meanwhile, for financial intermediaries they will be incented to enhance their maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).

So both the demand and supply variables will likely be responding positively to the incentives provided by the gaping interest rate spreads as a result of policy distortions.

As you can see in the chart above, like in the past, world markets ($DJW) have belatedly responded to the steepening of the yield curve, albeit faster than in the previous cycle- the recent reaction had 1½ years lag compared to previous 2-3 years lag.

The faster response appears to have been abetted by the Quantitative Easing (QE) program, aside from other guarantees and other Federal Reserve as the “last resort functionaries” seen in diversified alphabet soup to the tune of TRILLIONS of dollars.

Moreover, gold ($gold) appears to be resonating the current undulations of the yield curve.

As caveat, correlation isn’t causation. This isn’t to suggest that gold has been driven by the yield curve arbitrage. What can be casually observed is gold’s apparent rhythmic symmetry with the curve during the past 3 years.

It must be remembered that Gold has risen in spite of the current and previous easing-tightening policy cycles, which experienced two boom-bust episodes during the last decade. Gold has been up for 9 straight years with an average of 17.1% returns denominated in US dollars (James Turk)!

Bubble Cycles Do NOT Discriminate

SUBSIDIZED interest rates are likely to generate borrowing traction for institutions or industries or countries which had been LEAST blemished by the recent bubble.

This had been elaborated by both Professor von Mises- where credit take up is ``caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”- and by Professor Rothbard’s description of the impact of such policies- ``As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level”-as duly noted above.

China’s recent response to increase bank reserves, aside from last week’s higher T-bill sales, is on path to this as discussed in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff.

Figure 3: McKinsey Global Institute: Leverage of Financial Institutions

It is also the major and fundamental reason why major emerging markets and Asia have fundamentally outclassed and significantly outsprinted developed economies in 2009 and why it would likely do a similar rendition in 2010.

Again, specifically because low systemic debt, high savings rate, least affected banking system (see figure 3) and importantly the increasing adoption of economic freedom among other variables have allowed policy impelled circulation credit to percolate more within the national borders and within the region in a relative scale compared with other parts of the globe.

And this is why many have been aback by the sudden surge or the rampant improvement in Asian and major emerging markets financial markets, which have prompted some skeptics to call a “top”.

Figure 4: Bloomberg Chart of the Day: Asian Outperformance

For instance, the combined European sovereign Credit Default Swaps (CDS) or a gauge of default risks of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) have spiked more than those of their emerging Asian counterparts (see figure 4-upper window) for the first time in history as measured by the CDS. This implies that Asian debts have been inferred as less risky than its European peers.

By using non sequiturs or the implication of political risks such as “nuclear armed neighbour”, “number of political coups”, “unstable neighbour” or “imposed currency controls”, an analyst calls for a “top” for emerging markets based on what he thinks as unrealistic valuations and euphoric sentiment that replicates 1994.

The analyst appears to have forgotten about the ``differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”, which serves as the essence of what default risks is about.

Where the PIIGS have taken on debt more than they can afford to pay for, they were ultimately found swimming naked when the tide receded, to paraphrase Warren Buffett.

The markets have, in essence, justifiably priced such debt laden PIIGS as relatively more likely to default than the Asian peers, because the latter have learned, endured and painfully adjusted from the excesses of the Asian crisis (twelve years past) and have engaged in a more circumspect borrowing and lending activities and eluded emulating the West’s risky behavior during the last bubble cycle. [Although eventually persistent bubble policies will likely force us to embrace extravagance]

In the same context, we see a parallel in the default risks dynamics manifested on corporate debt ratings via VIX indices (figure 4-lower window). Americans have been perceived as having the most relative risks, the UK second and lastly China (go back to figure 3 to answer any whys).

Besides it would signify as spurious analysis to anchor on past performance. Who would have ever thought that Iceland, once belonging to the world’s elite, has fumbled? [see Iceland's Devaluation Toll: McDonald's and Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?]

In short, bubble cycles have effectively sanctioned credit extravagance with no palpable discriminations; because it is a market imposed discipline.

Once it had been the Asians and now it is the turn of the Europeans and the Americans. That’s how the cycle, under the laws of scarcity, operates.

So the general rule is whoever inflates eventually suffers from the consequences of such political actions (yes inflation is fundamentally a political decision), irrespective of the identity (nationality) or present and past financial or economic standings or political or culture framework.

For now, markets appear to have been rewarding the prudent.

And like the forces nature, there are cyclical risks that one can insure against and there are black swan risks.