DR.

KURT RICHEBÃCHER

) CURRENCIES AND CREDIT MARKETS

No. 2511 March 1994

"Even in such a time of madness as the late 192Os, a great many

men in Wall Street remained
quite sane. But they also remained very quiet. Tbe sense of responsibility in the
financial
community for the community as a whole is not small. It is nearly nil. It

J.K.. Galbraith, The Great Crash 1929,

p. xxi

HIGHLIGHTS

00 recent market calamities mark tbe beginning of the end? Financial markets, led by crashing
bond markets, have been shaken everywhere. It's possible that the
mania the great financial
-

bubble of the 1980-1990s may finally have started its bust.

-

f What is solamentable, we find, is that so very few were able to recognize the build-up of the

I bubble, the biggest on record, and one tbat was so easily traceable through widely.available
statistics. Unwittingly, the
poor private investor will bear the greatest pain.

As we have so consistently argued in these letters, the

epicentre of this bubble was in the U.S.
bond market, instigated and nurtured by
an over-easy Fed. Prolonged, super-low interest rates
) have led to an overspeculated financial system, spreading troubles to the world's
financial markets.

To be sure, there will be great efforts to resuscitate financial markets by

policymakers and
members of the financial system in upcoming weeks and months.
Expect volleys of calming
pronouncements and professed surprise over what happened in recent
weeks.

Can the central banks restore order, per:baps by (educing interest rates? At best, it would
only
delay the ultimate outcome. The hard truth is that the greatest financial
and economic disasters
in history have generally been courted by prolonged periods of
abnormally low interest rates.

We wonder if the next banking crisis is already under

way. Bond losses for some banks must
already be large. Even more worrisome, many banks have huge exposures to the
derivatives
markets. Rumours are thick.

What makes a bubble? The key gauge is

the source of the funds flowing into the financial
markets. Are they new savings or "ioDation" derived fund flows? We again
show conclusive
evidence of the "inßationary" source of funds.

It's possible that minor recoveries will take place in both

stock and bond markets. But, we're
inclined to think that the great bullish tide of the bubble has crested. The
general trend for most
equity markets and the overleveraged bond
markets will be down. How fast? It will depend on
how well the financial system can hold together.

) For investors, as we have repeatedly emphasized, liquidity remains all important. Short-term
/
bonds in the hard-currency markets and cash-equivalent investment
remain the recommended
harbours for conservative investors.
 1929. 1987 OR WORSE?

It was always our suspicion: that an impending financial crash, most likely of global proportions, would
find its trigger in the U4S. bond market. There were always other possible triggers, but the U.S. bond
market was the epicentre from which the entire global marùa of the past two to three years has radiated..
It used to be that bond investments were thought only appropriate for widows, orphans and pensioners.
But totally different game has prevailed ever since the U.S. Fed embarked on a desperate mission to
a

rescue the banking system and "jump start" the U.S. economy. By relentlessly reducing interest rates
and maintaining super-low U.S. short-term interest rates over a prolonged period, the Greenspan Fed was
instrumental in producing reckless inflation in the global stock and bond markets alike.

The U.S. bond market, considered to be the most liquid in the world, has nonetheless witnessed a near-
crash, its ttemors reverberating into the farthest corners of the globe. It was a risk we warned about
repeatedly in these letters. And, we think it is only the beginning of troubles. Although financial
markets may attempt minor recoveries in coming weeks and months, we think that the great speculative
tide of the 1980-19908, much larger than even experienced in the 192Os, has crested. From here on,
fmancial markets, we expect, will be labouring against a strong undertow~ Why? It's the nature of
bubbles. In this letter, we explain how the global financial inflation has come about and what its dire
implications are for investors and world economies.

CARNAGE

The Fed's quarter-point hike in its funds rate on February 4,1994 apparently caught the world fmancial
community including its smartest traders
-

sleeping at the switch. What was supposed to be a fillip

-

for the markets, so the Fed and others thought, may prove to be the infamous needle pricking the bubble.

....
.

"1\
"

Since October 1993, long-term interest rates in the U.S. have risen from a low near 5.8% to a recent }
high in excess of 6.80%. Triggering enormous losses for overleveraged speculators, it has caused a
daisy-chain reaction in all other financial markets, and is a far cry from the soothing message that Wall
Street greeted the New Year with: "Low inflation and low interest rates as far as the eye can see." Wall
Street and the markets had feasted on this rosy certitude and concluded that the "best of all possible
'1
worlds was ahead for the financial markets.

It was not to be. More recently, once the decline in the D.S.. bond market gathered momentum in
it quickly spread to other
February, markets. even the supposedly robust, hard-currency bond
. ~

markets. European and Japanese bond markets suffered sizable losses. Emerging country bond markets
virtually collapsed, some falling more than 15% in less than three weeks. (Table Ion the opposite page
lists the scale of the losses for various markets from their recent peaks.) Given the global scale of this
bubble, no market escaped.

These quicksilver market reactions betray and expose what we have been warning about for a long time:
That a great speculative bubble has been founded on extreme illiquidity. How can that be? Isn't that
a contradiction in terms? Weren't markets, as the brokers told us, liquidity-driven? Readers of past
letters already know how that can happen.

Recent developments also expose the total confusion in the markets. The fact that an itsy-bitsy rate hike
-

and not even a discount rate hike at that is now blasted as the culprit behind the bond disaster
-

shows ignorance and a total inability to recognize a bubble. Originally, we recall, the rate hike
was met

Currencies and Credit Markets \ March 1994

)
 3

) with near universal praise in the belief

that
it would actually have the opposite effect
RECENT SECURITIES MARKET TRENDS
on long-term interest rates.. A supposed
fI against inflation ~ ~ % Decline
Itpreemptive strike was
supposed to convince fmancial markets Stock Markets Hlgb. J.ml
that low inflation was here to stay.. France. CAe 40 2355.9 2144.7 -9.00/0

Germany. DAX 226840 2020.3 -10.go/Ó

LOOKING FOR A TRIGGER Hong Kong, Hang Sang 12201.1 98n.4 -1940%
-2.goÆ,
Japan. Nikkei 300 306.8 29841

In retrospect, perhaps sometime in the 2520.3 2146.5

U.K.. FT 100 -14.80/0
future after a full-blown fmancial bust has
MaJaysia. KLSE Composite 1586.3 1314.5 .17_1%

run its course, the lessons of history will Maxioo.IPC 2881.2 2514.2 -12.70/0

seem more obvious.. The present great U4S.A.. Dow Jones Industrials 3978.4 3824.4 -3.go/o

bubble has had all of the classical

la-Year Bond Futures. March
ingredients. -

greed, illusions and

131.2 125.1 -4.70/0
France
delusions.. But for now, the delusions still
10144
Germany 96.6 -4.]0/0
seem to prevail: that there is no inflation;
U.K. 120.1 111.2 -7.40/0
'that low inflation guarantees low interest
U.S.A. 116.0 110.0 -5.2D/o
rates; that the financial bull markets are
118.3 110.2 gala
Japan -6.
liquidity driven and other sundry mistaken
beliefs.

And so, commentators are bound to disagree over the causes and implications of the recent bond
disaster. Many bank and broker analysts the notorious professional bulls have been quick to
þ ) -

discard it as just a long-overdue correction that will soon right itself once the excellent underlying
-

fundamentals are again recognized.. According to some of them, lower rates are likely -

new lows, in
fact -

later in the year.

We think that too many of these "experts" don't have the faintest inkling of the nature and fantastic scale
of the speculative bubble that's overhanging the fragile world economy presently.

A SHORT HISTORY OF THE BUBBLE

In order to determine what will happen next, it

is important to understand how the markets got into such
a mess in the first place.
This latest saga started almost five years ago.. To recall, when the U,S4
economy began to weaken in the course of 1989, the Greenspan Fed lowered its Fed funds rate from
almost 10% in mid-1989 to just over 8% by the flISt half of 19904 Once it was learned that this cautious
easing failed to prevent a recession, the Fed stepped on the accelerator more forcefullY4 By early 1991,
the Fed funds rate had fallen to 6%4

Late 1990 was the key starting point for the speculative frenzy in the financial markets. Faced with a
very sluggish economic recovery far below -

cyclical norms and a tottering financial system, the

-

Fed threw caution to the wind and opened its money spigots as never before. While at the same time
flooding the banking system with reserves, it proceeded to slash its Fed funds rate to 3% by early July
1992.

þ ,) Currencies and Credit Markets \ March 1994

j
i

I
r-- -

------- -...
-
 4

-"'\
The crucial consequence of the artificially low sholt-term interest rates was a monstrously positive yield
I
t It beckoned the fmancial community to a collective~ reckless
cmve, the steepest since the 9308.
fmancial orgy. Thousands of banks, brokers and other institutions that had access to funds at the super-
low money market rates embarked on a fantastic binge of yield-curve playing. Their huge bond
purchases, in turn, caused long-term interest rates to tumble.

In me case of the U.S. bond market, it was easy enough to track the build-up
of this bubble in the Fed's
Flow-of-Funds statistics. Banks and brokers, the two biggest groups of players, now hold leveraged
bond portfolios amounting to around $1.1 trillion. Approximately $450 billion of this position was
accumulated during the last three years. These purchases alone, as we've pointed out in previous letters,
fmanced more than 50% of the Federal budget deficit during this period.

Colossal as these figures arc, the yield-curve playing by other institutions was enormous as well
although harder to detect and track in'the available statistics. This is particularly true for the speculative
activities carried out through the international markets. Last, and certainly not least, are the huge
speculative activities implemented through derivatives instruments futures, options, over-the-counter
-

options, swaps and their myriad combinations. There is very little information available that sheds light
on the scale of these speculative activities through the derivative markets. Nevertheless, there is enough
anecdotal infonnation to know that it is 'enormous, in fact, involving sums many times the transaction
of all other markets. Rumours sweeping the markets that U.S. brokers and hedge funds (a misnomer,
these are really gambling funds) we~ forced to close out huge positions in European bonds (much of
these held through derivative holding strategies) in order to stop losses, testify to the large influence of
these activities.

NO CRASH INSURANCE )
Considering the colossal U.S. bond holdings of American banks and brokers, it seems obvious that the
biggest of all bubbles is in the U.S. Treasury market. Here, the fmancial intermediaries suffered the
biggest losses, naturally hitting the banks and brokers the worst.. In many cases, the bond losses were
compounded by big currency set-backs since U.S. banks, brokers and hedge funds had also heavily
shorted the yen. They had expected it to weaken on the back of widening U.S.-Japan interest rate
differentials in favour of the dollar.

Instead, President Clinton's Japan-bashing caused the dollar to plunge against the yen. At the same
time, the major European currencies, which also were forecast to fall against the dollar, are now trading
near or above their levels of the past half-year. As can be seen, bond and dollar speculation badly
misfired both at the same time.

A third big shock happened in the futures markets where events dramatically reconfinned a nasty lesson

from the 1987 crash: namely, that hedging with futures doesn't work when it's needed the most. The
sophisticated financial theories that the
math doctorates the t1quants tI as they are called
-

, have
-

popularized on Wall Street during the past half-decade have again malfunctioned "Tracking risk," to
use one of their technical terms (the great fear of these theorists) struck again.

Caught on the wrong foot, too

many bond speculators tried to hedge (offset their risk) in the future
markets~ and in doing so, started a price spiral in the ucash markets.ff InWldated with one-sided sell

Currencies and Credit Markets \ March 1994 ,)

 5

orders, future prices sagged sharply relative to those in the cash markets putting further pressure on the
) latter. Therefore, in extremely thin markets, the cost of hedging soared.. Essentially~ the resulting gap
between futures and cash prices, encouraging extensive arbitrage promoted massive purchases of futures,
matched by corresponding sales in the cash market, the two pulling each other
downward..

THE PROGNOSIS: BUST.OR TEMPORARY SETBACK?

So much for the recent past In the aftermath, we

are left with two paramount questions. The frrst one
concerns the recent bond market rout: Is it just a mere accident or simply a correction in
an ongoing bull
market, or is it the start of something much more serious and bearish for stocks and bonds alike? Most
worrisome is the second big question: How will a pronounced downdraught in stock and bond prices
impact the real economies?

Though history never precisely repeats itself, we like to study it for guidance. With respect to crashes~
there are two dramatic examples that had opposite effects on the economies the big stock market
-

crashes of 1929 and 1987. The latter one, the steepest of the postwar period~ had no
significant effect
on the economies. By contrast, the crash of 1929 did lead to an economic meltdown..

Generally speaking, we would' say that the final outcome in each case simply depended on the
vulnerability of the fmancial markets, on one hand, and the economies, on the other.. The effects of the
1987 crash soon dissipated. because it hit a
very strong world economy on the verge of a new boom..
By contrast, the 1929-crash had devastating economic effects because it
struck a foundering, fragile
world economy, thus tunùng an impending recession into a prolonged depression.. Which brings us
straight back to the question of the
nature of the recent financial boom Is it a
speculative bubble, and
) therefore prone to burst one day, or not?

It's defmitely a bubble, we

think, and one that~s becoming increasingly dangerous the longer it lasts.
As we said, we think: chances are that the bubble has begun to burst.. But most
experts are just as fully
convinced that the booming markets are a natural outgrowth of healthful developments.. A secular
decline in inflation and interest rates, a secular portfolio shift out of deposits into securities, and a
secular redistribution of incomes away from wages and towards profits through job shedding, downsizing
and re-structuring, are all pointed to as constructive and positive developments. And together, these
three ostensibly healthy and lasting shifts in the economic and financial structure
are believed to assure
permanently higher valuations of financial assets.

THE THREE FALLACIES

As ffold-timerslt in econofiÚcs, we have to say that every bit of Wall Street's bull
story (and London's,
too, for that matter) is pure hogwash.. Still, these false theories promising safety and
guaranteed higher
returns have lured millions of savers into investments that expose them to risks they
are not accustomed
to.. And because these nonsense theories found such widespread gullible belief, it became a
self-
fulfilling prophesy.. at least, temporarily.
.. ..

Just how valid are these tfconsensustf theories? First of all, to

us, to relate long-term interest rates simply
to inflationary expectations, is ludicrous.. It
implies the absurd: that monstrous budget deficits and paltry
savings are completely
irrelevant to interest rate levels. Obviously, they are not.

) Currencies and Credit Markets \ March 1994

 6

No less ludicrous is the exuberant appraisal of the big switch from bank deposits into stocks and bonds,
the biggest on record in the U..S.. The following graph shows the enormity of this shift Of course,
it
while it occurs, this migration of capital nicely buoys the securities markets, but disregards the advelSe
side of this shift: namely, a record deterioration in household liquidity. Deposits, as a percent of
flip
30 years. Liquid assets have fallen to less than
disposable income, have fallen to the lowest level in
22% of total financial assets held by individuals, also the lowest on record. (See Chart below.) Just
think of it: Since their peak: in February 1991, small time deposits have fallen almost $400 billion~ This
surely speaks of growing and dangerous illiquidity.

U.s. INDIVIDUALS: SHIFf IN FINANCIAL HOLDINGS

% of Total Financial Assets, Annual
4O~O"
Total Uquid Assets -
34.0%
as a % of Total Financial
38~O%
Assets =
LH Scale I
32.0%
3640~ I

3440% , 30.0%
- - I
.! 32~O%
" t/f1
CllJ

j I
, ,

"
- - - .
28.0% E
CIi

=:J
~ 3O~0% ~ I
-
0
, .
"3 ~ en

;'
, I
g 28~O% II
26.0%
'~ ,
,
I

26.0% 24.0%
Securities Including
24.0% Mutual Funds as a %
22.0%
22.0%
of Total Anancial Assets
RH Scale
'II::

1993 Data as of 3Q )J
2OJ)% 20.0%

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Source: BcMtrd of Govenaon 01 tile Feden! Reserye

Just as absurd and delusionary is the general glorification of job shedding, downsizing and restructuring.
These measures are presented as the hallmarks of economic revitalization as once-sluggish enterprises
whip themselves into shape for the new era of global competition.. Whatever benefits single companies
it spells inexorable
may reap from this puI'StlÏt for businesses and the economies in the aggregate.,
erosio~ of long-term growth. Recent modest cyclical improvements in U.S. productivity and profits only
temporarily mask clearly deterio~g trerids over the long-term..

THE GLOBE IN FOCUS: NO ROSY PICTURE

Our misgivings about the current global financial boom really start with our highly critical assessment
of all those glittering~ fake, ttnew era theories1l that seem to justify an endless rise in stock and bond
humbug because,
valuations.. Every one of them is utter humbug in our eyes.. In reality, it's worse than
knowingly or unknowingly, these theories serve to delude and deceive millions of investors about the
it fits the
true risks and eventually will cause them to lose a sizable part of their savings. Actually,
involved the professionals who
regular pattem of manias that those individuals who are most closely
-

old
concoct new crackpot theories that foretell of new era in which economic
a
ought to know better -

laws no longer apply..

I
Currencies and Cred.lt Markets \ March 1994
 7

1 Looking at the world economy, "e still see budget and trade deficits of unprecedented size.. Critical,
as well, is a worldwide slump in investmenL And unfortunately we don't see any meaningful
If

improvement in these internal and extemal imbalances and excesses..

In past letters, we have extensively addressed the deeper-seated causes of the present world economic
malaise in the industrial countties. In coDlIadicti.on to the complacent consensus view, we have always
stressed that it will take many years to work: off the appalling financial and economic distortioßS that
have accumulated in the world as a consequence of the credit and debt excesses of the 19808. Even this
J
view presupposes that the problems are being properly addressed. And we are by no means convinced
) of that.

In our view, the most dangerous of modem myths is the widespreacL blind belief that central banks can

cure all and any economic pain J,y the simple expedient of cutting interest rates. To the contrary, the
hard truth is that the greatest financial and economic disasters in history have generally been courted by
prolonged periods of abnonnally low interest rates. Rather than curing economic ills, it invoked huge
speculative bubbles. It may lessen the apparent pain over the short-run, but it most certainly worsens
the long-term, terminal outcome. Easy money, over the long-run, is not the panacea it is generally
thought to be..

THE COST OF LOW INTEREST RATES

To hear it from economists and mooey managers, there is no price to pay for super-low, short-term
interest rates.. It seems none of them is aware of Japan's recent, ill-fated experience with super-low
-..... interest rates that led to its asset bubble of the late 19808 and also the disaster of the U.S. stock bubble
) of the late 19208.
./
Common to both of these financial asset bubbles, was that the following crashes were harbingers of
deep, prolonged downturns for the economies. At the root of Japan's bubble, from early 1987 to early
1989~ were two
years of super-easy money and super-low short-term interest rates at around 3% which
launched fumtic credit and broad money growth.

While Japanese consumer price inflation persisted well below 2%~ the excess money from the credit
inflation largely poured into domestic and foreign asset markets. In Jap~ land and stock prices
virtually exploded.But given the low consumer price inflation, this price explosion in the asset markets
was generally viewed with acquiescence. Rather, the world financial conununity hailed the astronomic
price~amings ratios that became commonplace in the Tokyo market as the emblem of Japan's virility
and super-strong economy. More than anything eIse~ it was the low inflation rate that gave rise to a
false sense of security about the boom. As long as consumer price inflation was low~ it was reasoned~
} there can be no excesses and risks of higher interest rates..
\
The bursting of the bubble was ushered in with the arrival of a new governor at the Bank of Japan in
early 1989, Mr. Mieno.. He focused on the soaring land and stock prices~ decrying it as "asset price
inflation" and a speculative bubble. He believed that it would be better to puncture it before it burst of
its
own accord even more violently and from more extreme levels of over-valuation, risking untold
damage to the banking system and the economy..

Currencies and Credit Markets \ Mardt 1994

 8

Despite continuing low inflation rates, the Bank of Japan successively raised its discount
rate between
May 1989 and August 1990 from 2.5% to 6%. Even though the Tokyo stock market suffered a steep
slide during 1990, the central bank remained confident of being able to
manage a soft landing for the
economy. Many clung to the comforting notion that the excesses of the bubble economy were somehow
distinct and separate from the real economy.

The Japanese economy then abruptly slowed in mid-1990, and subsequently, in nñd-1991, began a steep
decline. Its major causes were plunging business investment and exports, associated with a general
profit collapse smacking of depression. The important point to see7 though, is that Japan's present
extraordinary economic and fmancial difficulties are directly related to the previous speculative bubble
and its bursting. Excessive monetary ease and super-low interest rates usually have an enormous cost

Obviously, undeterred by Japan7s disastrous boom-bust experience with super-low interest rates, the
Federal Reserve has repeated the same mistake during the last two years. Remarkably, it has happened
with very much the same effects relatively weak effects on the real economy contrasted with hyper-
-

stimulative effects on the financial markets.

WHO CAN SEE A BUBBLE?

We still wonder what the true motive of the Fed's recent mini-rate hike was: insurance against
an
overheating economy or against overheating financial markets? To begin with, did the Fed ever realize
that it was nurturing a global financial mania that was rivalling Japan's bubble? As it was happening,
few people were able to grasp the enormity of the bubble and its eventual potential disasttous
implications, not only for the fmancial markets themselves7 but for the world economy. --,

It really te~tifies to an un~liev.able igno~ce on the part of the world fmancial community. How
miser~ble it is that these
so-called experts failed to realize the nature of this boom though it was plainly
visible in the official U.S. monetary statistics, in particular, as we pointed out, in the Fed's very detailed
Flow of Funds Accounts.

a bubble? The
What makes common symptom of a bubble are unusually high valuations. But what
causes this symptom? Here, the key gauge is the sources of the funds flowing into the markets because
they In this last analysis, the crucial test is distinguishing between new
are the underlying cause.
savings and "inflation" derived fund
flows.

It used to be conventional wisdom that capital values or the level of long-term interest rates in a
country
are determined by the supply of new savings -

more precisely, by available savings relative to credit

demand and asset supply. Today, nobody looks at savings any more. The popular explanation for the
steep decline in long-term interest rates were super-low and
falling short-term interest rates, excess
liquidity, falling inflation and sluggish credit
demand. Savings dynamics were completely ignored.

THE SOURCE OF BUBBLE

general, private credit demand around the world is extremely

In weak. Budget deficits, however, loom
large as never before. Combined, the two still add up to pretty strong overall credit demand. The
bottom line of it all~ however, is that in many countries, total credit demand is running far in excess of

Currencies and Credit Markets \ March 1994

Q
 9

sign of such savings shortages are the big current-

t: -) current domestic savings. The infallible,
account deficits of many countries..
telltale

Take the U..S..: It's full of absurdities and contradictions.. As we have repeatedly explained, the global
bubble is primarily driven and lubricated by American money.. But where has all of this money come
from in the U.S..? Definitely not from a savings boom New personal savings, the nonnal source of
investible funds, have been running at an annual rate of less than $200 billion. The savings ratio is near
.

its
all-time low, and according to the latest figures for January, continues to weaken..

A look at U..S.. credit, savings and money flow data is illuminating and provides some ~ight into the

enonnity of the speculative bubble.. We shall focus on the last three years from 1990 to 1993.. -

During this period, available new household savings totalled about $620 billion. Business savings, in
the form of undistributed profits, amounted to about $130 billion. But total domestic credit expanded
by $1.6 trillion during this period.." Within Treasury and agency bonds accounted for more than
this total,
$1.2 trillion. That's a staggering gap between savings and credit growth.. Yet, interest rates plummeted.

As unbelievable as that is, it's not the end of it At the same time, investors poured an additional $900
billion into equities and mutual funds.. Lately, a significant portion of this flow has rushed into foreign
markets.. Ironically, though the U..S.. doesn't have enough savings to fund its own budget deficit, U.S.
money has elevated fmancial markets throughout the world.

Where then did this huge ocean of money deluging the fmancial markets come from if not from an
excess of savings? Where could it come from? On this question, as we so often do, we consulted the
books of the great economists of times past. Many of them did a lot of thinking on the topic of the
~ ) sources of money flowing into financial markets and econonùes~

One of them, the late Professor Gottfried Haberler, a personal acquaintance of ours, put his fmger on
the answer.. In his book, Prosperity and Depressions, he says the following: 'The supply of investible
funds may be said to flow from three sources -from amortisation quotas, from new savings antifrom
'inflation' in the broad sense (including not only newly created money, but also withdrawals from
existing hoards of money). "

Since the capital expenditures of.U.S~ corpo~ations in ~e aggregate currently exceed their cash flow, we
disregéÙd "amortisation" quotasu
can as a potential source of investible funds.. That leaves us with two
other originators of investible funds savings and uinflation'1. Since we have already determined that
-

it is not savings, the source therefore must be the "inflation1l Haberler describes.

Bubbles are made by money that comes from inflationary sources. Haberler continues his analysis with
this further explanation: 'There are various inflationary sources of supply the central bank, the
-

commercial banks, and, last but not Least, the liquid reserves (/wards) in the hands of business firms and
individuals.." With this, he actually expressed a view which was shared by the leading econoItÙSts of
Europe at that time.

TRACKING DOWN INFLATION

The primary source of inflation in every economy, of course, is the central bank.. .
.. the Federal Reserve

Ð .:.:..
,~
Currencies and Credit Markets \ March 1994

--.~ ~~~'5~.~~~~~t:~;;~--.':".:~"'''' .'-

 10
I in the case of the United States.. For its part, it purchased $90 billion of government bonds during the
I-

I past three years..

I.
But the Fed does not directly increase the money supply all by itself. It -creates new deposits to the
t credit of its member commercial banks so-called bank reserves.. The increase in the money supply,
-

I
measured by the different M's, comes about as the rising supply of reserves induces the banks to expand
I: their bond holdings or loans.. Generally, the size of these purchases are many multiples of the reserve
injections.. As it happened, the banks added more than $270 billion in bonds to their balance sheets over
1-
the three years 1990 to 1993.. (See the chart below..)
1
I U.S. GOVERNMENT BOND PURCHASES
$U..S Billions,
BY FINANCIAL INTERMEDIARIES
Annual
L $250
r
j
1

j o
~ $200 Brokers

E3 Commerlcal Banks

$150 . federal Reserve

$100

$50

$0

($50)

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Source: Board of GoverDon of the Federal Reserve

We now come to the third big source of the bond market bubble, one which Haberler doesn't mention
because it has never played such a big role as today.. It's the additional yield-curve playing activities
of the non-banks brokers, pensions funds, hedge funds, corporations and rich private individuals.
-

Like the banks, they have built up huge bond portfolios

financed at the low "repo" interest rates. Most
of this money is borrowed through the money markets from other non-banks, corporations and financial
institutions..

This part of the speculative bubble difficult to verify statistically..

is But without question, in the order
of magnitude, it amounts to many hundreds of billions of dollars. There is one group for which these
figures are available the security dealers and brokers. In late 1993, they alone held a bond position
-

of almost $300 billion, half of which they accumulated during the past three years.

This massive yield-curve playing by the non-banks has one important peculiarity. Unlike the activities
of the banks, it does not result in deposit or money creation. Rather, it's a game that is played with
Q'-'~."
~> -.'.

~-
'~y~{
..

CUlTendes and Credit Markets \ March 1994

 11

existing bank deposits. These are shuffled among the participants, facilitating massive institutional bond
þ speculation. In this last analysis, the existing money stocks are more intensively utilized.. Expressed

in more conventional words, money velocity is increased..

existing depositsU
But the biggest source of the bubble by far is what Haberler calls Uwithdrawals from
or what we otherwise might call dishoarding.. It's the mass exodus of individual investors out of bank
deposits and money market funds into stocks and bonds, largely through mutual funds.. These

investments, nearly $1 trillion, are the most tragic and malicious part of the bubble.. The responsibility
for this lies with the Fed and the many fmancial institutions, who in their drive for profits, lured millions
of savers with "sugar plum" dreams of prosperity and fmancial gains.. Many of these individuals,
deprived of interest income, were only too vulnerable to the claims of safety and guaranteed high

returns. Little did they know that they were assuming high risk. For the most part, they still don't

know.

A SCARCITY OF LIO UlDITY

As to the monetary implications of such ~ portfolio shift namely the use of existing money for the
-

in textbook teons it is referred to as dishoarding, increasing money

purchase of stocks and bonds
-

velocity, liquidity The key point is that these stock and bond purchases
preference and the like.
essentially leave the broad money supply unchanged.. The demand deposits that are employed do not
vanish; they simply become the property of mutual funds, for example..

All these monetary technicalities may appear complicated and boring.. Yet, they are crucial to
understanding the true cause of the recent panic sell-off in the world's financial markets.. The true

) -\

./
j
causes of the near-crash are all found
~l.ter
in the preceding speculative orgy which
between
drove
the
markets
supply and
to extreme
demand for
valuations, absurdly out of with the enormous imbalances
savings.

Since June of 1993, an apparently inexhaustible supply of money from American investors and highly-
leveraged speculators flooded global fmancial markets, pushing prices upwards in an almost vertical
trajectory. As we said in earlier letters, America exported its bubble.. Remarkably, however, U.S~ stock
and bond prices began to lag during this time.. In fact, the bond market already peaked in October of
1993..

1994 was the inert catalyst that punctured the

In our view, the mild Fed tightening on February 4,
bubble. It is in the nature of fmancial manias that virtually anything unexpected can trigger its collapse..

is it reasonable
This leaves us with two questions of paramount importance: Now following the sell-off,
to expect that the speculative froth is out of the markets? Second, could the bond disaster spill over into
the stock markets and possibly undermine the world economic recovery?

To the first question, our short answer is defmite "no". 1bis speculative bubble is far too big for it
a

to be liquidated within a few weeks. The huge overleveraged bond portfolios of the banks, investors
hanging over
and speculators, running into the .hundreds of billions of dollars, are the Damocles sword
the markets.. Who out there is able or willing to bail them out? Any rally, therefore, is bound to invoke
more liquidations..

It . Currencies and Credit Mark.ets

\ March 1994
 12

If U.S. bonds continue to weaken, as we assume in view of the

described, it looks very black for the share markets, too. In fact,
appalling imbalances that we
a long-term bear market may have have,
already begun. Watching recent market action, we suspect that there have been secret interventions in
the stock futures to prop up the U .5.. share market, much as occurred in October 1987.

As to the second question, fearfully, this time it won't be like 1987. When the financial markets melt
down, the economy will not be spared.. In this respect, we tend to draw some comparisons
with the
1929 household tied in the today than
crash of that deeply worry us: Pmt, far more wealth is up markets
bubble
in 1987 (again see the chart on page 6); second, this is the biggest fmancial in history taking on
global proportions. There is no such thing as a purely national stock market any more~ In 1929, Wall
Street's crash didn't lead to an immediate worldwide collapse.. This time around the implications of
such an is much weaker and more vulnerable than in
event are much larger. Thir~, the U.S~ economy
a much higher
the late 1920s~ The main positive difference between then and today is that we start from
level of prosperity.

CONCLUSIONS

Liquidity, liquidity, liquidity! Nothing else matters. Currency recommendations, economic forecasts
..
it's all secondary right now. This is not the time to invest, but to liquefy.
.. .

j
J cheaply
! It's curious thing, liquidity. It can't be had when everybody wants it. It's only available
a
~
when its held in disdain.. To this point, few have wanted it in fact, people have run from it. As
II
. . .

we've outlined, liquidity is at its lowest on record.

jl
11
II Given the inordinate capital preselVation remains the overriding
risks in global financial markets~
11 objective. Investors should only focus on short-term, cash-equivalent securities.
!l
II
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I! Next issue to be mailed on April S, 1994.

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,
source
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Copyright: Dr. Kurt Rlchebicher 1m
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I Currenda and Credit Markell \ March. 1994

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