Living on the banks of the mighty Mekong River that flows from the Tibetan Plateau across thousands of miles through Indochina and into the South China Sea, Tran Nguyen knows how high his home needs to be built above the banks.
Nguyen and his family have farmed and fished the Mekong for generations, through war and strife, they have carved a living for themselves, by reading the signals of the river that gives and takes.
But over the past decade, and thanks to numerous hydroelectric projects upstream on the Mekong, the once bountiful river that provided much-needed nutrients downstream has taken more than it’s given.
Crop failures have become more common and fish stocks have grown thinner.
Initially, the changes were too subtle to be of much significance, too slight to command much attention.
But in the past few years, the seasonal floods from the relentless monsoon rains that are part and parcel of life on the Mekong have been getting more extreme.
And last year, despite generations of the water level never rising above where Nguyen built his house, his home and all his belongings were swept away in a massive flood.
According to Nguyen,
“It’s either that there isn’t enough or water comes too much and floods — nothing about the Mekong is normal now.”
“I haven’t seen the Mekong change so fast before.”
But it’s not just the Mekong that’s been changing rapidly, the global monetary system has as well and in ways that may provide the perfect setup for the next big financial crisis.
Been there done that, blown that bubble
For veterans of previous financial bubbles, there is an unmistakable sense of déjà vu.
Stock valuations at their richest since the dot-com bubble of 2000, home prices are back to their pre-financial crisis peak, and some of the diciest companies have no trouble raising debt from the markets, or selling shares.
All this is happening while investors are pouring billions of dollars into everything from green energy to cryptocurrencies.
But at the root of all of this seemingly method-less madness, is the U.S. Federal Reserve and whose prints have been on previous bubbles and crashes as well.
It’s no big secret that easy monetary policy has regularly fueled financial booms and it’s exceptionally easy now.
With the Fed having kept interest rates low since the pandemic first landed in America last March — and even signs of heightened inflation only bringing forward the schedule for raising rates, instead of spurring an actual move to increase borrowing costs — it has signalled to the markets that it has little appetite to tighten liquidity.
It’s fixed, let’s break it
Despite signs that the U.S. economy is on the mend, the Fed still continues to soak up both U.S. Treasuries and mortgage-backed securities to the tune of some US$120 billion a month.
And despite a recent spike in bond yields, over the past week, yields have slipped down again and the benchmark U.S. 10-year Treasury yield, from which almost all other debt takes reference, is still well below inflation.
For only the second time in over four decades, real yields remain deeply negative, distorting market incentive mechanisms and asset prices.
But did the Fed or indeed, any other central bank really have any other choice but to flood the markets with liquidity?
A rock and a harder place
Students of the Great Depression will know that a reluctance to intervene by both the Hoover administration and the U.S. Federal Reserve made things worse and prolonged the economic malaise unnecessarily.
While the Hoover administration did roll out relief packages, it refused to intervene in the economy directly.
And the Fed at the time restricted liquidity, refusing to prop up failing banks when the financial system needed it the most.
This is why there is no question that the Fed had to act during the pandemic, which at its most intense, threatened far more damage than even the 2008 Financial Crisis.
But signs that not just the U.S. economy, but the global economy, is on the mend, could undermine the justification for such low interest rates, threatening the underpinnings of market valuations.
Yet the Fed has been here before.
In the late 1990s, the Fed slashed rates in response to the 1997 Asian Financial Crisis and the near-collapse of the hedge fund Long-Term Capital Management.
The move by the Fed was seen by many as an implicit market backstop, and while it shored up markets, it also teed them up for the dot-com bubble that followed almost immediately thereafter.
Once the dot-com bubble had burst, the Fed’s low-rate policy in response to that crisis kept liquidity taps flowing to water the ground for the subsequent housing bubble and crisis.
On both occasions, Fed officials vehemently defended their policies, arguing that to raise rates (or not cut them) simply to prevent bubbles, would compromise their main goals of low unemployment and inflation, and do more harm than letting the bubble deflate on its own.
While the Fed of those previous bubbles was at least ostensibly concerned about inflation, the current Fed is now proselytizing its own home-brewed economic theory called “New Monetary Policy,” which accepts higher inflation (over 2%) during some periods to “make up” for periods of lower inflation (in the decade after the 2008 Financial Crisis).
And while this may all sound like a bit of voodoo — because who wouldn’t want to have their cake and eat it? — Fed officials have been expounding on New Monetary Policy with a straight face, as if inflation is like a dial on a thermostat that you can set.
To be sure, the pandemic shutdown last March triggered a hit to U.S. economic output that was initially worse than the 2008 Financial Crisis, but after just two months, economic activity began to recover as restrictions eased and businesses adapted to social distancing.
The Fed initiated new lending programs so numerous that many of them went unused, and Congress passed the US$2.2 trillion Cares Act, making the Emergency Economic Stabilization Act of 2008 look like pocket change in comparison.
Since then, however, coronavirus vaccines have arrived faster than anyone could have hoped for, and the U.S. economy has reopened at breakneck pace, and even though scores remain unvaccinated, the U.S. still leads the rich world in vaccination numbers.
At current rates, the U.S. economy is not only likely to hit its pre-pandemic size before the end of the year, it’ll likely be larger and more powerful than it was heading into the pandemic.
Yet despite that, both fiscal and monetary taps remain wide open.
In March, the Biden administration won a huge victory by passing a sweeping US$1.9 trillion additional coronavirus relief package and is working to roll out a fresh US$1.2 trillion infrastructure framework by August.
And although bond markets appear to be functioning normally, the Fed is still the 400-pound gorilla that is weighing heavily on bond yields.
This unprecedented injection of both monetary and fiscal stimulus into an economy already rebounding thanks to a broad reopening and pent-up demand is why asset markets are starting to build-up into bubble territory.
S&P 500 stocks are now trading at about 22 times the coming year’s profits, according to data from FactSet, a level which was only exceeded at the peak of the dot-com bubble in the year 2000.
Investors have also demonstrated a willingness to accept the lowest yields since 1995 for bonds of junk-rated companies, the narrowest spread above safe U.S. Treasuries since the eve of the 2008 Financial Crisis, according to data from Bloomberg Barclays.
Residential and commercial properties, adjusted for inflation, are also near the peak when the housing bubble was at its fullest in 2006.
And cryptocurrencies, an asset class that didn’t exist prior to the 2008 Financial Crisis, are now worth an estimated US$1.37 trillion according to data from CoinMarketCap.com
While stock and real estate valuations may be more justifiable today than they were in say 2000, or 2006, because the returns on U.S. Treasuries are so much lower, it becomes a bit of a stretch to justify other asset prices.
It’s Not the Size That Matters, It’s What You Use to Measure It
Just as has been the case in previous bubbles, conventional valuation metrics are being dismissed as outdated, especially when it’s come to nascent asset classes.
A Bank of America report noted in April that companies with relatively lower carbon emissions and higher water efficiency attracted higher valuations, but not because of superior cashflow or future profits, but because of a flood of new money in so-called ESG funds which invest according to environmental, social and governance criteria.
Conventional valuations are also redundant for cryptocurrencies which for the most part earn no interest, generate no rent, and produce no dividends.
More importantly, cryptocurrencies have yet to firmly establish substantial use cases outside of speculation.
Advocates claim that cryptocurrencies will one day displace fiat currencies, and use decentralized finance or DeFi as an example of how the industry will disintermediate the legacy financial system.
And as recently as May, cryptocurrencies were valued in total at over US$2.4 trillion, more than all the U.S. dollars in circulation.
Whether it’s cryptocurrencies or the internet, as with previous episodes of bubble blowing, financial innovation is also at work.
Zero-commission brokers such as Robinhood Markets and SoFi have empowered a previously unserved investor class, with limited experience or education on the machinations of the markets.
Stock splits, by retail investor favourites such as Apple and Tesla, have made their bite-sized chunks more consumable for the mass retail investing market.
Retail investors are now estimated to account for up to 26% of market volume, according to data from Vanda Research, and the Bank of International Settlements, a clearing bank for the world’s central bank, estimates that retail investors now influence the overall direction of the markets more than ever before.
Investors also don’t need to go too far to find examples of retail investor influence either — just look at GameStop, AMC Entertainment, and the league of extraordinary meme stocks, and the fortunes of “professional investors” like Melvin Capital licking their wounds from their short positions.
Just like traditional metrics, retail investors are also using their own tools for valuation that have nothing to do with what you may have learned in Finance 101, buying stocks and other assets for reasons completely unrelated to their underlying business or prospects.
And while such speculative activity is often blamed on the Fed, U.S. Treasury Secretary Janet Yellen will do well to remind everyone that “correlation does not imply causation.”
But the causal link between fiscal stimulus and speculation remained unbroken when last March, flows into both ETFs and mutual funds spiked after the U.S. Treasury started distributing US$1,400 stimulus checks.
So how does it end?
It’s impossible to say if, or even whether, this all ends.
Expensive stocks could eventually earn the profits necessary to justify their current prices and valuations may eventually normalize, especially if the global economy continues on its current trajectory.
And more extreme pockets of speculation may collapse under their own weight, as profits disappoint, competition emerges or aspirations go unfulfilled.
But for assets across the board to fall would need some sort of larger macroeconomic event, such as a recession, financial crisis, or even runaway inflation.
With the pandemic in retreat, a recession seems unlikely for now.
And with the Fed demonstrating its willingness to raise rates (or at least bring forward the schedule for rate hikes) and supply constraints eventually being ironed out, inflation is less likely as well.
This leaves a crisis linked to some hidden fragility in the system as being the most likely precursor to a wider financial fallout and it looks like Wall Street is laying the pipes to that sewer right now.
Over the past 18 months, the number of big Wall Street names signing up to cryptocurrencies has increased to such a level that it hardly registers anymore in the digital asset markets.
Whereas in the past, an announcement such as the US$55 billion hedge fund of Marshall Wace planning its first forays into the cryptocurrency market would have seen a huge uptick in prices, last week that news received a disinterested yawn instead.
Cryptocurrency markets have become so accustomed to fresh institutional entrants that news of their arrival fails to make waves anymore.
And like the boy who cried wolf one too many times, even Elon Musk’s tweets throwing shade on Bitcoin and Ether did nothing to stop them from ascending into the weekend.
From BlackRock to Fidelity Investment Management, Goldman Sachs to Citigroup, Morgan Stanley to JPMorgan Chase, Paul Tudor Jones, MicroStrategy, Stanley Druckenmiller, Ray Dalio, Tesla, Square, Visa, PayPal, Mastercard, the list of cryptocurrency converts keeps growing.
And that all boils down to excess liquidity chasing increasingly sparse opportunities.
It should therefore come as no surprise that financial institutions, for whom a low interest rate environment eats into their profits and trading activity can no longer generate the alpha of last year, are turning to cryptocurrencies.
And each additional institutional name betting on cryptocurrencies, adds to the cache and credibility of the space, which in its current state is unregulated and growing in size and significance.
With the crypto-savvy Gary Gensler heading up the U.S. Securities and Exchange Commission, the likelihood of an inaugural U.S. Bitcoin ETF grows, and then it’s off to the races.
Miffed that they have yet to blow up the cryptocurrency bubble to its fullest potential, Wall Street, which was initially dismissive of the digital asset dominion, may now take the lead to apply their creativity to the space the same way they did for internet companies and mortgages.
And if something as pedestrian as a mortgage can be juiced up, what more the exotic nexus of finance and technology that is cryptocurrencies?
Wall Street’s signature move has been making money by selling clients the most complex instruments that even they themselves struggle to understand and to that end, cryptocurrencies are the perfect product by melding two already complicated fields — finance and technology.
Even seasoned investor Mark Cuban couldn’t avoid taking a hit from his investment in Titan, an algorithmic-linked stablecoin.
The Fed thankfully has already noted the risks, singling out cryptocurrency prices as a potential danger for the first time in its overall assessment of financial system stability.
In a brief comment contained in the Fed’s semi-annual Monetary Policy Report, the central bank noted that policymakers are paying more attention to cryptocurrencies, which even on a good day, represents just a sliver of the massive financial system.
U.S. Federal Reserve Chairman Jerome Powell has said that he wants the Fed to play a “leading role” in the development of international standards for digital currencies, which is exactly what Wall Street wants because you can’t game the system if there are no rules.
For now, cryptocurrencies are too small and too insignificant in the grand scheme of the global financial system to register concern.
Even at its highest watermark, cryptocurrencies were a fraction of the value of derivatives traded on a daily basis, but Wall Street could change that.
While bubbles aren’t blown in a day, there are signs that Wall Street is already in the midst of laying the pipes to blow up a massive sewer bubble in cryptocurrencies.
From proprietary trading desks specializing in cryptocurrencies, to the proliferation of exchange-traded products underpinned by digital assets in Europe, there is a growing sense that the space is maturing, and the groundwork for a massive hype cycle is being laid down.
Like so many other bubbles before, the clues are subtle and the warning signs only obvious with the benefit of hindsight, but cryptocurrencies could potentially cause the next financial crisis, maybe not today, maybe not tomorrow, but someday, and for the rest of its life.
By Patrick Tan, CEO & General Counsel of Novum Alpha
Novum Alpha is the quantitative digital asset trading arm of the Novum Group, a vertically integrated group of blockchain development and digital asset companies. For more information about Novum Alpha and its products, please go to novumalpha.com/ or email: [email protected]