The mother of all bubbles

Christopher Joye

Coolabah Capital

In  The AFR  I present  new research from Goldman Sachs that shows the US Federal Reserve is currently well "behind the inflation curve"---with a Taylor Rule advocated by Chair Yellen herself implying interest rates are already 100bps-300bps too low---which, based on the experience of the 1960s and 1970s, can have savage consequences if the unemployment rate drops to very low levels (it is already just 4.7%). I contend that the central bankers' tendency towards hubris and projecting a sense of infallibility by not acknowledging and correcting recent decision-making errors is the essential source of their vulnerability with a classic case in point being a speech given during the week by the RBA's new head of financial stability, which rewrote recent financial market history to purport that the RBA (and APRA) had intervened early to cauterise the great Australian housing bubble blown by the RBA's own cheap money policies when nothing could be further from the truth.  Free here: (VIEW LINK)

Excerpt enclosed: 

"According to this revisionist narrative the  global  financial crisis (GFC) "hasn't  fundamentally changed the way we think about  financial system stability". The RBA is evidently so sensitive to allegations it has  failed to heed the lessons of  the GFC—by blowing the mother of  all bubbles with excessively cheap money—that it  felt compelled to repeat the mantra the crisis had not altered its approach on  five separate occasions in the speech. There are demonstrable  flaws in this fiction. First, the RBA never came close to anticipating the GFC. Its  financial stability guru,  Luci  Ellis, published a paper in 2006 arguing "the most important lesson to draw  from recent international experience is that a run-up in housing prices and debt need not be dangerous  for the  macroeconomy, was probably inevitable, and might even be desirable". Ellis maintained that "the experience of   Australia and the UK seems to suggest booms in housing price growth can subside without themselves bringing about a  macroeconomic  downturn".  Two years later the 33 per cent drop in US house prices would trigger the deepest global recession since the great depression. Second, the GFC necessitated a raft  of  policy responses that had never been seriously contemplated before, which have transformed the way we think about dealing with shocks and the unanticipated consequences.  Contrary to the recommendations of  the 1997 financial system inquiry, the Commonwealth guaranteed bank deposits and bank bonds  for the  first time. The RBA agreed to buy securitised mortgage-backed portfolios via its liquidity  facilities, which it had never done, and  Treasury independently acquired $16 billion of  these loans in the  first case of  local "quantitative easing". Banks borrowed more money on longer terms  from the RBA than anyone previously envisioned, which led the RBA to create a new bail-out program called the committed liquidity  facility. In emergencies banks can now tap over $200 billion of  cash instantly at a cost of  just 1.9 per cent that makes trading while  insolvent an impossibility. A central tenet of  pre-GFC regulation--attributable to the 1997 Wallis Inquiry—was that taxpayers should never guarantee any private  firm  for  fear of  inducing "moral hazard". This is the "heads bankers win, tails taxpayers lose" dysfunction that emerges when governments insure downside risk.  The RBA  has  since  conceded that the crisis bail-outs unleashed unprecedented moral hazards, such as  too-big-to-fail institutions,  that require new mitigants. The Australian Prudential Regulation Authority used to allow the major banks to leverage their equity 65 times when lending against housing because these assets were presumed to be nearly risk-free.  Since  the 2014 financial system inquiry APRA has been persuaded to  deleverage  the major banks' home loan books to merely (!) 40 times. In 2013 the RBA was publicly dismissive of  foreign regulators' efforts to contain credit growth via  so-called  macroprudential  interventions to cool hot housing markets. One and a half  years later APRA belatedly sought to cauterise the housing boom the  RBA's 2012 and 2013 rate cuts precipitated with light-touch  macroprudential  jaw-boning. Of  course in 2017 the RBA has a different version of  events. Apparently it has always seen "macroprudential  policy as part and parcel of  the  financial stability  framework". It turns out that "in 2014 the Australian regulators [presciently!]  took the [rear-]view that risks were building in the residential housing market that warranted attention". Actually, none of  APRA's December 2014 announcements had any impact until well into 2015 (two years after the boom started) and they proved to be woefully inadequate. This column revealed,  for example, that many banks had completely ignored APRA's minimum serviceability tests on home loans. Good risk management requires intellectual honesty, which is missing in action among those overseeing the "wonder down under".

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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