/Federal Reserve is popping everything bubble, fueling stock market sell off, chaos

Federal Reserve is popping everything bubble, fueling stock market sell off, chaos

Federal Reserve

Chairman Jerome Powell wants you to know everything is under control. Powell sounds calm and clinical when he talks about the frighteningly volatile economy. Despite price inflation rising at the fastest pace in 40 years and an economy limping sideways out of the ruin of the pandemic, he keeps repeating one important point: The Fed has all the tools it needs to meet these mounting challenges, particularly inflation.

Inflation, when left unchecked, can feed into itself and create an economically ruinous and socially destabilizing spiral. There is virtual unanimity among economists and politicians on the need to prevent this nightmare, and Powell has promised that the Fed can slay the inflation dragon. “No one should doubt that we will use our tools to guide inflation back to 2%,” he asserted during a speech in October, repeating the point this month as the Senate considered Powell’s all-but-assured reappointment as Fed chairman. But despite this confidence, year-over-year inflation is running at 7%, the highest level since the early 1980s. 

Powell, a former private-equity executive and member of the Fed’s Board of Governors since 2012, is telling the truth — at least in a technical way. The Fed really does have all the tools it needs to stop inflation, but what Powell leaves unsaid is that using these tools could create a disaster. And what the Fed chair definitely won’t tell you is that this mess will be all the more catastrophic because of the Fed’s own policies over the past 12 years.

Since 2009, the Federal Reserve has injected extraordinary quantities of easy money into the Wall Street banking system in an attempt to boost the economy. And every time the Fed has tried to ease up on this firehose of cash and started to raise interest rates — as it will try to do again this year — investors dumped anything risky and markets fell. And every time, the Fed lost its nerve and reversed course. But now, inflation is forcing Powell’s hand and the Fed is being forced to tighten the money supply. The result will be a reordering of the economic system and carnage in markets for stocks, bonds, and corporate debt. As weary American workers already know, the chaos in financial markets will be quickly transmitted to the real economy when companies respond by cutting jobs and pulling back on investment. 

The Fed spent 12 years blowing up an ‘everything bubble’…

To understand just how chaotic the next year could be for America’s economy and the world’s markets, it’s helpful to understand the unprecedented economic experiment the Fed conducted over the last decade. One of the Fed’s primary functions is to print dollars, and thus control how much money is sloshing around the economy. Between 1913 and 2008, the Fed used this power to gradually increase the money supply from effectively zero to roughly $900 billion. Then between late 2008 and mid-2014, the Fed created a program called “quantitative easing,” which tried to bolster the economy by injecting 3 trillion new dollars into the system. That’s three centuries worth of money printing in about five years. During the same period, the Fed launched another unprecedented program — it kept interest rates pegged at zero. Before 2008, short-term rates under the Fed’s control had only brushed up against the zero rate for short periods of time. But for seven years after the financial crisis, the Fed pinned them to the zero-percent floor.

Ben Bernanke, Janet Yellen

Former Federal Reserve Chairs Janet Yellen and Ben Bernanke both pumped trillions of dollars into the world economy through quantitative easing — and now the bill is due.

Alex Wong/Getty Images

This two-pronged experiment had a profound effect on financial markets around the world. For most of the last century, investors could earn a decent profit, or “yield,” on safe investment instruments like 10-year US Treasury bonds. These supersafe Treasuries were the equivalent of Wall Street’s savings account, helping deliver a stable flow of cash to retirees and letting hedge funds stash money while looking for worthwhile investments. However, the Fed effectively closed this savings account during the last decade. When the Fed pumps new money into the banking system through quantitative easing, it does so by buying up long-term Treasuries, which pushes down yields. In turn, investors — from average Americans saving for retirement to complex hedge funds — are forced into what has become known as the “search for yield,” a scramble to earn what they need by putting their money into riskier investments.

Trillions of dollars injected into the system forced investors to chase yield by putting their money in risky assets like shares of unprofitable companies, securitized leveraged loans, and bonds for shady overseas companies. This, in turn, created what Wall Street traders call the “everything bubble.” Usually, asset bubbles pop up in a certain segment of the economy, like housing or high-flying tech stocks, but traders are worried that the search for yield has pushed so many dollars into so many risky assets that the bubbles are everywhere at once.

lord of easy money cover

The Lords of Easy Money: How the Federal Reserve Broke the American Economy

Simon & Schuster

These bubbles are the source of the Fed’s current dilemma. In order to fight inflation, Powell and his compatriots must raise short-term interest rates — thereby taking some money out of the system. But when interest rates go up, investors can start earning more money in safe havens like the 10-year Treasury and pull back from the risky investments they were incentivized to make over the last decade. And when that happens … bubbles can pop. We saw just a little preview of the danger in 2018 and 2019, the last time the Fed tried to rein in the money supply. Back then, the Fed raised interest rates slowly but steadily, while at the same time withdrawing some of the new cash it had injected into the banking system through quantitative easing.

The result was a scary and synchronized downturn in late 2018 that hit all kinds of markets, with stocks, bonds and commodities falling in unison.  The stock market even plunged on Christmas Eve 2018, normally a quiet trading day, which seemed to be the final straw for Fed officials. Powell, who had been promising for months that the Fed would stick to its plans, reversed course and abruptly called off the tightening in January of 2019, in an incident that came to be known as the “Powell pivot.”

   As inflation continues to soar, Powell has little choice but to raise interest rates, even though the costs will be much higher now than they were in 2018. There are some markets where prices are so egregiously high that there seems to be little doubt that a reckoning is in store.

… and now they have to pop it

The most obvious sign of the “everything bubble” is the stock market. When investors go scavenging for higher profits, moving their money from safe assets like bonds into assets with higher profit potential like stocks has always been the low-hanging fruit. So during the Fed’s decadelong experiment, the value of stocks rose steadily in spite of weak economic growth — the Dow Jones Industrial Average skyrocketed 77% between 2010 and 2016. One typically caustic hedge-fund trader described to me the frothy stock market of 2016 as being like the crowded deck of the Titanic as it sank. The deck wasn’t crowded because it was a great place to be; it was crowded because people had nowhere better to go. 

Even the pandemic hasn’t slowed these stunning stock-market gains — the Dow is up 26% since the end of 2019 despite the chaos of the past two years. Even James Gorman, the CEO of Morgan Stanley, begged the Fed in October to impose some kind of sanity. “You’ve got to prick this bubble a little bit,” Gorman said. His pleas had little effect. Investors, desperate for gains, have eschewed the stocks of safe companies with strong profits and instead pumped their money into companies telling pie-in-the-sky stories about their future — and their future stock gains. The market value of Tesla, for example, rose nearly $200 billion in December, according to The Wall Street Journal, which was more than the total combined value of Ford and General Motors. 


The popping of the “everything bubble” is already causing chaos in stock markets worldwide and the worst is yet to come.

Craig Ruttle/Associated Press

Another overheated market is corporate debt. When interest rates are near zero, it’s cheap for companies to simply issue debt and use the money to invest in new equipment or buy back shares of their own stock. And when the bill comes due, they just take on new, cheap debt to pay off the old. Investors like this debt because it has a higher yield than supersafe government bonds, and so they can bring in more profits. Add it all up and you get a debt boom. In 2010, there was about $6 trillion worth of US corporate debt outstanding. By early 2020, that number had nearly doubled to $11 trillion. And this new debt wasn’t coming from companies with pristine credit ratings, either. 

Much like the housing market in the 2000s, the frantic demand for loans reduced the scrutiny on who was issuing the debt. Corporate borrowers were wildly overly optimistic about their income prospects when they borrowed, just like homeowners in the 2000s. Importantly, this new, lower-quality debt isn’t just being held by Wall Street speculators; it is being bought by pension funds and other institutional investors who manage the retirement accounts of average Americans, who typically like to own safe and boring investments. So when the Fed starts to hike rates, and it becomes more expensive to pay back those loans, these companies and the investors who own their debt may find themselves in a mess like the housing crash of 2008. 

In fact, we got a taste of this potential disaster in 2020 when the COVID shutdown slammed companies across almost every sector of the economy. The fragility of corporate debt markets was an open secret on Wall Street, and everyone began preparing for an apocalyptic downturn. But the Fed delayed this reckoning by pumping even more money into the banking system that spring — about three centuries worth of money printed in a matter of months. Corporate debt markets didn’t just recover, they once again headed toward the moon, reaching a new record high of $11.4 trillion this year. 

Unfortunately for the economy, corporate debt is not the only smoldering debt tower — emerging markets are also in trouble. As the Fed suppressed yields of Treasuries, investors went looking for other government debt that could fill the “relatively safe, but still gives me yield”-sized hole in their portfolio. They turned to up-and-coming economies like Mexico, Poland, and Turkey that have somewhat less stable economies than the US, and thus, have to pay higher interest rates (read: yield) to attract lenders. Since the Fed started its quantitative easing program, billions of dollars have poured into these government bonds, incentivizing them to keep issuing more debt. 

Turkey borrowed six times as much money by issuing bonds between 2009 and 2012 than it did between 2005 and 2008. The borrowed money helped construct new shopping malls next to old shopping malls in Istanbul. The borrowing left nations like Turkey enormously vulnerable to any changes in the debt markets. When the Fed announced a slowdown in quantitative easing in 2013, the market adjusted immediately, and investors sold off riskier government debt. About $4.2 billion of Turkish bonds were sold in the following three months, and about $2.4 billion fled Poland. When foreign investors dumped their bonds, it caused the value of each nation’s currency to decline, making it harder for citizens to buy everyday items or get goods from abroad. It stands to reason that a similar effect would unfold when the Fed begins to back off its current quantitative easing program again this year.

‘Do you think that no one will suffer?’

It is hard to see how any of these asset classes — tech stocks, corporate debt, and emerging-market debt — can survive in a world where the Fed hikes interest rates to anything like 3% while simultaneously pulling back on its cash injections through quantitative easing. 

The scary contours of what’s coming was summed up well by a former Federal Reserve official Thomas Hoenig, who voted against the Fed’s easy money policies before retiring in 2011. Back in 2016, Hoenig was warning about the very large and long-term risks that the Fed was piling up through zero-percent rates and quantitative easing. 

“You had seven years of basically zero-interest rates. Now, what happens in an economic system over seven years? The entire market system develops a new equilibrium — around a zero rate,” Hoenig told me in 2016. “An entire economic system around a zero rate. Not only in the US, but globally. It’s massive. Now, think of the adjustment process to a new equilibrium at a higher rate. Do you think it’s costless? Do you think that no one will suffer? Do you think there won’t be winners and losers? No way.” 

foreclosure california

There will be winners and losers once the Fed starts raising interest rates. It’s almost guaranteed that average Americans are going to be the ones to take the biggest blow.

Erin Siegal/Reuters

When I talked to him last month, Hoenig was just as worried. The Fed had avoided making this adjustment for many years, but now it appears that inflation is forcing the central bank’s hand. And if the Fed really does follow through on its promises to hike rates, it seems highly likely that we see soon enough who the winners and losers are. 

If history is any guide, the winners will be the Wall Street powerhouses that make money when the bubbles inflate, and then get bailed out when the bubbles collapse. The losers are the type of people who earn a living by getting a paycheck, rather than owning assets. That is, a lot of average Americans. The wealthiest 10% of Americans own about 65% of all assets, while the bottom half of the population owns roughly 5%, as of late 2020. This large group of Americans suffered the worst toll of the 2008 crash, the decade of weak growth that followed, and the turmoil of the pandemic. Now it seems inevitable that they will have to withstand another blow.

Christopher Leonard is a business reporter and author of “The Meat Racket” and “Kochland.” His latest book, “The Lords of Easy Money: How the Federal Reserve Broke the American Economy,” is out now.

Based on “THE LORDS OF EASY MONEY: How the Federal Reserve Broke the American Economy” by Christopher Leonard. Copyright © 2022 by Christopher Leonard. Reprinted by permission of Simon & Schuster, Inc.

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