Inside Investment: Federal Reserve – tiny bubbles in the wine
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Inside Investment: Federal Reserve – tiny bubbles in the wine

Like an alcoholic that believes another drink can do no harm, the Federal Reserve has not learnt the lessons of the global financial crisis. Once more it seems determined to mop up only after the next bubble bursts.

Janet Yellen-R-envelope

When we were in high school in the late 1960s, my brother developed an inexplicable enthusiasm for the music of the Hawaiian nightclub performer Don Ho, who had achieved a certain celebrity by performing his signature abomination, Tiny Bubbles, on the Ed Sullivan Show. (My brother was perhaps influenced by the fact that we lived in a dry town in Massachusetts, and Tiny Bubbles is a drinking song.) 

The lyrics are: “Tiny bubbles in the wine/Make me happy/Make me feel fine.” Don Ho died of heart failure in 2007 just as the financial crisis was developing. He sang of tiny bubbles until the very end.

I thought of tiny bubbles this week when I read Jeremy Grantham’s comments in the money manager GMO’s second quarter report: “In early July, Janet Yellen made an admirably clear statement that she is sticking faithfully to the Greenspan-Bernanke policy of extreme moral hazard. She will not use interest rates to head off or curtail any asset bubbles encouraged by the extremely low rates that might appear. And history is clear: very low rates absolutely will encourage extreme speculation.

But Yellen will, as Greenspan and Bernanke before her, attempt to limit only the damage any breaking bubbles might cause. Well, it is a clear policy and in my opinion clearly wrong. I had thought that central bankers by now, after so much unnecessary pain, might have begun to compromise on this matter, but no such luck, at least in the case of the Fed. 

If we play the bubble right, we will be able to
move upscale from the cheap New York
sparkling wine to the good French product

The evidence against this policy after two of the handful of the most painful burst bubbles in history is impressive. But not nearly as impressive as the unwillingness of academics to back off from closely-held theories in the face of mere evidence. This affirmation of moral hazard – we will not move to stop bubbles, dear investors, but will help you out when things go badly wrong – should be of great encouragement to speculators and improve the odds of having a fully fledged equity bubble before this current episode ends.”

Of course, Grantham is speaking of giant, not tiny, bubbles, but he does make clear that Yellen wants tiny ones, thousands of them, like in a plastic flute of cheap, malodorous upstate New York ‘champagne’. Yet she is likely to get at least one giant one, too. No doubt, the individual investor, now on the sidelines, will be sucked in just before the bubble bursts.

The Fed, and Janet ‘Tiny Bubbles’ Yellen (I am referring neither to her stature nor to her demeanour but to her policies) think, like Don Ho, that tiny bubbles will “make me happy, make me feel fine,” and, eventually, “warm all over”. And if big bubbles result? Well, she’ll worry about that tomorrow. Her aim is jobs at any monetary cost.

What’s a dual mandate?

On March 31 she reiterated her firm view: “The past six years have been difficult for many Americans, but the hardships faced by some have shattered lives and families. Too many people know firsthand how devastating it is to lose a job at which you had (sic) succeeded and be unable to find another; to run through your savings and even lose your home.”

As for fiscal policy, she claimed in her Senate testimony on July 15 that, “fiscal policy has been unusually tight for a period like we’ve lived through,” despite the fact that we have had a fiscal stimulus programme of 5.5% of GDP – about equal to the first New Deal of the 1930s. I remember being in a central bank presentation in Moscow in 1996 in which governor Sergei Dubnin said: “We will print as many rubles as the people need.” That policy ended badly. So Fed policy will be loose, and, as Grantham says, we can speculate on the coming “fully fledged equity bubble”.

This is not a time to engage in normal investment activity, focusing on things like market share, valuation, relative spreads and credit quality. Remember the internet bubble when Applied Materials (AMAT) went up 20-fold between 1995 and 2000? That part of the move was good, but you did not want to be there when AMAT, a real company, subsequently lost three quarters of its value.

The speculative bubble probably will not help the real economy much. The best way to play it will be through financial intermediaries like regional banks (avoid the big ones, the government seems determined to suck out all their blood) and life insurance companies, both of which profit from the steepening of the yield curve. Institutional investors may also consider shadow banking companies and can use futures and options as well.

As for individuals, banks and insurance companies offer equity-linked CDs and fixed-index annuities, which provide varying degrees of upside exposure to the market while guaranteeing a return of principal after a certain number of years. (Choose carefully, there are more varieties of contracts than there are life forms in the Amazon rainforest, and some are dangerous.)

Looking at the bright side, and if we play the bubble right, we will be able to move upscale from the cheap New York sparkling wine to the good French product. We can then raise our glasses in a hearty toast to the health of Tiny Bubbles, even as we view the Fed scrambling, once more, to cope with the burst-bubble misery and economic cardiac arrest all around us.

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