China Tells

It all started from the black Monday in 1987, when Dow Jones Industrial Average fell by 23% in one single day. The economic impact has not been contained within the stock market, however, as the black Monday crash was soon followed by a Saving and Loan crisis in the US and a spike of oil price after the beginning of the Gulf War, resulting in an 8 months long recession.

The central bank of the United States, the Federal Reserve, reacted to the recession by slashing the interest rate from almost 10% to 3% during 1989 and 1992, along with other simulative policy in the hope that it will bring the economy back to the long term growth path. It seemed to have worked: US economy has started to recover with the Clinton government returning to budget surplus. The oil price has come down to modest level and the inflation in the US was successfully kept within comfortable levels. The phenomenal growth of Internet technology has hugely increased the productivity across all industries, and sparked the hope of an age of new economy coming.

The good days never last forever. The dot com bubble that burst in 2000 brought the zealous investors back to the reality. To be fair, the FED has already started to notice the heat of the economy before the 2000 peak of Nasdaq and begun to raise the interest rate gradually since the middle of 1999. Such a precautionary measure, however, has not prevented one of the world’s biggest stock market bubbles from bursting, which resulted in the first recession of US economy in the new century. Again the FED reacted by slashing rates aggressively from about 6% to 1.5% in 2 years, and the economy was brought back to the growth path again under this magic. In fact, the 2001 recession after the dot com bubble burst only lasted for 8 months, which is one of the shortest recessions in the history of US.

The FED has been praised with generous compliments and it seems that after learning the painful lessons in history, the central bankers have finally learned to tame the beast of economic cycle: the banks would adopt dovish monetary policy in recessionary times, such as lowering the interest rate, increasing the money supply and encourage the spending to fight against a slow down in the economy, and do the opposite in good times to prevent the economy from over heating. During the whole process the economy would also be immune from concerns of inflation. The problem of stagflation, an economic malaise originated in the 70s, is gone, and gone for good.

What most people have not noticed, however, is the other side of such therapy: to revive the economy after the burst of one bubble, a new bubble will have to be created to replace the busted bubble. With the process to be repeated, there would always a bubble to be created and then bust, which brings the whole economy down to recession again. To quote Paul Krugman, the Nobel Economics Laureate in 2002: “To fight this recession (the early 2000 recession), the FED needs more than a snapback,… Alan Greenspan (the then FED chairman) needs to create a housing bubble to replace the Nasdaq bubble”.

The FED successfully made it. Since 2000, the inflation adjusted US housing price (measured in Case Shiller National Home Price Index) has gone up by almost 60% till the peak in 2007. During the same time, the US GDP has had another robust run as during 1991 to 1999 with an average growth rate above 3% per year, and unemployment rate has been managed well under 6% through the period.

The story after 2007 is all well known to most financial savvy readers. The point of going through a brief chronicle of US recessions, however, is to remind ourselves that history does rhythm even if it does not repeat, and there has been a level of consistency in the central bank of US to react to economic slumps, and thereafter a certain level of predictability on its impact on certain asset prices.

In my view, three assets have shown signs of forming bubbles thanks to the FED’s effort to fight against the current unacceptably high unemployment in the US, namely Gold, US Treasury and Commodity. Since the beginning of 2009 when the FED started to launch the first round of quantitative easing, Gold price has gone up from around $800/oz to $1800/oz at the time of writing (up 125%), US treasury 10 year yield has come down from around 4% to a current level of around 2%, and CRB index (a commodity composite index) has gone up by about 44%.

The implication of such bubble creating policy is profound. Due to the fact that USD is a world reserve currency, FED’s policy has had a de facto global impact. The potential bubble in commodity has resulted in economic heats in commodity producing countries such as Australia and Brazil, while the potential bubble in Treasury bonds has indirectly lead to a mini boom in emerging Asia markets with their unemployment rates at historical lows and domestic inflation under the upside pressure. This is one of the fundamental reasons why we see a global economic heat map of stark contrast (cold in US, hot in Asia and commodity exporters) as of today.

There is good reason to believe that such an economic dichotomy shall continue in the near future, especially after the recent FED announcement that short end rate will likely to stay at zero for another two years. Based on many historical precedents, such bubbles created by central bank policies could last for multiple years, and will have profound impact on investment implications. It is perfectly conceivable that the heated economies will need a stronger currency (eg., AUD, BRL, SGD, KRW) to cool down the growth and inflation threat, while certain asset classes such as gold and commodities shall continue to provide decent upside for the investors in the years to come.