Asset Cycles: “When The Music Stops Playing”

The famous American economist Mr. Herbert Stein stated, “If something can’t go on forever, it will stop.” Yet, when it comes to asset price cycles it has been hard to pinpoint when the music stops playing as it has been very difficult for analysts and policymakers to identify their causes and symptoms.

The US is currently experiencing its third large asset price cycle in the past 25 years. Each asset price has become successively bigger in scale and in comparison to Nominal GDP the current asset price cycle is the largest of the three.

The “Wile E. Coyote” moment for 2020 that former Fed Chairman Ben Bernanke warned about in a recent presentation could easily occur sooner as the asset-based economy is extremely vulnerable to a sharp and abrupt asset price correction.

Asset price cycles have had unique characteristics as well as features shared with each other. For example, asset price cycles vary in terms of scope and duration. Moreover, the internal dynamics of each cycle is different. The 1990s asset cycle was largely centered in the equity market, heavily concentrated in technology area, and driven by large corporate borrowings. The 2000s cycle was largely a real asset (housing) cycle, driven by record household borrowings.

The current cycle is most unique, as it is the largest in scale (asset values have increased nearly $50 trillion) and duration (nearly twice as long as past two cycles). It also has been driven primarily by record asset purchases of debt securities by the Federal Reserve, which makes it even more difficult to predict a top because the central bank, unlike households and companies, is not subject to a margin call.

History shows that one particular asset component tends to outperform the other. In the 1990s, financial asset values (mainly equities) far exceeded the value of real assets and conversely in the 2000s real asset values far exceeded the value of financial assets. Today, the extreme valuations are once again on the financial asset side of the ledger, which makes sense since that’s where the central bank has concentrated its purchases.

Lessons from prior asset cycle reversals indicate that the “fault line” is in the sector or the area of the economy that had been most responsible for the asset price surge. To be sure, the equity bubble burst when large segments of the tech sector lost access to new liquidity and many tech firms could no longer use their equity price to compensate workers, access new loans or finance capital investment. Similarly, the housing bubble burst occurred when many homeowners were unable to meet debt-obligations, borrow against their homes to support spending and later were unable to refinance due to plunging asset values.

Today’s fault line is the Federal Reserve as policymakers have used an unconventional asset purchase program in order to stabilize the financial system. At this juncture, the Fed has started to unwind its balances sheet program, but in reality it only lowered the music level a little as it is gradually reducing the size of the reinvestment of principal proceeds. For example, in Q4 2017 the cap on reinvesting principal proceeds was $10 billion, but by Q4 2018 it will be up to $50 billion and that's when the balance sheet will start to runoff at a faster pace. The faster runoff will also occur when the Treasury borrowing requirements are increasing, diverting funds from other markets into the Treasury market to fund a larger budget deficit. At the same time, official policy rates are expected to be over 2% and on their way to 3% in 2019.

In the end, what investors and analysts may be overlooking is that when the Fed is the “fault line” it can’t easily provide the liquidity or reduce interest rates as it did in past episodes when asset prices fell abruptly and sharply. That’s especially true when fiscal policy is lifting the growth and inflation impulses in the economy. So this time the rush to exit may come when investors realize the Fed's so-called “put” on asset price corrections is not alive and well.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.