The Everything Bubble is a term coined by Graham Summers who wrote a book with the same title. In this article we will take a closer look at what the Everything Bubble is, what central banks around the world will do in an attempt to prevent it from popping and how investors can position themselves to profit from the Everything Bubble.
To understand the Everything Bubble we have to look at history. In 1913, the Federal Reserve was created. About twenty years later president Roosevelt made gold ownership illegal by issuing Executive Order 6102. All Americans were asked to turn over their gold in exchange for paper money. This was part of a large-scale gold confiscation in order to prop up the government’s gold stock. At the time, the world was still technically on the gold standard and any paper currency in circulation had to be backed by and redeemable into physical gold.
(Photo of president Roosevelt around the time of the gold confiscation in the early 1930s)
President Roosevelt issued Executive Order 6102 in an attempt to fight the Great Depression. Since the United States was still on the gold standard, the US government couldn’t just print money to stimulate the economy. The paper money supply could only be expanded as long as the gold reserves backing the paper money grew as well.
The backing requirement was 40% at the time. Since Roosevelt wanted to expand the money supply but all paper currency had to be backed to 40% by actual gold reserves, he forced Americans to turn over their gold coins and bullion. This gold confiscation propped up the government’s gold reserves which then allowed Roosevelt to expand the paper money supply and increase government spending. This was one of the first steps taken by the US government to abolish the gold standard in the United States.
Around forty years later president Nixon severed all ties to gold and effectively ended the gold standard by “temporarily” halting the redeemability of paper money into gold. Central banks that were holding US dollars in their reserves as part of the Bretton Woods System weren’t able to exchange their dollars for physical gold anymore.
From 1971 onward, the US dollar and all other currencies weren’t backed by anything other than the full credit and faith of the United States government. With paper money decoupled from gold, the United States government could theoretically spend as much money as it wanted.
Whenever the United States government wants to spend money, all it has to do is issue debt in the form of government bonds.
(United States government Treasury Bond from 1979)
These government bonds can be bought by anyone. However, in case there aren’t enough buyers of government bonds, the Federal Reserve steps in and buys the government bonds. In other words: If the United States government needs money, it simply reaches out to the Federal Reserve and asks the Federal Reserve to buy its debt. The debt issued through government bonds is expected to be paid back. But just like individuals and companies can go bankrupt, governments can go bankrupt as well if they spend too much money and don’t generate enough income.
While private and public companies’ income depends on the growth of their business, the tax revenue the US government can collect depends on the growth of the economy, or simply put, the Gross Domestic Product (GDP).
When economic growth slows down or turns negative, such as during a recession or a depression, this has negative consequences for businesses and individuals: They tend to “hoard” their money and spend less. They also aren’t as likely to lend money to others which can lead to a contraction in the credit market.
This negatively impacts the US government because it needs the economy to grow in order to continue financing itself through tax revenue and pay back its debt. But if the economy contracts and the US government can’t finance its expenses through taxation, it can sell more debt to the Federal Reserve. The Federal Reserve then prints money to buy these government bonds.
Since the US government and the Federal Reserve are “in cahoots” (the Federal Reserve is technically a separate entity but can be seen as part of the government), the US government can’t default on its debt.
When the US government cannot pay back its debts to bond holders, it simply issues new debt to pay off the old debt. This is called “rolling the debt”.
Since the Federal Reserve acts as the lender of last resort, it is widely believed that the US government cannot go bankrupt or default on its loans. While an individual or a business that runs out of income to pay back its debts would go bankrupt, the Federal Reserve can just keep providing the US government with money.
Due to the fact that the US government has a lender of last resort, US government bonds are considered a “risk-free” investment. If you lend money to the US government you are guaranteed to receive the agreed upon yield in the form of interest payments as well as your principal.
But are government bonds really risk-free and is a default of the US government out of question? To understand the Everything Bubble, we have to take a closer look at how the bond market works.
Most people are aware of the stock market where equities can be bought and sold. However, there is a much bigger market than the stock market. Enter the bond market also known as the credit market. This is where corporations and governments issue debt.
Whenever a corporation or a government doesn’t have enough money to cover their expenses, they can borrow money by issuing a bond. This money is expected to be paid back with future revenue. For example, a company in its early stages might not have sufficient income to expand and grow.
Investors who believe in the company’s potential and are confident it will be able to pay back its debt with cash flows generated in the future, can buy corporate bonds. As someone who buys bonds, you are taking on a certain risk that the corporation will default on its loan. This is why there are different credit rating agencies that rate bonds depending on their risk.
When an investor buys a corporate or government bond, the bond will have a maturity date, a coupon and a price. The maturity date is the date when the loaned sum, also known as the bond principal, is expected to be paid back to the investor. When investors loan money to a corporation or government, they don’t just want to get their initial principal back. They want to earn interest. When you buy a bond, you receive fixed income in the form of interest payments also known as coupon.
Finally, bonds are subject to price fluctuations due to supply and demand. Bonds can be traded and sold before maturity for a profit or loss. This means, if an investor sells a bond before maturity for a premium, the investor gets back more than the principal. As such, bonds can be uses as fixed income investments and to make a capital gain if their price increases.
(Government bonds being sold during World War II in order to help fund the war by Richard)
The interest rate or coupon rate of a bond has an inverse relationship to the price of the bond. In case lots of people are piling into the bond market and buying bonds of a particular corporation or government, due to the increased demand, prices of those bonds will rise.
Since bonds consist of fixed interest payments, when the price of a bond rises, the interest rate or coupon rate drops. Let’s say a bond was purchased for $1,000 with a coupon of $100. At the time the bond is purchased, the coupon rate or interest rate is 10%. However, if the price of the bond increases to $1,200, the investor still receives the same $100 coupon. This means the coupon rate has dropped to 8.33%. When bond prices raise, the coupon rates and yields drop and vice versa.
Now that you understand how the United States went off the gold standard and how the bond market works at a basic level, we’ll dig deeper and take a look at how the Everything Bubble emerged in the aftermath of several other bubbles.
Following Nixon’s decision to sever all ties to gold and effectively take the United States off the gold standard, the United States witnessed three consecutive and closely related bubbles:
We briefly discussed the Federal Reserve earlier in this article. The Federal Reserve acts as lender of last resort to the US government. But its main purpose is to engage in Keynesian counter-cyclical monetary policy. Whenever there is a financial crash, recession or depression, the Federal Reserve cuts the interest rate and engages in Quantitative Easing.
The interest rate that is being “cut” in this context refers to the Federal Funds Rate.
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. Law requires that banks must have a minimum reserve level in proportion to their deposits. This reserve requirement is held at a Federal Reserve Bank. When a bank has excess reserve requirements, it may lend these funds overnight to other banks that have realized a reserve deficit.From Investopedia
When the Federal Reserve raises or lowers the Federal Funds Rate, this is often simply referred to as an interest rate cut or hike. The Federal Funds Rate impacts all other interest rates from mortgages to how much interest you earn on bank deposits.
It also indirectly impacts the interest rates of bonds. When the Federal Funds Rate is lower than bond yields, investors are incentivized to chase higher yields by purchasing bonds.
If the Federal Funds Rate is 1%, the interest rate on bank deposits and mortgages will be similarly low. But if interest rates of bonds are 5%, investors will pile into the bond market to chase the higher yield. Why hold money in the bank and earn 1% interest if you can buy bonds and earn 5% interest?
This increased demand for bonds will bid up bond prices until the interest rates of bonds drop to a similar level as the Federal Funds Rate.
During the Dotcom Bubble there was a mania in stock markets. Investors got excited about the internet and how it would change businesses. But nobody knew what to expect. What impact would the internet have on companies? How big of a deal would it be? These questions along with the excitement about the internet as a new technology led to the rapid increase in tech stock prices.
Alan Greenspan, the Federal Reserve chair at the time, turned a blind eye to the mania in tech stocks and even contributed to the bubble by cutting the Federal Funds Rate.
During the mid-90s, the US economy was growing at 5-6% per year. Despite this growth, Greenspan lowered the Federal Funds Rate and made money cheaper. When the Federal Funds Rate is lower than economic growth, investors can borrow money and invest in almost anything that is expected to keep pace with the economy.
This is the other side of the Federal Funds Rate:
When the cost of borrowing money is kept artificially low, investors will take advantage of the cheap money and buy bonds, stocks and real estate. This is why a low Fed Funds Rate can lead to the formation of bubbles such as the Dotcom Bubble.
When Greenspan cut the Federal Funds Rate in the late-90s, the NASDAQ started going parabolic. This was partially because of the internet-induced stock mania, but also because borrowing money got cheaper and investors began piling into technology stocks due to the artificially low interest rates at the time.
(NASDAQ index growth and collapse visiualized)
Then in 2000 the Dotcom Bubble burst and the NASDAQ dropped 72%. In 2002, Greenspan hired economics professor Ben Bernanke to help the Federal Reserve and the economy get out of the mess it was in. Both Greenspan and Bernanke believed the Great Depression was caused by debt deflation. Bernanke believed that debt deflation could be avoided through monetary policy.
At the time, nobody wanted to experience another depression. Certainly not under Greenspan’s watch. With the help of Bernanke, Greenspan engaged in extreme monetary policy and lowered the Fed Funds Rate from 1.82%, which was already considered low at the time, to 1% in mid-2003. It stayed there for another year despite the economy growing by 5%. By doing this, Greenspan and Bernanke effectively flushed the market with “free money”.
When the economy is growing by 5% and interest rates are kept at 1%, this can be seen as the equivalent of “free money”. The reason for this simple: Most asset classes which are linked to the economy should grow at least at the same rate as the economy or more. So when the Federal Reserve keeps interest rates at 1% despite GDP being at 5%, investors can borrow money and invest in almost any asset and expect a return. This flood of “free money” had to go somewhere and it ended up in the housing market where it caused another bubble.
The 1% Fed Fund Rate led to a boom in single-family home sales and a sharp increase in housing prices. There are several other reasons that led to the housing bubble becoming a systemic risk such as ridiculously low lending requirements and derivative markets. But the bottom line is that people who under normal circumstances wouldn’t be able to afford a home or qualify for a loan were able to get cheap mortgages.
Since real estate is a much bigger market than tech stocks, the US housing bubble which was deeply intertwined with derivative markets, became a systemic problem of unseen proportions. In 2008, the US housing bubble burst, triggering the worst financial crisis in history: The Global Financial Crisis.
By the time the US housing bubble had burst, Greenspan wasn’t Federal Reserve chair anymore. Ben Bernanke had taken over Greenspan’s place in 2006. The debt deflation Bernanke dreaded so much finally took place and Bernanke resorted to even more extreme monetary policies to deal with the problem. Bernanke cut the Fed Fund Rate to 0% and kept it there between 2008 and 2015. He did this although the recession caused by the Global Financial Crisis officially ended in June 2009. He also engaged in aggressive Quantitative Easing programs which created an even bigger problem.
Quantitative Easing refers to central banks purchasing large amounts of government bonds and other types of assets with freshly printed money. This increases the money supply and inflates the prices of bonds and other assets.
(Newspapers covering the Global Financial Crisis in 2008 by Scorpions and Centaurs)
When Bernanke cut the Fed Fund Rate to 0% and kept it there for 7 years, while at the same time engaging in various Quantitative Easing programs, the market was flushed with even more “free money”. This time, the money was truly free. This meant the US government could borrow money without barely having to pay interest at all and as a result went on an even bigger debt binge than before.
And here’s how this played out in the aftermath of the Global Financial Crisis:
The Federal Reserve bought US government bonds with freshly printed money at a staggering rate to counteract the debt deflation that took place in 2008. Since bond prices depend on supply and demand, the extreme demand in US government bonds from the Federal Reserve led to an increase in bond prices. Since bonds are fixed income investments where investors get fixed interest payments until maturity, when the prices of bonds rise, the interest rates drop.
If an investor bought a US government bond for $1,000 with a coupon of $100, this equals a 10% coupon rate. When the price of that same bond rises to $1,200 before maturity, the investor gets the same $100 coupon but the coupon rate has dropped to 8.33%. However, in the aftermath of the Global Financial Crisis bond coupon rates dropped as a result of the Federal Reserve’s frantic purchasing of US government bonds. This further fueled the bull run in the bond market.
The Federal Reserve acted as ultimate “dumb money” investor that bought bonds at any price, and even announced in advance when it was about to start buying bonds through Quantitative Easing.
Since the Federal Reserve announced every Quantitative Easing program down to the month they were planning to start and exactly how many billions of dollars worth of bonds they were buying every month, investors could simply front-run the Federal Reserve. They could buy bonds low and sell them high. The yield didn’t matter since bonds can act as income investments but also to generate a capital gain if bonds are sold at a premium before maturity.
This led to investors piling into the bond market in an attempt to profit from the ultimate “dumb money” investor, the Federal Reserve, and front-run the increase in bond prices.
The low Fed Fund Rate maintained by Greenspan and his successors as well as the massive Quantitative Easing programs deployed by the Federal Reserve led to a massive bubble in the bond market which we are currently still in today.
Since sovereign bonds are the bedrock of the financial system and act as the risk-free rate against which all other assets are measured, everything went into a bubble. This is why the sovereign bond bubble can be seen as the “Everything Bubble”. It is the final and most systemic bubble we have ever experienced since it is happening in the most senior asset class: US government bonds.
At the slightest hint of debt deflation, the entire bond market, financial system and economy as a whole is at risk of collapsing.
In case the bond market deflates, interest rates will increase which means the US government can’t borrow money as cheaply anymore. This would exacerbate the debt problem the United States already has. If interest rates suddenly were to increase to 5-10%, the US government wouldn’t be able to roll its debt anymore. It would make the debt less and less sustainable, leading to the eventual insolvency of the United States.
If the Federal Reserve were to allow debt deflation to happen, this would destroy the status of the US dollar as world reserve currency. Even before the world went off the gold standard, the US dollar acted as world reserve currency since 1944. All central banks around the world hold US dollars in their reserves and back their own currencies with US dollars. The only reason why sovereign nations are still comfortable doing this after Nixon ended the gold standard in 1971 is because the US dollar is backed by the full faith and credit of the US government.
In case debt deflation takes place, it would severely harm the creditworthiness of the US government. It is widely believed that the US government can’t go bankrupt and won’t ever default on its outstanding loans.
If debt deflation makes the US government’s debt even more unsustainable than it already is, this would shatter the trust in the US dollar as world reserve currency. In other words: The faith and credit of the US government, which is “backing” the US dollar, depends on how inflated the US sovereign bond market remains.
If the Federal Reserve lets the sovereign bond market deflate, the faith and credit of the US government will collapse along with the bond market. If the US government were to default on its debt, this would have equally detrimental consequences.
(Federal Reserve building in Washington, D.C. by AgnosticPreachersKid)
Because of this, the US government can neither default on its government debt nor let debt deflation happen. It would completely shatter the trust in the US dollar as world reserve currency and lead to a global financial and economic crash of unimaginable magnitude.
If any politician or central banker were to intentionally inflict this much economic pain on the United States and the world as a whole, it would mean losing their jobs, making re-election impossible and effectively ending their careers. Since no central banker wants to go down as the person who let “it” happen on their watch, they will continue doing everything they can to keep re-inflating the bond market.
This leads us to the end game of the Federal Reserve and central banks around the world. Since central banks such as the Federal Reserve act as lender of last resort, governments can continue borrowing as much money as they want without having to pay it back. They can continue rolling the debt. In an extreme situation, the Federal Reserve could even print money outright and give it to the US government without the need to pay it back at all.
The Federal Reserve will do everything it can in its power to keep the bond market inflated and prevent debt deflation from happening. But just like an addict slowly builds up a tolerance, the sovereign bond market requires ever more extreme monetary policies to get the “fix” it needs to stay afloat.
As we saw, the Federal Funds Rate was cut from 5-6% all the way down to 0%. The European Central Bank already deployed negative interest rates and it’s likely that they will come to the United States in due time as well. In order to keep the bond market propped up, interest rates will eventually have to turn negative.
Why would anyone buy sovereign bonds with a negative interest rate? In order to front-run the ultimate “dumb money” bond buyers in the form of central banks and make an almost risk-free capital gain. Furthermore, pension funds are used to and in some cases required to buy bonds as part of their portfolios. Since government bonds are considered the safest investment of all, individuals, institutions and funds continue piling into bonds despite low and even negative interest rates.
Apart from implementing negative interest rates, at some point the US government might have to use a variety of other strategies to lessen its debt burden. These strategies could include different forms of taxes, such as wealth taxes or unrealized capital gains taxes. Central Bank Digital Currencies (CBDCs) will be another tool in the arsenal of central banks. With CBDCs money becomes programmable which gives central banks a more advanced and nuanced way of conducting monetary policy in the future.
But most importantly, the Federal Reserve will have to continue printing money to keep rolling the US government debt and prop up prices of bonds, stocks and other assets. At the slightest hint of debt deflation, the entire system might start crumbling.
Through the continued use of extreme monetary policy and nuclear levels of Quantitative Easing, the US dollar will continue to lose value due to inflation. In case these monetary policies become extreme enough, this could result in hyperinflation in the United States.
While inflation and hyperinflation are bad, central banks regard it as the lesser evil compared to debt deflation. With inflation, the can is kicked down the road and the sovereign bond bubble can be reflated without risking an immediate collapse. Debt deflation or default on the other hand would lead to an immediate and serious economic crash.
The Federal Reserve is stuck between a rock and a hard place. The end game of the Federal Reserve will likely either lead to debt deflation or hyperinflation. Since nobody will let debt deflation happen on their watch, a period of heightened inflation or even hyperinflation seems more likely.
While real estate, stocks, bonds and bitcoin are expected to remain volatile in the short-term, it seems that the Federal Reserve will have to inevitably continue inflating asset prices including risk assets. It will have to keep the Everything Bubble inflated. The loss of trust in the US dollar as world reserve currency, whether it’s caused by debt deflation, default or hyperinflation, could increase the likelihood of hyperbitcoinization.
While nobody knows what the future holds, the need to continuously re-inflate the “Everything Bubble” would be bullish for stocks, real estate, scarce commodities and bitcoin. While dips, sell-offs and even crashes are possible and to be expected, they are unlikely to last very long since any contraction in asset prices could lead to debt deflation. Inflation is the only remedy for debt deflation, and this includes inflating asset prices.