"It was very difficult to definitively identify a bubble until after the fact--that is, when its bursting confirmed its existence.”--Alan Greenspan, former Federal Reserve Chairman, Jackson Hole, August of 2002
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The Federal Reserve had driven the effective federal funds rate down to a low 1.7% (see here: http://research.stlouisfed.org/fred2/series/FEDFUNDS/) when Greenspan made that comment, and the housing bubble was ballooning, ready to burst.
Now, the next Fed-induced bubble is popping, a bubble that helped mask weaknesses in the economic recovery.
“The beneficiary of the Fed’s easy-money policies – energy – has burst,” says Stephanie Pomboy of MacroMavens, who has a dedicated following on Wall Street. “The sudden and dramatic souring of the economic data in the last few months suggests the energy bubble had a much bigger role in the recovery than commonly perceived.”
The U.S. oil boom is largely pegged to the plunge in the value of the dollar. The U.S. dollar index dropped nearly 20% in value from 2009 through the beginning of 2013 as the Federal Reserve cut rates and embarked on quantitative easing, a “money-printing for bond buying” program that eventually more than tripled the size of its balance sheet over the past seven years. Central banks around the world also moved to debase their currencies, triggering fears of a global currency war.
A cheaper dollar helped drive oil prices higher, and financial flows into commodity investments ignited the oil and gas boom. But the dollar has reversed its slide, the dollar index is up about 20% since 2013 as other currencies weaken, and in turn, oil prices have plunged, sparking fears of an energy bust.
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Pomboy points to analysis put out by the Manhattan Institute last February which “is looking less outlandish.” The Institute claimed the entire economic recovery was due to the U.S. oil and gas boom, which overall “has added $300 billion to $400 billion annually to the economy—without this contribution, GDP growth would have been negative and the nation would have continued to be in recession.”
Pomboy also notes that the report “attributed a large portion of the job gains to the energy sector.” About 600,000 people are directly employed in the U.S. oil and gas sector, based on statistics from the Census Bureau. Looking at that same Census data, Manhattan Institute researchers estimate that, “since 2003, more than 400,000 jobs have been created in the direct production of oil and gas and some two million more in indirect employment,” in industries such as restaurants, hotels, transportation, construction and information services.
But as a resurgent King Dollar drives oil prices down, “it should go without saying that the energy sector bust doesn’t thus augur well for capex or employment going forward,” Pomboy warns.
The data support Pomboy’s analysis. Industrial production on the regional and national level measured by the Institute for Supply Management has been soft.
Stripping out the anomalies from holiday hiring and layoffs, outplacement consultancy Challenger, Gray & Christmas notes that layoffs rose dramatically year over year in the first two months of 2015. Nearly 40% of the U.S. jobs lost since the beginning of the year were the result of the decline in oil prices, Challenger says. “That puts 2015 on track to be the first year that layoffs have increased since 2011,” Pomboy notes.
Moreover, the pace of layoffs in the energy sector has picked up speed.
“In just the first two months of the year, energy sector layoffs have totaled 36,532, seventy-one times the 513 layoffs announced in the first two months of 2014,” Pomboy adds. “As the energy bubble deflates and the size of the economic hole is set in stark relief, investors will finally acknowledge the profound underlying weakness in this economy that has been the bee in my bonnet for the last five years.”
The energy bust has also blown a hole in Treasury demand “created by reduced dollar recycling,” Pomboy says.
Meaning, profits from the boom in global oil transactions settled in U.S. dollars (the dollar is the reserve currency) had to be parked somewhere. As energy prices rose, more dollars were recycled in U.S. Treasuries, driving yields to historic lows and helping consumers to borrow to spend.
But as the dollar has strengthened, that has led to a sharp, “inexorable reduction” in demand for U.S. Treasuries, Pomboy says. From their peak last September, foreign transactions in Treasuries have flipped from a positive $74 billion per quarter in purchases to a negative $26 billion in quarterly sales through year-end 2014, Pomboy adds.
Foreign central bank purchases of U.S. Treasuries through mid-March reflect this trend. Based on the U.S. Fed’s custody account, “Treasuries held in custody at the Fed have declined by $32 billion, a negative $185 billion annualized rate,” Pomboy says. “The degree to which the energy boom led to outsized demand for Treasuries is now being revealed in its absence.”
Consumers saving and spending less, and decreased petro-dollar recycling through Treasuries, could exert upward pressure on rates for things like consumer loans. “Slower growth and rising interest rates, not exactly a compelling backdrop for Fed tightening,” Pomboy warns.
To be sure, the energy bubble isn’t as big as the housing bubble, but “that doesn't mean it won't hurt” since “the bubble did contribute mightily to both the ‘recovery’ and the uniquely low level of interest rates,” Pomboy adds.