The largest asset bubbles occur while economic growth and inflation remain positive, but subdued, for extended periods of time.  According to its dual mandate, the Federal Reserve focuses primarily on growth and price stability, and tends to ignore the creation of asset bubbles as long as economic activity is not running too hot and inflation is benign.  Historically, the Fed has not considered it a priority to prevent or pop asset bubbles, despite inadvertently enabling their creation through various policy measures.

During the inflation of asset bubbles, it is common for excess liquidity (easy money) to follow the path of least regulation outside of traditional regulated banking systems.  These channels are known as the shadow banking system or shadow lending markets where it is more profitable for both lenders and borrowers to transact due to lower costs and lax oversight.  During the last financial crisis, companies like Countrywide, New Century and even certain money market funds helped fill this role.  Unfortunately, the boom-time “innovations” which emerge around these shadow lending markets are not battle-tested, and often fail spectacularly when inevitably stressed.

Today, we here at Fox Capital believe a bubble highly vulnerable to collapse lies in the corporate debt market and the passive investment vehicles accompanying it.  While C&I lending from the traditional banking system has been healthy since the last crisis ended, the corporate bond market has absolutely exploded, tripling in size from the peak of the prior cycle in 2007.  As a direct result of the Fed’s zero interest rate policy, investors of all kinds were forced out on the risk curve, scrambling for yields attractive enough to meet their own obligations. Pension funds, endowments, insurance companies and retail investors (through ETF’s and bond funds) gorged on corporate debt for extra yield in a ZIRP world.

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