A Funny Thing Happened On the Way to Raising Rates
It wasn’t too long ago that the stock market was busy celebrating a “great” September jobs report. There were 248k net new jobs created and the unemployment rate dropped to 5.9 percent. Janet Yellen, Ben Bernanke, and the rest of Washington D.C.’s central planners deemed it a great time to take a Keynesian victory lap, basking in the delusion that they now have proved that you actually can print and borrow your way to prosperity.
And, because of their success, the Fed would be able to raise interest rates without any damage to the economy.
But while crossing the finish line they discovered they were on the wrong track. U.S. stocks have dropped for the third consecutive week and have erased all the gains for the year. The market’s anxiety stems from the global economic slowdown (that includes the United States). Industrial commodity prices, most notably oil, are tumbling and sovereign debt yields are plunging — asset prices around the world have begun to collapse.
Ever since the late 1980’s, the Fed has viewed itself as the savior for the stock market; this is affectionately referred to on Wall Street as the Fed put. Like a fireman standing ready to put out a major fire brewing in the economy’s kitchen, the central bank has stood ready to bail out any of the markets bad behaviors — most of which were first derived from the Fed’s provision of artificially-low interest rates to begin with.
But, today’s Fed isn’t merely waiting for a fire to start, it is using a flame thrower to light the stove. It has stopped relying strictly on overnight repos to manage short-term rates and providing liquidity on the margin; but instead has now put the responsibility of the worldwide economy squarely on its shoulders.
This is why former Fed Governor Laurence Meyer recently complained that too-low inflation “is getting to be a real issue again,” With inflation at 1.5 percent according to the Fed’s preferred index, Meyer believes FOMC policy makers aren’t likely to raise interest rates, even if the economy approaches full employment — what Keynesians believe causes inflation.
And taking this a step further, John Williams, president of the San Francisco Fed, said in a recent interview with Reuters that the first line of defense at the central bank would be to telegraph that U.S. rates would stay near zero for longer than mid-2015. Then, if inflation isn’t really hollowing out the middle class fast enough, Mr. Williams suggests the Fed should be open to another round of asset purchases. Even so-called Fed Hawks, like St. Louis President James Bullard, are now suggesting that the current quantitative easing program should be extended.
It has become clear that the Fed is no longer just tinkering on the edges of the economy, it is now micromanaging every economic data point and, most importantly, each tick of the stock market.
This over-engaged Fed has created an overwhelming sense of investor complacency — an entitlement that asset prices will always go up and bond yields will always stay low.
All central bank intervention comes with a price. The upside of lowering interest rates is that it lowers debt service costs. The down side is it encourages more gluttonous debt consumption. That is why the U.S. National debt has risen from $9.2 trillion, to $17.9 trillion, since the beginning of the great recession. This is also why total Global debt has soared by over $40 trillion, since the start of the Great Recession. Stated differently, total global debt has leaped from 176 percent of GDP in 2008, to 212 percent by the end of last year. The truth is there has been no deleveraging at all since the financial crisis; but rather a dramatic re-leveraging of the global economy.
Rising rates are not the current problem. Despite the fact that the biggest buyer (the Fed) is nearly out of the picture, yields are falling because deflation is pervading across the globe. However, the ending of our central bank’s massive QE programs is acting like a de facto tightening of rates.
The fact is that debt levels have increased to such a lofty level that zero percent interest rates are not enough to keep the current stock market bubble afloat. If you don’t agree with this, take a look over in Europe. Central Bank head Mario Draghi is having difficulty getting a genuine QE program going and there has been no increase in the ECB’s balance sheet. Despite the negative nominal interest rate environment in Europe all stock indices are down on the year; with the German DAX down 11% in 2014.
U.S. markets fell around 15% after QEs 1 and 2 ended. That’s because asset bubbles have risen to the extent that they now rely on perpetual central bank money creation to survive. Investors need to be reminded that the stock market did not bottom from the panic selloff experienced during the height of the great recession until QE1 was expanded to $1.55 trillion in March of 2009. Each time QE ended the stock market fell apart. Only this time the end of QE III finds the market more than 40% higher than it was at the end of QE II. In addition, the end of this round of money printing coincides with the majority of developed and emerging market economies at or near a recession. And, the Fed isn’t just ending QE but is planning to raise interest rates in the next few months.
Bond yields and industrial commodities have already tumbled in price; and now real estate and stock prices have also begun to plummet. I believe that stocks have entered into a significant bear market.
Without having the ability to further lower interest rates, it will take another massive and protracted QE program to pull equities out of this tailspin. To keep the bubble growing we will see a promise from the Fed that QE won’t end until inflation has become permanently entrenched in the economy.
It looks like yet another Fed prediction has failed to materialize and another of its strategies has been thwarted. The sad truth is that the Fed’s plan to raise interest rates next year will not come to fruition. In sharp contrast, the new plan will be called QE infinity.
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