Back in the dark days of 2008 the Federal Reserve lowered it’s Discount Rate” (the short term rate at which it lends to financial institutions) down to .25%. In effect, it had reduced the return on government bond yields down to 0%. Adjusting the Fed Funds rate is a tool given to the Federal Reserve to battle inflationary pressures and to defend the U.S Currency from devaluation. Protecting the purchasing power of the currency is the Fed’s primary purpose.
In reducing interest rates so dramatically, they had essentially fired all of their guns at once and were left with few choices with which to fight off the dreaded deflationary pressures that were already building in the economy. As you may recall, it was deflation that afflicted Japan for the last two decades and crippled their once vibrant economy. Politicians, economists and equity investors have a much greater fear of economic deflation than they do of inflation. In fact, a little bit of inflation helps economies to grow, or at least gives the impression of growth… and in politics, perception is everything.
A small amount of inflation will boost corporate earnings (and stock prices), increase wages, consumption and add to growth in GDP (Gross Domestic Product). It is when inflation begins to spiral upward that the face of the true demon is revealed as it destroys the purchasing power of paper currencies which are basically an IOU backed by nothing more than the promise to repay.
Deflation on the other hand, chokes off growth by devaluing asset prices. No one is willing to borrow money to purchase an asset which is depreciating in value. The effects of deflation are much more difficult to reverse that those of inflation which can be countered by increasing real interest rates.
So What Is Quantitative Easing?
Quantitative easing refers to the quantity of the money supply that is in circulation. By easing or relaxing the restrictions on financial institutions ability to borrow cheaply, the Federal Reserve is increasing the money supply as they attempt to re-inflate the economy and put it back on a path to sustained growth.
The problem lies in the Fed’s ability to turn off this massive flow of dollars and drain the liquidity out of the system. It is Bernanke’s printing presses that have boosted the stock markets by 60% in the last eight months. With the yield on the 10 year note at 3.18%, investors have turned to the equity markets to increase their returns. The huge amount of liquidity sloshing around in the economy has to go somewhere and accounts for this meteoric rise in equity prices.
Needless to say there has been a complete disconnect between the stock market and the economy. When the economy is strong and growing, the fundamentals lead to increased earnings and growth in stock prices. This has not been the case. While the overall economy is still in full freefall investors have bid up equity valuations in the stock market beyond all reality.
The “Price to Earnings” (PE) Ratio of the S&P Index now stands at 18 times next years earnings. Is there a sane person among us who truly believes that earnings and stock prices will rise that much with the domestic unemployment rate approaching 10%?
The ridiculous bank bailouts, TALF, TARP, Cash for Clunkers, the Fed’s purchases of Mortgage Backed Securities (MBA’s) and their purchase of their own treasury agency debt has created a new stock market bubble that is destined to wipe out more wealth than the original problem they were created to fix. It is through the purchase of these mortgage backed securities and treasuries that the Fed has managed to manipulate the mortgage and bond market in an effort to inflate the economy and stimulate growth in the housing market. But, the bond market can not be manipulated.
The Bond Market
It has been said that the Bond market is smarter than the stock market. The sheer size (value) of the U.S. Bond market is 5 times larger than the entire stock market. Bond traders are long term players and therefore tend to take a broader view of the economy than stock traders. One year ago the 10 year bond was priced at 4%, the current yield on the 10 year bond is 3.18%. There is no question that the bond market is pricing in a coming deflationary environment. If the bond market sensed even a minuscule amount of future inflation, it would be demanding much higher rates on the bonds it is pricing today.
The Bush administration had estimated the cost of the Iraq/Afghanistan wars would be $60 Billion dollars (non inflation adjusted). It is now approaching $1 Trillion Dollars. The FHA, as the lender of last resort, has in the past 8 months funded nearly $700 Billion dollars in single family mortgage purchases (at 3% down!!) and has a reserve of less than $4 billion dollars. The Obama Administration is handing out $8,000 tax credits to new home buyers while Bernanke buys up mortgage backed securities in a misguided attempt to force down mortgage rates. Since we have no savings rate, every dollar that is spent must be borrowed and repaid with interest. Someone needs to tell President Obama that you can’t tax and spend your way to prosperity. This is a house of cards and is totally unsustainable.
Supply and demand determine price. The bond market see’s an increasing unemployment rate which eliminates wage inflation and reduces demand for goods and services causing prices to fall further. The American consumer will not buy something when they feel they could get it cheaper tomorrow. This is how a deflationary spiral begins and the bond market has already priced it in. Ignore them at your own peril.
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