Comstock Partners, Inc.February 21, 2013
Sometimes you CAN "Fight the Fed"
The Fed's current attempt to control long term rates, "QE to infinity", is based on the hope that by providing cheap money, banking and financial firms will lend and thereby stimulate the economy. This would be a sound plan if the problem with the US economy was a shortage of credit. With corporations holding back cash and depending on productivity gains to drive earnings, the typical recovery scenario where the private sector borrows money for investment and drives job growth and ultimately demand, is not materializing.
Demonstrably cheap money is not the answer. The real constraint on the economy is two pronged: 1. expectations of low growth keep corporations from investing funds and instead they hold large sums of cash on their balance sheets and 2. continued high unemployment and a continued deleveraging of household debt keeps consumers from spending. We have discussed this before and used the term to describe it as a "liquidity trap." Despite the evidence that QE is not working as planned (employment and GDP remain lackluster) the Fed continues on this course as QE has become the proverbial financial crack pipe that allows the asset markets to continue higher and higher.
Surely inflating housing, stock and bond prices by governmental money printing is a good thing, right? Ask Alan Greenspan how well the Fed's last foray into propping up asset prices worked out for them. Every time the government decides to manipulate markets, there are many very unpleasant unintended consequences. Under Greenspan artificially low rates were used to expand the housing market and allow businesses and consumers to get cheap money to leverage up their balance sheets. As we know, it ended badly. The unintended consequences were that the entire financial system almost collapsed and the stock market had its worst retracement since the Great Depression.
The real danger of QE is not the risk of hyperinflation, but the possibility that there is a "bubble" created in the bond market by artificial government purchases and that eventually there will be some failed auctions followed by a quick sharp rise in rates. This rise in rates will affect mortgages, consumer debt and, perhaps most alarmingly, the Federal debt cost. A quick rise in mortgage rates will not only slow down home purchases, but will add to the costs of anyone who has an adjustable rate. The Shadow Inventory which is still estimated at over 2.3 million homes will start to increase again as people are unable to make the drastically higher mortgage payments. Car loans, credit card payments, student loans and other consumer debt costs will increase and further dampen demand. Inflated asset prices will turn over violently.
While many pundits agree that the bond market will eventually pay for the Fed induced asset inflation, they do not seem to be outwardly worried about a quick, vicious rise in long term rates and the financial calamity to follow. Goldman Sachs, however, has recently reduced its exposure to the bond market while at the same time has locked in low borrowing costs to the tune of $8 billion. They expect a 25% drop in bond prices.
Many credit Albert Einstein with defining insanity as "doing the same thing over and over again and expecting a different result." The Bernanke Fed's use of Quantitative Easing may seem different than the easy money policies of the Greenspan Fed on the surface, but the ultimate payoff of artificially inflated asset prices will end up with similar results. And by the look of the S&P 500's long term chart, it looks like it is about to peak soon, and form a significant triple top with the 2000 and 2007 peaks-see the attached chart.