Central banks are incapable of saving economies or creating growth. The only
thing a central bank can do is create inflation. These market manipulators
set forth on a journey seven years ago to save the world by engaging in massive
monetary manipulation, euphemistically called Quantitative Easing (QE), and
a Zero interest rate policy known as (ZIRP).
As I could have told them before they started, all this easy money will fail
to create viable growth. The economy, held back by massive debt levels, initially
clocked in at 0.2% for the first quarter. This number is set to be revised
down to negative territory due to a huge increase in the trade deficit during
March. And the second half isn't setting up to be much better either.
But the Fed was successful in re-inflating the housing and equity bubbles
and also creating another new massive bubble in the bond market.
Despite tepid growth, most at the Fed have become anxious to wave the "Mission
Accomplished Banner" and to move towards interest rate "normalization". Ceremoniously,
they have set goals for the economy to reach in order to begin that long journey:
unemployment around 5% and inflation at 2%.
As the Fed's luck would have it, discouraged would-be workers have dropped
out of the labor force and have found it more profitable to sit home than to
work, which has allowed the unemployment rate to approach the Fed's target.
The unemployment rate has finally returned to the 2008 bubble level of 5.4%.
But when we look at the Employment to Population ratio it is nowhere near where
it ought to be. (59.3% today, down from 63.3% prior to the Great Recession.)
Employment to Population Ratio: Source BLS
But those at the Fed stand determined to never let real data points get in
the way of the narrative that printing money saved the economy. In fact, San
Francisco Fed President, John Williams, was recently touting a new way to calculate
GDP that he called GDP plus. It appears when you take out everything he defines
as "noise", first quarter GDP would have come in at exactly 1.7%. Perhaps a
better term would be GDP minus: GDP minus all the things we wish didn't happen
in the economy this quarter.
Now the only thing hampering the Fed's path to rate normalization is the "too-low" rate
of inflation--the inflation resulting from unprecedented money printing and
years of ZIRP that caused massive stock, bond and real estate bubbles doesn't
count in the government's inflation indices. Nevertheless, the official core
CPI number used to measure inflation appears at the moment to be "just right."
And for a brief moment, if we dismiss those asset bubbles, ignore discouraged
workers, cherry pick economic data points and squint a little--we can be deluded
into believing the economy has reached Goldilocks Nirvana...or even Goldilocks
Nirvana plus.
But before Goldilocks reaches for her porridge, she may want to pay closer
attention to what the Bond Market is telling us.
Normally, interest rates are a product of credit and inflation risks. Until
a few weeks ago, central banks got away with the notion they could monetize
unlimited amounts of sovereign debt without creating inflation. That is until
now; look at sovereign bond yields in the past month: the Italian 10 year went
from 1.26 on April 14th, to 1.91%, Portugal--April 14th 1.71, to 2.49%, Spain
April 14th 1.26, to 1.88%, France April 15th 0.35, to 0.99%, Germany April
16th 0.08, to 0.72%. And all this is causing the U.S. 10 Year Note to jump
from 1.87% on April 16th, to 2.31%.
For the past seven years, investors didn't have to worry about credit risk
because central banks were ready buyers regardless of a nation's insolvent
condition; as long as inflation was thought to remain quiescent. But here is
a news flash--investors won't own sovereign debt if real interest rates plunge
much further into negative territory. And neither will they accept negative
real and nominal yields on fixed income if they can instead own Precious Metals,
Commodities, Real Estate, or any other hard asset.
There is also a lack of liquidity in bond markets because central banks have
removed all the supply. Investors don't want to buy new debt with negligible
yields, but also don't want to sell if central banks are providing a perpetual
bid. Therefore, there is no trading outside of institutions front running the
central banks' purchases--again, as long as there is no inflation.
But here is the rub; once inflation becomes a problem central banks will then
become sellers instead of buyers of bonds and principal depreciation will quickly
erase the paltry yield away from investors.
And here is where it gets interesting: the Headline CPI is down 0.1% YOY in
March, but the core rate of CPI is up 1.8%--coming very close to triggering
the Fed's "return to normalization" target. A steep decline in the price of
oil that began in the summer of 2014 has dragged the overall CPI number down.
But gas prices have risen over 30% since the January lows. And the effect of
the energy price collapse on the headline number starts to diminish in July,
and is completely erased by the end of the year.
Therefore, very soon the Fed should be confronted with all the data points
it previously mapped out in order to start raising rates. But perhaps the central
bank should be careful about what it wishes for. This is because seven years
of interest rate suppression has created a powerful vacuum that could suck
higher long-term interest rates in accelerated fashion.
On The Other Hand
Despite years of QE and ZIRP, the economy is still scraping along the bottom.
If the Fed were to raise the cost of money above the one percent level, it
will bring this bubble-addicted economy to its knees, as it provides the pin
to the bubbles in real estate and equities. The growth rate in broad Money
Supply (M3) has been falling from 9% in 2013, to just 3% today. Therefore,
when short term interest rates rise it is also very likely that the yield curve
will invert and cause money supply growth to turn sharply negative; just as
it did during the Great Recession. This is precisely because the long-end of
the yield curve has been artificially suppressed for so many years. Longer-dated
maturities could discount even slower growth ahead, and the yield curve would
quickly invert from its already compressed starting point.
As previously explained, if I'm wrong about the yield curve flattening after
the Fed starts hiking rates, it will only be the result of the market losing
complete confidence in the US tax base to service Treasury debt and for global
central banks to keep inflation in check. This alternate scenario would occur
if the Fed decided to hike rates just once and then sat on its hands for a
long period of time. The Fed's prolonged "patience" in hiking rates further
would soon lead to that intractable rise in US long-term rates and result in
a complete disaster for markets and economies worldwide.
Either Way We're Sunk
Whether long-term interest rates rise or fall when the Fed begins its exit
is still in doubt--it all depends on the slope of Fed Funds rate. The yield
curve could quickly invert or rise intractably. However, the only sure outcome
is chaos on a global scale because central banks have never been able to extricate
the economy from the bubbles it created. Such is the inevitable result of the
massive and historic intervention of central banks into the sovereign debt
market. In other words, bubbles never pop with impunity and the international
bond bubble is certainly not going to be the exception. Therefore, no matter
what happens to interest rates in the future you can be sure of one thing...the
suffering will be immense.
