It is amazing so many investors are oblivious to the fact that the developed
world is completely addicted to artificially-produced low interest rates.
Perhaps that is why there is still a debate over whether the ending of QE
will adversely affect the economy, and if rising rates can occur within the
context of a healthy economy.
It isn't so much about whether or not QE is about to end, or even if growth
is now causing interest rates to become unglued. The truth is the end of QE
and the normalization of interest rates -- for whatever reason--means it will
be the end of this anemic and unsustainable recovery in both Japan and the
U. S. economies. This is because you cannot separate the central banks' influence
on markets from their affect on economies. The BOJ and Fed have dramatically
supported equity and real estate prices by taking interest rates to record
lows. Therefore, it is simply illogical to then assume that rates can increase
without negative ramifications.
The nascent and fragile recovery in Japan has been predicated on vastly lowering
the Yen's value and by inflating asset prices. Likewise, our economic stabilization
has been accomplished through the Fed's dilution of the dollar. The Fed has
monetized trillions of dollars in deficits and helped send the S&P 500
up 140% in five years. One should not credit corporate earnings for the rebound
in equity prices and then ignore the fact that better profits have been realized
as a result of our central bank's ability to re-inflate the consumption bubble.
And, most importantly, record-low interest rates have provided consumers and
government with massive debt service relief. Without the aid of rising real
estate and equity values (brought about by central bank debt monetization),
along with drastically reduced debt payments, the consumer and the economy
would be in full deleverage mode.
Rising interest rates have now become the lynchpin in the Japanese and U.S.
economies. Japan's national debt to GDP was "just" 170% in 2008. Today it
has climbed all the way up to 230% of the economy. In the U.S., the publicly
traded debt jumped by $7 trillion since the start of the Great Recession.
Our total debt hit a record $49 trillion (353% of GDP) at the end of 2007
-- which precipitated a total economic collapse. But by the start of 2013,
total U.S. debt increased to $54 trillion, which was still 350% of our GDP.
It is clear, once that interest rate "pin" is pulled, the entire house of
cards will collapse.
Evidence of this interest rate addiction is very easy to find. Just this week
the U.S. 10-Year Note yield spiked to 2.16%, which eclipsed the dividend yield
on the S&P 500 and reached a 13-month high. Stock prices didn't like it
at all and the S&P 500 dropped as low as 2% on Wednesday the 29th, before
rebounding slightly after a speech was given by Federal Reserve Bank of Boston
President Eric Rosengren. He indicated in his prepared remarks that the Fed
should continue with record stimulus to engender stronger growth, reduce unemployment
and boost inflation. His promise of continued interest rate manipulation calmed
bond yields back down to 2.12%.
The same is true for Japan. Their 10-Year Note jumped from 0.6% on May 9th,
to near 1% in a matter of days, which sent the Nikkei Dow down over 1,100
points on May 23rd.
Central banks have created the illusion of growth that is based upon re-inflating
asset prices. And, it is also predicated on their ability to suppress interest
rates.
However, record debt levels and central bank inflation targets are a deadly
combination. Once those inflation targets are achieved, the bond vigilantes
will have the central banks in checkmate. The Fed and BOJ will then have to
choose whether they want to aggressively raise interest rate; by not only
ceasing bond purchases but also unwinding their massive balance sheets in
order to fight inflation. Or, they can sit idly by and gradually let their
balance sheets run off; while watching inflation -- the bane of the bond market
-- send bond prices plunging and yields soaring. In either case it will mean
the end of the over thirty-year bull market in bonds. And it will finally
prove beyond a doubt that the combination of interest rate manipulations,
massive levels of debt and betting the economy's future growth on creating
ever-increasing inflation is nothing short of a miserable mistake.
