I started Pento Portfolio Strategies three years ago with the knowledge that
the unprecedented level of fiat credit creation had rendered the globe debt
disabled and would result in mass global sovereign default. As a consequence,
there would be wild swings between inflation and deflation dependent upon the
government provisions of fiscal stimulus, Quantitative Easing and Zero Interest
Rate Policies...
For much of the third quarter the US Federal Reserve has avowed to raise rates.
This in turn caused a sharp stock market correction on a worldwide basis. The
flattening of the Treasury yield curve and the strengthening of the US dollar
were the primary culprits. But then the September Non-Farm Payroll Report came
in with a net increase of just 142k jobs, which was well below Wall Street's
expectation. The unemployment rate held steady at 5.1% but the labor force
participation rate dropped to the October 1977 low of 62.4%. Average hourly
earnings fell 0.04% and the workweek slipped to 34.5 hours. There were also
significant downward revisions of 22k and 37k jobs for the July and August
reports respectively.
The jobs data had previously been heralded by the Fed and Wall Street as the
one bright spot in an otherwise dull economic picture; and gave the Fed extra
incentive to move off of zero -- as if offering free money to banks for seven
years wasn't compelling enough. But at least for now the weak data has caused
the Fed to step back from jumping of the cliff on raising rates, which has
caused a swift move lower in the value of the dollar and boosted the prospects
for multi-national corporate earnings.
The reasons why Wall Street is so enamored with ZIRP and QE are clear. Here
is a partial list of what will start to occur once the Fed moves away from
the zero-bound range:
-
Debt service payments will begin to rise on the soaring outstanding $44
trillion in total non-financial US debt -- $12 trillion of which was accumulated
in the last decade. This will render the already debt-disabled consumer
increasingly unable to borrow and spend.
-
The value of US high-yield (junk) debt outstanding has doubled since 2009.
Many companies have survived by rolling over this debt at record-low and
perpetually falling yields. Default rates will spike as Junk-bond prices
begin to fall and yields start to rise.
-
Rising rates will decrease the home ownership rate of 63.4%, which is
already at its lowest level since 1967. A rate rise will also cause home
prices to fall back toward the historic home price to income ratio of 2.6;
it is now 4.4.
-
The Mean reversion of interest rates on the $13.2 trillion of US publicly
traded debt would then take about 30% of all the Federal tax revenue. Rising
rates would also cause annual deficits to jump back to $1.5 trillion as
they did in the great recession, causing outstanding debt levels to rise
inexorably, thus eating up a much greater portion of tax revenue.
-
There is $9.6 trillion of US dollar denominated debt owned by non-US borrowers.
As the US dollar rises debt payments become more challenging to manage
and would cause rising defaults on marginal foreign corporate holders.
-
It will sharply attenuate the amount of stock buy backs, which were done
mostly by taking on new debt ($2.9 trillion worth since March of 2009)
for the purpose of artificially boosting EPS. This would cause EPS and
PE multiple contraction, sending the stock market into freefall.
-
The impaired credit of hundreds of trillions' worth of interest rate derivatives,
such as credit default swaps and interest rate swaps, which will need an
unprecedented bailout from the government once the counterparties become
insolvent.
-
Finally, pension plans will become bankrupt once the Fed succeeds in flattening
the yield curve and completely crashing the stock market and the economy.
Pension plans need 9% annual returns to fulfill their obligations. But
the stock market has gone nowhere in the past 14 months even though the
Fed has assured the country that there would be no competition for stocks
from the fixed income sector for the past 7 years. Rising rates would most
likely cause the stock market to lose half its value for the third time
in the last 15 years.
Those are the reasons why the Fed is so afraid to start hiking interest rates.
The highly accurate Atlanta Fed's GDP model is predicting Q3 growth of just
1.1%. As a consequence, the Fed Funds Futures Market now is predicting that
ZIRP will be in place until March of 2016. Will five more months of ZIRP be
enough to levitate stocks? The answer to that question is probably yes in the
short term; but it will lead to a catastrophe in the long term.
The simple truth is QE and ZIRP blow up asset prices to an unsustainable level,
but do nothing in the way of supporting viable economic growth. The proof of
this can best be found in Japan, where the Bank of Japan is printing 80 trillion
yen ($665 billion dollars) per annum but has rendered the nation in a perpetual
recession. Indeed, after three years of Abenomics the nation will probably
suffer through its third recession in as many years -- Q2 GDP came in at an
annualized minus 1.6%.
Further evidence of the ineffectiveness of central planning can be found in
the United States, where we have experienced sub-par 2% growth for the last
5 years despite unprecedented monetary easing. And 2015 is now on track to
underperform that low five-year bar.
The IMF recently lowered its global growth projection by 0.2 percentage points
to 3.1%. This includes an overly optimistic 6.8% read on China growth.
The Real Danger
The real danger is that the higher asset prices get pushed by central banks
and governments with fiscal and monetary stimuli, the more precariously they
become perched high on top of a hollow economic foundation.
With ZIRP in place for another five months, this ominous condition should
only worsen. However, it also means that whenever the Fed resumes its bluster
about raising rates, the markets will careen lower from an even higher level.
In addition, central banks' inability to engender the promised prosperity is
rapidly eroding confidence in these institutions. Therefore, there is a growing
risk that the markets will collapse despite perpetually free money -- especially
in real terms. Such will be the unfortunate but inevitable consequences of
obliterating honest money and free markets.
