The reactions of the stock and bond markets to the mere mention of a slower rate of money printing shows how those markets have become hooked on such injections.
The consequences of the first baby-step change of policy toward something more normal evoked violent market reactions not only in the U.S. but worldwide.
Those reactions may quash the nascent private sector recovery, will certainly risk short-term negative effects of a stronger dollar on imports and exports, will likely have negative consequences on housing values and sales, and will exacerbate the long-term issues of the size and cost of the debt.
While the Fed didn’t actually take any steps at all with regard to a reduction in money printing, the markets reacted just to the fact that they were thinking about such action.
The wealth effect
The “wealth effect” has been studied for decades with the universal conclusion that its overall economic impact is marginal, i.e., the wealthy simply have a low marginal propensity to consume.
The benefit of higher stock prices (the rich get richer) appears to be the only benefit of the massive quantitative easing programs. As documented by two revered market pundits, Rosenberg and Gundlach, QE has a near-90 percent correlation with the equity markets.
In recent weeks, we saw the violent reactions in both equity and fixed-income markets to the mere concept of “tapering,” which is not tightening, but simply less easing (a change in the second derivative). Clearly, just the thought of lesser ease has begun to reverse the small success that massive QE has had. Since May 22, when Federal Reserve Chairman Ben Bernanke announced that the Fed was thinking about “tapering,” the S&P 500 fell nearly 6 percent as of June 24 and daily volatility spiked, a sign of high uncertainty.
One bright spot in the U.S. has been a recovery in home prices. While suspect because of a lack of first-time buyers, the run-up of 71 basis points, or .71 percentage points, in the 30-year fixed mortgage rate is sure to have an impact on home values.
Those who could afford the $1,144 monthly payment for a $250,000 home in May can now only offer $229,000 for the same property to maintain the same payment. That’s an 8.4 percent reduction in affordability and is sure to negatively impact the sector.
Deflation is a worldwide issue even among emerging industrial powers like the BRICS. China’s economy, which has been the world’s economic growth engine for the past half-decade, appears to be slowing significantly despite its official purported 7.5 percent growth rate.
The government’s attempt to control real estate speculation has resulted in a credit crunch in the banking system which is likely to have a negative impact on China’s lending growth.
Marc Faber, author of the “Gloom, Boom and Doom Report” newsletter, opined on Bloomberg TV on June 21 that China’s growth rate was, at a maximum, 4 percent. That is just a little more than half of official estimates and, if true, is a shock to the world’s economy.
The underlying data tell the story, including depressed raw commodity prices, excess high seas shipping capacity, the value of the currencies of commodity producing countries like Australia and a falloff in exports from lower-cost producers like South Korea. The Asian equity exchanges have been pounded hard this year, a sign that economies in that part of the world are struggling.
The rising cost of U.S. debt, much of which is financed by foreigners, makes even a small move toward normal monetary policy highly risky for U.S. fiscal policy.
The U.S. public is unaware that the true deficit, using Generally Accepted Accounting Principles, which all of corporate America is required to use, has exceeded $5 trillion for the past five years.
Instead, the $1 trillion cash flow budget deficit is viewed as the issue. Nevertheless, as time passes the already built-in additional $4 trillion per year of promises will become current obligations.
I have seen several estimates of the cost of that future debt in rising interest rate scenarios. None is pretty. The most recent from Jeffrey Gundlach of Doubleline estimated the cost of the debt and deficit at $2.5 trillion by 2017 if the 10-year rate were to rise gradually from a 2.1 percent level (the level when he calculated the estimate) to 6.0 percent. As of this writing, the 10-year rate is near 2.6 percent.
By then, Gundlach says, the debt itself will be $26 trillion. Such deficits and debt levels risk not only inflation, but the dollar’s role as the world’s reserve currency.
The consequences of rising U.S. interest rates could be dire.
Within the U.S., home values are likely to stop rising and could easily begin falling again. Stock prices have become more volatile and bond prices have been hard hit. The rise in consumer confidence, largely due to home and stock values, could reverse, impacting consumer spending and employment. Rising interest rates in the U.S. will exacerbate worldwide deflation and could have dire consequences for U.S. fiscal policy.
The size and rapidity of the rate rise was probably a surprise to the Fed. I suspect that if the summer’s economic data shows softness in the economy, the Fed will jawbone rates to lower levels.
Nonetheless, this episode has revealed the truly difficult road ahead for the Fed, as one of the unintended consequences of the Fed’s massive experiment in money printing is the equity market’s addiction to it.