Something Doesn't Jive In This!

This doesn't make sense! If the economy is doing so well, why would central bankers need to artificially boost the markets and asset prices to bubble levels by more quantitative easing?

Fed Leaves Interest Rates Unchanged, Market Sighs

The Fed's Open Market Committee today left rates unchanged and indicated that it has no plans to change interest rates through the end of this year. However, by dropping the word "patient" from its statement, it hinted that it is more open to cutting rates.

Bond Market Flashes SIgns of Trouble Ahead

Interest rates are collapsing in the bond market, which is a sign that investors are very worried.

Look out belooooow!
“Recent data points suggest US earnings and economic risk is greater than most investors may think,” says Chief Equity Strategist Michael Wilson of Morgan Stanley.

Bullish Bonds Spell Worry

Bonds don't rise this sharply, and interest rates plunge similarly, unless there are concerns in the financial markets. Note the last candle at the far right. That sharp buying binge for bonds is indicative of grave worry in the financial markets because investors are running for cover by buying bonds, which they consider to be the safest investment available.

Do These Headlines Look Like a Healthy Economy to You?

Following a relentless barrage of recessionary industrial and manufacturing data, moments ago the Business Roundtable released its latest, fourth quarter 2015 CEO Economic Outlook Survey, and it is an absolute disaster.
According to the report, for the third quarter in a row, CEOs expressed growing caution about the U.S. economy’s near-term prospects and indicated they are moderating their plans for capital investment over the next six months, according to the Business Roundtable fourth quarter 2015 CEO Economic Outlook Survey, released today.

 ISM Manufacturing, a key manufacturing economic index has now fallen below 50 for the first time since Nov 2012, crashing to 48.6! This is the weakest since June 2009.

Today was the weakest PMI report since October 2013 (as ISM Manufacturing also dropped to its lowest since Dec 2012).

 

The chart above is the percent of stocks in the Gavekal Capital International DM Americas Index that are at least 10% off of their 200-day high. A stunning 55% of DM Americas stocks are at least 10% from their 200-day high while the DM Americas Index is hovering just below its all time high. That's startlingly concerning! 

Canadian GDP plunged 0.5% - its largest Month-over-Month drop since March 2009 and the biggest miss of expectations since Dec 2008. Good thing stocks are up 100 today, or we might have thought the economy was weakening!

Eurodollar Futures Rocket Higher on ECB Rate Hike Likelihood

HONG KONG, April 4 (Reuters) - Eurodollar futures contracts expiring in March 2012 are forecasting a half point increase in U.S. interest rates, helped by increasing evidence that the economy is gaining momentum.
A widely expected rate increase by the European Central Bank on Thursday could also add pressure on the Federal Reserve to begin reversing its super-loose monetary policy.
Such an increase would be the ECB's first rate hike since October 2008 and widen interest rate differentials further between the U.S and Europe.
A surge in eurodollar futures in early March fuelled by expectations that the earthquake in Japan would stay the Fed's hand in tightening policy has taken a sharp U-turn in the past two weeks due to hawkish comments from some Fed officials.
While the disaster could push the Japanese economy back into recession for a few quarters, analysts now do not expect it to have a major impact on global economic growth.
Barclays strategists said the March employment report, which showed the U.S. jobless rate slipping to 8.8 percent, signaled a continuation of the trend towards solid business expansion, notwithstanding risks such as the Middle East unrest and rising commodity prices.
Even though the shift in rate expectations has led to some heavy profit-taking in the eurodollar and fed fund futures markets, a majority of analysts in a Reuters poll do not expect a rate hike in 2011. 
"The message here is that we do not believe the softness in the first quarter data should be interpreted as the start of a significant slowdown," they said.
Underlining that optimistic view, hawkish comments from some Fed officials hurt the market last week with two-year Treasuries , seen as among the most vulnerable to interest rate risk, underperforming longer-dated debt including 10-year notes.
Two-year notes briefly tested support at yields of around 0.89 percent on Friday, their highest levels since last May before subsiding to around 0.80 percent on Monday.
The gap between two-year and 10-year note yields has narrrowed to around 266 basis points from 283 bps on March 8.
Players in the fed fund futures markets are expecting about 40 bps of increase in U.S rates by March 2012.
Rate markets are also eyeing a speech by Fed chief Ben Bernanke later in the day where he might temper some of the recent hawkish comments by other Fed officials. (Editing by Kim Coghill)

What Happens When We Revert to the Interest Rate Mean?

When discussing central planning, as manifested by the policies of the world's central banks, a recurring theme is the upcoming reversion to the mean: whether in economic data, in financial statistics, or, as Dylan Grice points out in his latest piece, in luck. While the mandate of every institution, whose existence depends on the perpetuation of the status quo, is to extend the amplitude of all such deviations from the trendline median, there is only so much that hope, myth and endless paper dilution can achieve. And alas for the US, whose 3.5% bond yields are, according to Grice, primarily due to "150% luck", the mean reversion is about to come crashing down with a vengeance after 30 years of rubber band stretching. The primary reason is that while the official percentage of interest expenditures as a portion of total government revenues is roughly 10% based on official propaganda data, the real number, factoring in gross interest expense, and assuming a reversion to the historic average debt yield of 5.8%, means that right now, the US government is already spending 30% of its revenues on gross interest payments! And what is worse, is that the chart has entered the parabolic phase. Once the convergence of theoretical and real rates happens, and all those who wonder who will buy US debt get their answer (which will happen once the 10 Year is trading at 6% or more), the inevitability of the US transition into the next phase of the "Weimar" experiment will become all too obvious. Because once the abovementioned percentage hits 50%, it is game over.
Below Grice lays out the framework for the disinflation delusion that has permeated the minds of all economists to the point where divergence from the mean is now taken as gospel:

What drove the disinflation of the last thirty years? Politicians would say it was because they granted their central banks independence. But the pioneering experiment here didn’t take place until ten years into the disinflation, when the Reserve Bank of New Zealand Act 1989 gave that central bank the sole mandate to pursue price stability. Macroeconomists would site breakthroughs in our understanding. Except there haven’t been any. Today’s hard money/soft money debate is identical to the Monetarist/Keynesian debate of the 1970s, the US bimetallism agitation of the late 19th century, and the Currency vs Banking School controversy in the UK during the 1840s.

Was it the de-unionisation of the workforce? The quiescence of oil markets since the two extreme shocks of the 70s? The dumping of cheap labour from Eastern Europe, China and India onto the global labour market? Technology enhanced productivity growth? Or maybe it was just because the CPI numbers are so heavily manipulated?

Maybe it was all of these things. Maybe it was none of these things … for the little that it’s worth, my theory is that no-one has an adequate theory, other than it being down to the usual combination of luck and judgment on the part of policymakers … or about 150% luck. The problem is luck mean-reverts. The mammoth fiscal challenges (see chart below) currently being shirked by the US political class suggest that mean-reversion is imminent.

Ireland is probably the best example of an entity for which the cognitive dissonance between an imaginary desired universe and a violent snapback to reality has finally manifested itself after a 30 year absence:

Ireland provides a good illustration. Today it’s going through a real and wrenching depression - there is no other word for it and it is heartbreaking to watch – partly because the terms of its bailout are so onerous. And what may well be the seeds of a future popular backlash against the euro can be detected in the election of Fine Gael on a ticket of renegotiating the bailout terms, which currently require them to pay a 5.8% rate of interest.

Unlike Ireland, the US still has the luxury of being able to stick its head deep in the sand of denial.

Look at the following chart showing two hundred years or so of US government borrowing costs. Two hundred years is a lengthy period of time. There have been economic booms and financial panics, localized wars and world wars, empires have risen and empires have fallen, technological change has made each successive generation’s world unrecognizable from that which preceded it. Yet government yields have remained broadly mean-reverting (and the US has been one of the best run economies over that time – other governments’ bond yields demonstrate an unpleasant historic skew towards large numbers). Coincidentally enough, the average rate of interest over that period has been around 5.8%, the rate which the new Irish government today says is ‘crippling.’

And here is the math that nobody in D.C. will ever dare touch with a ten foot pole as it will confirm beyond a reasonable doubt that the US is now well on its way to monetizing its future (read: not winning)

In other words, Ireland is so indebted that it is struggling to pay a rate of interest posterity would barely yawn at. But Ireland isn’t the only one.Take the US government, for example, which currently pays around 10% of its revenues on interest payments. This doesn’t sound too bad. The problem is that those federal government interest payments are calculated net of the coupons paid into federally run programs (e.g. social security) as these are deemed ‘intragovernment transfers.’ Yet those coupons to social security are made to fund a real obligation to American citizens and as such, represent payments on a real liability. On a gross basis the US government pays out 15% of its revenues on interest payments, which makes for less comfortable reading. So the net numbers remain the most widely quoted.

And where the figure gets downright ugly is if one assumes that in order to find buyers for the $4 trillion in debt over the next two years (once the Fed supposedly is out of the picture after June 30), rates revert to the mean. Which they will. What happens next is a cointoss on whether or not we enter a Weimar-style debt crunch.

Suppose the US government had to pay the 5.8% yield it has paid on average over the last two hundred years? The share of revenues spent on gross interest payments would be a staggering 30% (see chart above). If it had  to pay the 6.9% it’s paid on average since WW2, those gross interest payments would account for 37% of revenues. So it’s not difficult to see the potential for a dangerously self-reinforcing spiral of higher yields straining public finances, hurting confidence in the US governments’ ability to repay without inflating, leading to higher yields, etc.

Lastly, Grice makes it all too clear why we are now all screwed, and no matter how many Bernanke dog and pony shows we have, the final outcome is not a matter of if but when.

America’s political class might arrest the trend which threatens their government’s solvency (chart below). They might find a palatable solution to the healthcare system’s chronic underfunding. They might defy Churchill’s quip, and skip straight to doing the right thing. But if they don’t, such a spiral becomes a question of when and not if. And what would the Fed do then? Bernanke says the Fed “will not allow inflation to get above low and stable levels.” He says it has learned the lessons of the 1970s. He’s read the books. He can recite the theory. Yet a lifetime reading books about the Great Depression (and writing a few) didn’t help him spot the greatest credit inflation since that catastrophe any more than reading “The Ten Habits of Highly Successful People” would make him successful. It’s the doing that counts. So before lending to the US government for 3.5% over ten years, bear in mind that when it comes to a real inflation fight, not one of the Fed economists you’re betting on has ever been in one.

Our advice to the good doctor and his minions (not to mention all readers), is instead of reading multitudes of history books on the depression, on Japan, or on midget tossing (for those from the SEC), is to read one book. Just one. Link here.

Geithner Admits Interest Costs to Surge

from Bloomberg:
Barack Obama may lose the advantage of low borrowing costs as the U.S. Treasury Department says what it pays to service the national debt is poised to triple amid record budget deficits.
Interest expense will rise to 3.1 percent of gross domestic product by 2016, from 1.3 percent in 2010 with the government forecast to run cumulative deficits of more than $4 trillion through the end of 2015, according to page 23 of a 24-page presentation made to a 13-member committee of bond dealers and investors that meet quarterly with Treasury officials.
While some of the lowest borrowing costs on record have helped the economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expense will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the Obama administration’s adjusted 2011 budget.
“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion in assets. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”
The amount of marketable U.S. government debt outstanding has risen to $8.96 trillion from $5.8 trillion at the end of 2008, according to the Treasury Department. Debt-service costs will climb to 82 percent of the $757 billion shortfall projected for 2016 from about 12 percent in last year’s deficit, according to the budget projections.

Budget Proposal

That compares with 69 percent for Portugal, whose bonds have plummeted on speculation it may need to be bailed out by the European Union and International Monetary Fund.
Forecasts of higher interest expenses raises the pressure on Obama to plan for trimming the deficit. The President, who has called for a five-year freeze on discretionary spending other than national security, is scheduled to release his proposed fiscal 2012 budget today as his administration and Congress negotiate boosting the $14.3 trillion debt ceiling.
“If government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe,” Federal Reserve Chairman Ben S. Bernanke told the House Budget Committee Feb. 9. “Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living.”

Yield Forecasts

Treasuries lost 2.67 percent last quarter, even after reinvested interest, and are down 1.54 percent this year, Bank of America Merrill Lynch index data show. Yields rose last week to an average of 2.19 percent for all maturities from 2010’s low of 1.30 percent on Nov. 4.
The yield on benchmark 10-year Treasury note will climb to 4.25 by the end of the second quarter of 2012, from 3.63 percent last week, according to the median estimate of 51 economists and strategists surveyed by Bloomberg News. The rate was 3.64 percent as of 2:08 p.m. today in Tokyo. The economy will grow 3.2 percent in 2011, the fastest pace since 2004, according to another poll.
“People are starting to come to the conclusion that you’ve got a self-sustaining recovery going on here,” said Thomas Girard who helps manage $133 billion in fixed income at New York Life Investment Management in New York. “When interest rates start to go back up because of the normal business cycle, debt service costs have the potential to just skyrocket. Every day that we don’t address this in a meaningful way it gets more and more dangerous.”

‘Kind of Disruption’

While yields on the benchmark 10-year note are up, they remain below the average of 4.14 percent over the past decade as Europe’s debt crisis bolsters investor demand for safer assets, Bank of America Merrill Lynch index data show.
“The market is still giving the U.S. government the benefit of the doubt,” said Eric Pellicciaro, New York-based head of global rates investments at BlackRock Inc., which manages about $3.56 trillion in assets. “What we’re concerned with is whether the budget will only be corrected after the market has tested them. Will we need some kind of disruption within the bond market before they’ll actually do anything.”
Still, U.S. spending on debt service accounts for 1.7 percent of its GDP compared with 2.5 percent for Germany, 2.6 percent for the United Kingdom and a median of 1.2 percent for AAA rated sovereign issuers, according to a study by Standard & Poor’s published Dec. 24. Among AA rated nations, China’s ratio is 0.4 percent, while Japan’s is 2.9 percent, and for BBB rated countries, Mexico devotes 1.7 percent of its output to debt service and Brazil 5.2 percent, the report shows.

Auction Demand

Demand for Treasuries remains close to record levels at government debt auctions. Investors bid $3.04 for each dollar of bonds sold in the government’s $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg. Indirect bidders, a group that includes foreign central banks, bought a record 71 percent, or $17 billion of the $24 billion in 10-year notes offered on Feb. 9.
Foreign holdings of Treasuries have increased 18 percent to $4.35 trillion through November. China, the largest overseas holder, has increased its stake by 0.1 percent to $895.6 billion, and Japan, the second largest, boosted its by 14.6 percent to $877.2 billion.

‘Killing Itself’

“China cannot dump Treasuries without killing itself,” said Michael Cheah, who oversees $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “They’re holding Treasuries as a means to an end,” said Cheah, who worked at the Singapore Monetary Authority from 1982 through 1999, and now teaches finance classes at New York University and at Chinese universities. “It’s part of what’s needed to promote exports.”
At least some of the increase in interest expense is related to an effort by the Treasury to extend the average maturity of its debt when rates are relatively low by selling more long-term bonds, which have higher yields than short-term notes. The average life of the U.S. debt is 59 months, up from 49.4 months in March 2009. That was the lowest since 1984.
The U.S. produced four budget surpluses from 1998 through 2001, the first since 1969, as the expanding economy, declining rates and a boom in stock prices combined to swell tax receipts.
Tax cuts in 2001 and 2003, the strain of the Sept. 11 terror attacks, the cost of funding wars in Afghanistan and Iraq, the collapse in home prices and the subsequent recession and financial crisis has led to the three largest deficits in dollar terms on record, totaling $3.17 trillion the past three years.

‘Demonstrates Confidence’

The U.S. needs to manage its spending decisions “in a way that demonstrates confidence to investors so we can bring down our long-term fiscal deficits, because if we don’t do that, it’s going to hurt future growth,” Treasury Secretary Timothy F. Geithner said in Washington on Feb. 9.
The Treasury Borrowing Advisory Committee, which includes representatives from firms ranging from Goldman Sachs Group Inc. to Soros Fund Management LLC, expressed concern in the Feb. 1 report that the U.S. is exposing itself to the risk that demand erodes unless it cultivates more domestic demand.
“A more diversified debt holder base would prepare the Treasury for a potential decline in foreign participation,” the report said.
Foreign investors held 49.7 percent of the $8.75 trillion of public Treasury debt outstanding as of November, down from as high as 55.7 percent in April 2008 after the collapse of Bear Stearns Cos., according to Treasury data.

Potential Demand

The committee projects there may be $2.4 trillion in latent demand for Treasuries from banks, insurance companies and pension funds as well as individual investors. New securities with maturities as long as 100 years, as well as callable Treasuries or bonds whose principal is linked to the growth of the economy might entice potential lenders, the report said.
“They are opening up a can of worms with the idea of all these other instruments,” said Tom di Galoma, head of U.S. rates trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. “They should try to keep the Treasury issuance as simple as possible. The more issuance you have in particular issue, the more people will trade them -- whether it be domestic or foreign investors.”
White House Budget Director Jacob Lew said the Obama administration’s 2012 budget would save $1.1 trillion over the next 10 years by cutting programs to rein in a deficit that may reach a record $1.5 trillion this year.
“We have to start living within our means,” Lew said yesterday on CNN’s “State of the Union” program.
Still, about $4.5 trillion, or 63 percent of the $7.2 trillion in public Treasury coupon debt, needs to be refinanced by 2016. That gives the government a narrowing window as growing interest expense will curtail its ability to spend.
“There is roll-over risk,” said James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, one of 20 primary dealers that trade with the Fed. “It’s a vicious cycle.”

John Hussman: Fed Risks Inflation that Could Double Prices

The famous quote attributed to John Maynard Keynes - "the market can remain irrational longer than you can remain solvent" - is a favorite of speculators here. Actually, I very much agree with this observation, provided that it is correctly understood. Solvency is always a function of debt, and it's extremely important for investors to recognize that when you take investment positions by borrowing on margin, you'd better use stop-losses, because the debt obligation stays intact even if the investment values decline.

On the other hand, we certainly don't believe that this aphorism amounts to a recommendation that it is required (or even advisable) for investors to accept speculative risks just because prices are advancing, particularly at the point where overvalued, overbought, overbullish conditions are joined by rising interest rates, as they are at present.

In my view, the more appropriate quote for the present environment is from Benjamin Graham: "Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss."

Ironically, while the "irrational longer than you can remain solvent" quote is embraced by speculators as a license to take risk, they may not recognize that whatever lesson might be learned from Keynes has nothing to do with his views about "irrational" market advances. Rather, Keynes' learned his lesson as a result of steep losses that resulted from holding a poorly diversified portfolio - apparently on margin - during a market plunge, years after the Depression trough of 1932. As biographer Robert Skidelski observes, "In the year of the 'terrific decline' which had started in the spring of 1937, he lost nearly two-thirds of his money."

Let's briefly walk through the 1930's, to examine the context in which Keynes was operating. As I've noted in prior commentaries, the U.S. stock market at its 1929 peak was priced to achieve slightly negative total returns over the following decade (based on estimates using our standard methodology). Once the market had lost half of its value, the prospective 10-year total return reached 10% annually. From there, however, the market would lose another two-thirds of its value to its ultimate trough in 1932. All told, the market lost more than 80% from the 1929 peak to the 1932 low (which is what you get when a 50% loss is compounded with a 67% loss).

By 1937, the favorable valuations that existed at the 1932 trough were long gone. Stocks were overbought and overvalued, and interest rates were rising. The Dow moved above 194 at the beginning of March 1937, when in a conversation with Felix Somary ("the Raven of Zurich"), Keynes said "We will not have any more crashes in our time." Over the following year, the market lost about half its value, with the Dow reaching its trough near the 100 level. Based on our standard methodology for estimating prospective 10-year total returns on the S&P 500, a reasonable projection at the March 1937 market peak was only about 6% annually. The Shiller P/E was over 23 (meanwhile, long-term Treasury yields were at 2.84% and trending higher). By March 1938, the plunge in the market was enough to increase the projected 10-year total return of the S&P 500 to over 14% annually.

Judging from Keynes' confident assertion in 1937 that major market losses could be ruled out in the future, we might infer that the sentiment of investors at the time was probably overbullish, as well as being overvalued, overbought and coupled with rising yields. Needless to say, from our perspective, Keynes walked right into the 1937-1938 plunge.

That said, by early 1938, the market troughed, and with prospective long-term market returns now significantly higher, the market would gain nearly 50% in the next 8 months before stumbling again, experiencing a series of 20-30% gains and losses - though with little durable progress - for nearly a decade. One could have performed quite well over the full period by recognizing that while prospective returns may be very attractive at market troughs, they are no longer attractive - and sometimes abysmal - once a substantial advance has occurred.

Fast forward to the present, and the lessons that we should keep in mind here. First, it matters critically to long-term investors whether stocks are priced to achieve strong or weak long-term prospective returns. Moreover, regardless of what segment of historical data one examines, there is enormous risk in market conditions that feature overvalued, overbought, overbullish conditions coupled with rising interest rates. It is crucial to understand that the valuations we observe today are nothing like the valuations of early 2009. At the trough, our estimates of 10-year prospective returns exceeded 10% annually (though our concern at the time was that we could not rule out the sort of sustained follow-through we've seen in other crises). At present, we estimate that the 10-year prospective total return for the S&P 500 is just 3.2% annually. The Shiller P/E is currently about 24.

Risk premiums are no longer wide - they are dangerously compressed. Bullishness is excessive. Interest rates are rising. While the conditions we observed in early 2009 had mixed implications depending on whether one considered U.S. post-war data or data from other periods of credit crisis, the implications of the present set of conditions is unequivocal regardless of which data set one chooses.

If we can clear out any component of this syndrome - most likely the overbought or overbullish components - without a substantial deterioration in market internals, there will be enough ambiguity in market conditions that we can expect to accept at least a moderate exposure to market fluctuations. The ensemble methods that we've implemented in recent months have expanded the range of Market Climates we identify, so shareholders can expect to see more variation in the market exposure we accept than we've had in recent years. But without clearing some component of the present, hostile syndrome, we are simply in a set of conditions that has rarely worked out well in any subset of the data we consider - even during "uptrends" from a technical standpoint, even during "seasonally favorable" conditions, and even in periods when the Federal Reserve was easing monetary policy conditions.

Undoubtedly, the "unpleasant skew" that we've observed in recent months has been a challenge, as has the equally skewed performance of individual stocks toward cyclicals, commodity stocks, speculative small-caps, and highly-indebted, inconsistent businesses that we typically avoid as "low quality." Given how extended some of these speculative trends have become, and the hostile nature of the present set of market conditions, I certainly expect this to be resolved, but there's no assurance that we'll observe that resolution over the short-term.

From its all-time high in 2008, the Strategic Growth Fund is down about 16%, with about 12% of that decline occurring since mid-2010 in response to the simultaneous speculation in 'risk assets' and punishment of 'stable assets' that was triggered by QE2 (which I continue to view as the Emperor's Clothes). That's certainly a tough loss for us, which is saying something in a market that has lost more than 50% on two separate occasions in the past decade alone. Having broadened the set of Market Climates we define, and having introduced robust methods to allow us to combine the implications of multiple data sets in a satisfactory way, I'm comfortable that our long-term strategy is well suited to a far wider range of market environments than even we anticipated in 2008.

It's imperative to learn the right lessons from market. While simple aphorisms such as "don't fight the tape" and "don't fight the Fed" are appealing, their performance can be tested historically and their shortcomings can easily be evaluated. The lessons of recent years emphatically do not include the notion that trends should be blindly followed, or that an "easy" Fed can be trusted to defend the market against losses in a speculative environment. In our view, good lessons can be demonstrated to be valid in historical data, and good research improves the expected long-term performance of a strategy without substantially increasing the depth of its periodic losses. This remains our focus, and is the basis of the confidence we have in our investment discipline.

On the subject of the long-run (which we generally define as at least one complete market cycle measured from peak-to-peak or trough-to-trough), another favorite quote of speculators here is Keynes' remark that "The long-run is a misleading guide to current affairs. In the long run we are all dead." Once again, this quote is taken far out of context. Keynes was speaking about monetary reform, arguing that government intervention was necessary to control inflation, and that economists could not simply comfort themselves that the price distortions and misallocations resulting from inflation would be eliminated over time. With respect to investing, Keynes' views about the long-run could not be clearer: "I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself... An investor should be aiming primarily at long-period results."

Personally, I prefer self-reproach and self-criticism to a lack of reflection, but I also believe that abandoning long-term discipline in order to "fix" short-term returns is a mistake more often than not. We're excited to implement new research when we're convinced it will improve our process, but otherwise, we focus on adhering to our long-term investment discipline even in the face of short-term setbacks. I've always had a straightforward investment philosophy - find a set of actions that you believe will produce results if you follow them consistently, and then follow them consistently. We continue to approach each day with that objective.

QE jumps the shark

On Monday, Wall Street let out a collective squeal of excitement as Thomas Hoenig, the president of the Kansas City Federal Reserve said that QE3 "may get discussed" if economic progress turns out to be disappointing as the year progresses. Part of the subtext that was lost in this enthusiasm is that Hoenig has consistently dissented on the policy of quantitative easing, and has called for the Fed to immediately raise interest rates to 1% and possibly higher. In saying that QE3 may get discussed, he wasn't offering hope to Wall Street, but was instead criticizing the existing policy of the Fed. The way to understand the comment is to put it in the context of Hoenig's long-standing dissent and open criticism of quantitative easing. My guess is that his complete remark was something like "The current trajectory of Fed policy is dangerous. When will it stop? Who knows? Aside from fueling speculation and inflation risk, QE2 won't help the real economy, but if the numbers are disappointing, even more reckless policies like QE3 may get discussed." Last week, Hoenig warned of another boom-and-bust cycle, and repeated his call for the Fed to reverse course, saying "I hope I'm wrong. I hope they're right. But I don't think so."

Near the end of the old TV series Happy Days, as the writers became desperate for material, there was an episode where Fonzie jumped his waterskis over a shark. That episode was widely viewed as the point where the show had simply gone on too long. My impression is that the sudden hope for QE3 is Wall Street's version of jumping the shark.

Look, if the Fed successfully completes its current program of quantitative easing, individuals, banks and other parties in the U.S. economy will have to collectively hold 16 cents of base money (currency and bank reserves) for every dollar of nominal GDP. The willingness to hold base money is a tight function of the level of interest rates - since base money doesn't bear interest, high levels of base money (relative to nominal GDP) must be accompanied by low short-term interest rates, otherwise the yield competition reduces the willingness to hold the paper money and you get inflationary pressures. In order for the economy to choke down 16 cents of base money per dollar of GDP, short-term yields have to be held extremely close to zero, and the prospective returns on other far less perfect substitutes (such as stocks) also have to be suppressed. At that point - which is about where we are already - upward pressure on any competing yield, short-term or otherwise, will produce inflationary pressure unless the Fed responds by quickly contracting the monetary base to compensate.

If you examine the historical data (see Sixteen Cents - Pushing the Unstable Limits of Monetary Policy ), it's clear that the U.S. economy has never been willing to carry more than 9-10 cents of base money per dollar of nominal GDP, except when Treasury bill yields have been well below 2%. By the time the Fed completes QE2, the U.S. monetary base will be about $2.4 trillion, versus nominal GDP of about $14.9 trillion.

It's fairly straightforward to estimate (see the Sixteen Cents article for more formal calculations) that in order to accommodate short-term interest rates even in the 1-2% range without inflationary pressure, we would presently require the monetary base to contract to $1.4 trillion - still far higher than the pre-1998 norm of $800 billion, but $1 trillion less than what will be outstanding once QE2 is completed.

Carnegie Mellon economist Allan Meltzer, who is a well-respected monetary economist and former chair of the "Shadow Open Market Committee", wrote a piece last week in the Wall Street Journal ( Ben Bernanke's 70's Show ), which argued for an immediate increase in short-rates to about 1%. Meltzer noted "Current slow growth and high unemployment is not a monetary problem. The financial system has more than ample liquidity... perhaps most importantly, we need a new Fed policy to prevent 1970's-style inflation. Inflation is coming. Now is the time to head it off."

In my view, Meltzer is right, but I would qualify the timing of inflation pressures by carefully monitoring the level of short-term interest rates relative to the outstanding monetary base. If the Fed indeed completes QE2 and pushes the monetary base to $2.4 trillion, we'd better see the 3-month Treasury yield at roughly 0.05%. Even a yield of 0.25% would be incompatible with that level of monetary base, and would place upward pressure on inflation. Worse, any exogenous pressure (loan demand, reduction of default concerns, etc) pressuring short-term yields to even 1% without a corresponding contraction in the monetary base would generate near term upward pressure on the GDP deflator of about 20%, and a longer-run inflationary pressure of close to 90% - that is, a near doubling in the level of U.S. prices. Frankly, I doubt that we'll observe that, but that's another way of saying that the Fed is likely to be forced into a very hard reversal of its present course unless economic conditions stay weak enough, and credit fears remain strong enough, to hold short-term interest rates at roughly zero.

Fed's Money Creation to Have Terrible Consequences

This printing money is going to lead to huge trouble. It’s going to lead to higher interest rates. It’s going to lead to more inflation and at some point there is going to be a train wreck in the currency and the bond market." Market commentator and money manager Bill Fleckenstein

Yield Curve Debate

fantastic from Zero Hedge:

Rich Bernstein who while at BofA used to be one of the few (mostly) objective voices, today got into a heated discussion with Rick Santelli over yield curves and what they portend. In a nutshell, Bernstein's argument was that a steep yield curve is good for the economy, and the only thing that investors have to watch out for is an inversion. Yet what Bernstein knows all too well, is that in a time of -7% Taylor implied rates, QE 1, Lite, 2, 3, 4, 5, LSAPs, no rate hikes for the next 3 years, and all other possible gizmos thrown out to keep the front end at zero (as they can not be negative for now), to claim that the yield curve in a time of central planning, is indicative of anything is beyond childish. A flat curve, let alone an inverted curve is impossible as this point: all the Fed has to do is announce it will be explaining its Bill purchases and watch the sub 1 Year yields plunge to zero. Yet the long-end of the curve in a time of Fed intervention is entirely a function of the view on how well the Fed can handle its central planning role: after all, the last thing the Fed wants is a 30 year mortgage that is 5%+ as that destroys net worth far faster than the S&P hitting the magic Laszlo number of 2,830 or whatever it was that Birinyi pulled out of his ruler. As such, Santelli's warning that a steep curve during POMO times is just as much as indication of stagflation as growth, is spot on.
Furthermore, to Bernstein's childish argument of "where is the stagflation" maybe he should take a look at commodity prices, unemployment levels and double dipping home prices, and the answer will suddenly become self evident. But either way, the point is that during central planning the shape of the curve does not matter at all, and certainly not to banks. The traditional argument that banks make more money on the long end breaks down when nobody is borrowing on the long-end, and with mortgage apps, both new and refi, plunging to fresh lows, that is precisely what is happening. But who cares about facts: all one has to do is roll one's eyes and smile flirtatiously at Becky Quick (making sure of course that Warren is nowhere to be found).
The video of the argument between the two is below:
Regardless, while Bernstein's objectivity is now sadly very much under question, if understandably so as his new business requires a bullish outlook no matter what, here is a primer on curves that was posted on Zero Hedge previously for all those who may have been confused by today's debate.
Posted on Zero Hedge in June 2010:
Why the Yield Curve May Not Predict the Next Recession, and What Might

Gone Are the days when "green sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts. Even the experts now recognize the recovery as a BLS swindle, and it is important to reintroduce the possibility of not only a low growth future, but one of outright and persistent contraction. As “double dip” has recently worked its way into the popular lexicon, we will explain why a traditional forecasting tool of recessions may not flash a warning this time around. Afterward, we explore why even “double dip” may not be an accurate term, as well as what a cutting edge-new economic indicator is forecasting.

Gary North wrote an excellent article explaining why yield curve inversions predict recessions. It is instructive now to illustrate how the fundamental backdrop has changed amidst unprecedented government intervention.

The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.

In unique circumstances for short periods of time, the yield curve inverts. An inverted yield occurs when the rate for 3-month debt is higher than the rates for longer terms of debt, all the way to 30-year bonds. The most significant rates are the 3-month rate and the 30-year rate.

The reasons why the yield curve rarely inverts are simple: there is always price inflation in the United States. The last time there was a year of deflation was 1955, and it was itself an anomaly. Second, there is no way to escape the risk of default. This risk is growing ever-higher because of the off-budget liabilities of the U.S. government: Social Security, Medicare, and ERISA (defaulting private insurance plans that are insured by the U.S. government).

We are no longer in a persistently inflationary environment, despite the best multitrillion-dollar reflationary efforts to the contrary. Disinflation and outright deflation keep popping up in critical areas of the economy. While the central banks will likely overshoot in the end, resulting in an hyperinflationary spiral, for the time being, lenders are not worrying about inflation. And, while one may doubt the BLS’ calculation expressed by the Consumer Price Index, the below chart of CPI year-over-year is nonetheless striking, as it indicates the recent crisis brought it into the most negative territory since inception.

On the rise are medical and food costs, but continued deleveraging by banks and consumers are offsetting deflationary drags. Banks are writing down (and off) private and commercial real estate loans, and consumers will remain in spending retrenchment as long as they continue to work off credit in a high unemployment environment. Indeed, year over year consumer credit is in the most negative territory post-WWII.

Though headline civilian unemployment from the BLS’ household survey is ticking down from the ominous 10% level, this is largely a result of the birth/death model adjustmentand the removal of so-called discouraged workers from the counted pool. When viewed from the larger perspective of the civilian employment to population ratio, the job losses are staggering and unprecedented in the modern era. When the economy eventually does show improvement, these discouraged workers will reenter the job market and keep the headline unemployment rate persistently high.

Finally, creation of money supply, as expressed by non-seasonally adjusted year-over-year M2, continues to reflect slow money growth, notwithstanding the trillion or so in excess bank reserves sitting at the Fed earning interest at 0.25%. The very fact that banks are content to earn interest at this absurdly low rate indicates risk aversion and little fear of inflation.

North continues:

What does an inverted yield curve indicate? This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

The obvious failure of the central banks to reflate the economy has now renewed fears that monetary inflation will not return for some time.

This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.

On the demand side, borrowers now become so desperate for a loan that they are willing to pay more for a 90-day loan than a 30-year, locked in-loan.

Aside from government darlings, businesses and critically, small businesses, have largely stopped expanding and are in defensive retrenchment. The problem is a reduction in both the supply and demand for new loans. There is definitely a liquidity shortage, but it is being expressed unconventionally as central bank quantitative easing and government stimulus are directed into non-productive parts of the economy. It is these zombie behemoths in the financial and transportation sectors that are most desperate for funds, yet they are not penalized for it. Instead, they are encouraged to feed at the government trough even as their smaller (and more productive) competitors are edged out through oppressive regulation and inability to access loans at a similar rate. This will continue to be a drag on overall growth, and without small business growth, the threat of recession relapse is greatly heightened.

On the supply side, lenders become so fearful about the short-term state of the economy -- a recession, which lowers interest rates as the economy sinks -- that they are willing to forego the inflation premium that they normally demand from borrowers. They lock in today's long-term rates by buying bonds, which in turn lowers the rate even further.

Though long term US Treasurys are benefitting from safe haven flight-to-quality status, short term Treasurys are similarly benefitting to a greater degree, thus widening the spread between the two. As stated above, banks are content to park over a trillion dollars in excess reserves at the Fed earning interest at 0.25%. A combination of a (currently low but slowly rising) fear of eventual US default, extreme desire for short term safety in T-Bills, and low fear of inflation is keeping the spread wide. Also troubling is the recent disconnect between short term Treasury yields and the borrowing rates actually available to businesses with excellent credit.

North concludes:

An inverted yield curve is therefore produced by fear: business borrowers' fears of not being able to finish their on-line capital construction projects and lenders' fears of a recession, with its falling interest rates and a falling stock market.

Indeed, these are the fears being expressed, but in different manners that are not immediately obvious. Small productive businesses are throwing in the towel as their larger competitors build Potemkin villages.

A further problem is that nearly all yield curve studies look back no further than the mid-1950’s, the inception of Fed data on US Treasury rates. Inasmuch as every recession since then (save the last) has been manufacturing based as opposed to credit based and has occurred in an overall inflationary backdrop, there lacks a crucial window into prior deflationary times concurrent with extreme government meddling—in particular, the Great Depression.

Many economists from the Austrian school follow M2 money supply as a harbinger of economic growth or contraction, as it tracks the creation and destruction of money through economic activity at the margins. As noted previously on EPJ, Rick Davis and others at the Consumer Metric Institute have created a novel indicator that tracks, in real time, consumer demand for capital goods. Accordingly, it should and does reflect similar activity, though with enhanced granularity. Indeed, it anticipates US GDP by an average of 17 weeks. A future post will explore this aspect of their data and possible uses for market timing. For now, Davis tells a different story than the governments that collude to forge a statistical recovery:

Our 'Daily Growth Index' represents the average 'growth' value of our 'Weighted Composite Index' over a trailing 91-day 'quarter', and it is intended to be a daily proxy for the 'demand' side of the economy's GDP. Over the last 60 days that index has been slowly dropping, and it has now surpassed a 2% year-over-year rate of contraction.

The downturn over the past week has emphasized the lack of a clearly formed bottom in this most recent episode of consumer 'demand' contraction. Compared with similar contraction events of 2006 and 2008, the current 2010 contraction is still tracking the mildest course, but unlike the other two it has now progressed over 140 days without an identifiable bottom.

As we have mentioned before, this pattern is unique and unlike the 'V' shaped recovery (or even the 'W' shaped double-dip) that many had expected. From our perspective the unique pattern is more interesting than the simple fact of an ongoing contraction event. At best the pattern suggests an extended but mild slowdown in the recovery process. But at worse the pattern may be the early signs of a structural change in the economy.

While confounding the average GE cheerleader, this new normal of increasing destructive intervention is intuitively understood by the consumer, who responds to this reality by pocketing the debit card. So what can we expect in the ensuing quarters?

Davis aptly describes what has happened so far:

[I]t has instead, unfolded so far as a mild but persistent kind of
contraction, more like a 'walking pneumonia' that keeps things miserable for an
extended period of time.

Until governments stop punishing innovation, stop rewarding incompetence, stop distorting economic signals with arbitrary econometric targeting, stop coddling failures--we will continue to walk with this pneumonia indefinitely. The solution, as always, is nothing. Stop intervening and let the chips fall where they may. Markets will correct things faster than you might think.

---

And here is a useful primer from Fidelity on the various shapes of the yield curve and what they indicate:

Normal and Not Normal

Ordinarily, short-term bonds carry lower yields to reflect the fact that an investor's money is under less risk. The longer you tie up your cash, the theory goes, the more you should be rewarded for the risk you are taking. (After all, who knows what's going to happen over three decades that may affect the value of a 30-year bond.) A normal yield curve, therefore, slopes gently upward as maturities lengthen and yields rise. From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy. When those shapes appear, it's often time to alter your assumptions about economic growth.

To help you learn to predict economic activity by using the yield curve, we've isolated four of these shapes -- normal, steep, inverted and flat (or humped) -- so that we can demonstrate what each shape says about economic growth and stock market performance. Simply scroll down to one of the curve illustrations on the left and click on it to learn about the significance of that particular shape. You can also find similar patterns within the past 18 years by running our "yield-curve movie" and -- by clicking the appropriate box -- you can compare any shape within that time period to both today's curve and the average curve.

Normal Curve
Date: December 1984

When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward -- in the form of higher interest -- than those who risk their money for shorter time periods. Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.

December, 1984, marked the middle of the longest postwar expansion. As the GDP chart above shows, growth rates were in a steady quarterly range of 2% to 5%. The Russell 3000 (the broadest market index), meanwhile, posted strong gains for the next two years. This kind of curve is most closely associated with the middle, salad days of an economic and stock market expansion. When the curve is normal, economists and traders rest much easier.

Steep Curve
Date: April 1992

Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills. When it gets wider than that -- and the slope of the yield curve increases sharply -- long-term bond holders are sending a message that they think the economy will improve quickly in the future.

This shape is typical at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.

Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-termers can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.

In April, 1992, the spread between short- and long-term rates was five percentage points, indicating that bond investors were anticipating a strong economy in the future and had bid up long-term rates. They were right. As the GDP chart above shows, the economy was expanding at 3% a year by 1993. By October 1994, short-term interest rates (which slumped to 20-year lows right after the 1991 recession) had jumped two percentage points, flattening the curve into a more normal shape.

Equity investors who saw the steep curve in April 1992 and bet on expansion were richly rewarded. The broad Russell 3000 index (right) gained 20% over the next two years.

Inverted Curve
Date: August 1981

At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?

The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.

Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.

As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got. Interest rates fell dramatically for the next five years as the economy tanked. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh.

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown -- or outright recession -- as well as lower interest rates across the board.

Flat or Humped Curve
Date: April 1989

To become inverted, the yield curve must pass through a period where long-term yields are the same as short-term rates. When that happens the shape will appear to be flat or, more commonly, a little raised in the middle.

Unfortunately, not all flat or humped curves turn into fully inverted curves. Otherwise we'd all get rich plunking our savings down on 30-year bonds the second we saw their yields start falling toward short-term levels.

On the other hand, you shouldn't discount a flat or humped curve just because it doesn't guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.

That's what happened in 1989. Thirty-year bond yields were less than three-year yields for about five months. The curve then straightened out and began to look more normal at the beginning of 1990. False alarm? Not at all. A glance at the GDP chart above shows that the economy sagged in June and fell into recession in 1991.

As this chart of the Russell 3000 shows, the stock market also took a dive in mid-'89 and plummeted in early 1991. Short- and medium-term rates were four percentage points lower by the end of 1992.

New Record for Deficits

Meanwhile, the U.S. treasury just announced that the Federal deficit for November was $150 billion. That's $1.8 trillion for the year if sustained.
An article on the website of the Wall Street Journal indicated that for the first two months of this fiscal year, the U.S. government has borrowed 49.65% of every dollar it has spent. Amazing! Who would have ever imagined that we are borrowing half of every dollar we're spending. 

David Rosenberg Predicts Bond Yields to Fall Even Further

The benchmark 10-year Treasury yield will drop below 2% for the first time ever over the next 12 months as US economic growth loses traction, said David Rosenberg, a high profile economist and one of the biggest bond bulls on Wall Street.

Stephen Roach: Fed Making Same Mistakes Again!

The Federal Reserve is running the risk of replaying the disaster movie that led to the credit crisis by keeping monetary policy loose for too long, Stephen Roach, non-executive chairman at Morgan Stanley, told CNBC Tuesday.

Despite the central bank's efforts to juice the economy, a double-dip recession looms, he said.

 "This is a replay of exactly what the Fed did, but with different stakes, following the bursting of the equity bubble in early in 2000. They stayed easy for an extended period, gave us monster bubbles in property and credit. Those caused the crisis, and now they're playing the movie back again," Roach said.
Roach said the Fed's mandate should be expanded to include financial stability and the central bank should have a much more strategic outlook and be more transparent.

If it doesn't, it could risk sowing the seeds of another round of asset bubbles, he said.

"We have a reactive Fed, they're always being driven by the latest problem in the economy," he added. "They've gotten themselves into a big, big hole and they don't know how to get out of it."

Even though Roach thinks that U.S. monetary policy is too loose, he also said the economy is still spluttering and describes himself as being in the "double-dip camp."

"The case for a double dip is not a complex case; it starts with a weak recovery… You don't have the staying power to avoid a relapse," he said.

Because of the weakness in the economy, Roach said the Fed should not tighten, but rather be more open about its exit strategy and focus on the risk of asset bubbles.

"This is not the time for an aggressive Fed tightening, but it is the time for the Fed to stand back (and be more strategic)," he added.

The Fed is divided over its recent policy decision to buy Treasury notes with the proceeds from its mortgage securities maturing, according to a report in the Wall Street Journal.

Roach said the dissent is likely and justified, but also said that there is a desire within the rate-setting organization to stand behind Fed Chairman Ben Bernanke.

Fed Zero Rate Policy May Backfire, Cause Deflation Instead

by Bill Hester:

One group of investors was likely to give up its view. The divergence in the performance of stocks and bonds was clearly at odds during July and the beginning of August. In July, stocks had their best month in a year, while at the same time bond investors were piling into Treasuries sending their yields to near-historic lows. Last week, stock investors finally blinked and began to appreciate the concerns of bond investors, including weak trends in the leading indicators, in the jobs data, in components of the GDP data, and in the slowing rate of inflation among various price indexes.

Inflation, of the lack of it, is one of the trends market participants are focused on. On Friday the BLS reported that overall inflation rose last month, the first increase in four months. On a year-over-year basis, the rate of inflation slowed its decent. But from the end of last year, inflation has still cooled to 1.2 percent from 2.7 percent.

Another indicator of inflation is graphed below. It's the Federal Reserve Bank of Cleveland's tally of how quickly prices are rising. It improves on the BLS's Consumer Price Index – which can be noisy because of volatile components like food and energy – and the Core Consumer Price Index – which can be bullied around by a few of the components with large weightings, especially its imputed rent component. The researchers simply take the median price change of the components within the CPI Index. Not only is it less susceptible to outlier price changes, it's also done a better job at forecasting future inflation than have the two CPI indexes, according to the Fed's research. As the chart shows, the trend has been mostly down, and it's moved in that direction with a surprising amount of speed and consistency. This measure stabilized slightly in July, rising .1 percent.

With fears of deflation spreading among market participants, it was an auspicious time for a member of the FOMC committee to deliver a paper arguing that the Federal Reserve's current policy was likely to increase the probability of deflation. This was the paper put out earlier this month by James Bullard, the President of the Federal Reserve Bank of St Louis. Much of the focus has been Bullard's comment that the US is closer to a Japanese-style outcome today than at any time in recent history. It's also been highlighted that his preference is for the Fed to buy longer-dated Treasury securities, restarting the type of quantitative easing that it pursued last year.

Another part of Bullard's research paper ( Seven Faces of “The Peril”) that received less attention but was equally interesting was his argument that the Fed's repeated expectation for "rates to stay low for an extended period of time" might actually be increasing the risk of deflation, the very outcome Bernanke is desperately trying to avoid. Bullard, a voting member of the FOMC, has said that he preferred to jumpstart a dialogue on this topic through the paper, rather than dissent through his vote. It is ironic though that a member of the Fed such as Bullard – one who recently described himself as “the north pole of inflation hawks” – would suggest that the Fed itself could end up being one of the culprits that helped launch a period of sustained deflation.

While “The Peril” focuses mostly on the economy and the risks of deflation, there are also important insights for investors to take away from the discussion. Why does monetary policy become ineffective during periods of deflation? What are the risks to stock investors when the central bank can't adjust rates to incoming economic data? Are the signals from interest rates the same within periods of deflation as they are during periods of low inflation?

Bullard's paper mostly outlines and then expands on a discussion that began in a research paper entitled “The Perils of Taylor Rules”, written by Jess Benhabib, Stephanie Schmitt-Grohe, and Martin Uribe. The Taylor Rule has now gained fairly wide acceptance among economists, and was even acknowledged by Bernanke a few years ago. He said that "feed-back models" like the Taylor rule are helpful in setting policy rates. (Although, its message went unheeded from 2002-2004 when the Taylor Rule was suggesting higher rates as the economy was recovering and the seeds for the housing and credit bubbles were being planted.)

The Taylor rule suggests a level of short term rates by taking into account inflation and GDP, relative to target levels. In the case of inflation, the Taylor Rule would suggest that policymakers should adjust nominal interest rates more than one-for-one when inflation deviates from a given target. (For an earlier discussion of this topic see: "Taylor" Your Fed Expectations .)

In his paper, Bullard created the chart below to assist in his discussion of the risks that policymakers face when short rates fall toward zero. The green circles plot short-term rates against the rate of inflation in Japan over the last eight years. The blue squares represent the data in the US. They are clearly separate. Green circles on the left, blue squares on the right. The black line estimates the Taylor-suggested rate. The red dotted line is the level of interest rate suggested by the Fisher Equation, which suggests that interest rates consist of a real component and an expected inflation component. The real component in this example is fixed at 50 basis points.

The two parts of the graph that are noteworthy are where the solid black line intersects with the red dotted line. The point where they intersect among the US data is an area where monetary policy can be reactive to data. Short-term rates can be shifted to lean against incoming data. Short-term rates can be pushed higher when inflation is above acceptable levels and lower when inflation slows. And where these lines intersect monetary policy should be just about right, suggests Bullard. The original researchers called this the “targeted” steady state.

The intersection that occurs within the Japanese data suggests a more challenging situation for policymakers. Here their efforts become ineffective. This area of the graph is sometimes called the “unintended” steady state. As Bullard puts it, “in this unintended steady state, policy is no longer active: It has instead switched to being passive. When inflation decreases, the policy rate is not lowered more than one-for-one because of the zero lower bound. And when inflation increases, the policy rate is not increased more than one-for-one because inflation is well below its target.” He concludes that in this state, “the private sector has come to expect the rate of deflation consistent with the Fisher relation accompanied by very little policy response, and so nothing changes with respect to nominal interest rates or inflation.”

In effect, Bullard is saying that a policy that makes a promise to investors that rates will stay low for long periods of time backfires. While the Fed may intend to fan inflation concerns in order to motivate aggregate demand, the private sector begins to assume a semi-permanent state of very little change in inflation, and a growing inability for the Federal Reserve to do anything about it.

On Friday, Kansas City Fed President Thomas Hoenig expanded on the reasons why he has dissented from the current policy in place. “If an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty”, Hoenig said in a speech. “A zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery.” While Hoenig believes a deflationary outcome has low odds, his argument is the same. A Zero Bound strategy locks market participants into thinking inflation and growth are not likely near-term outcomes.

Promising low rates for long periods of time is particularly pernicious following periods of credit crises, points our Arun Motianey, now with Roubini Global Economics, in his book SuperCycles. In a discussion of Japan's low policy rates over the last 15 years, Motianey points out that deflation became worse the longer Japan's equivalent Fed Funds rate stayed at zero.

Motianey argues a slightly different transition mechanism that pushes the economy into deflation, mainly through lending markets. He argues that after a credit crisis, government-supported banks are borrowing at close to government rates and at the same time being coerced to lend at rates lower than they would otherwise demand for the risk of default. The result is that they demand higher credit standards (typically higher operating cash flow) of their borrowers. Borrowers, mostly companies, oblige by halting the growth in or cutting the nominal wages of workers. Generalized price deflation typically follows wage deflation.

Motianey sums up his argument up this way, “Very low nominal rates cannot be used to fight deflation, since they are, in these conditions – the condition of banking system distress – the cause of deflation.” He calls this the Paradox of the Zero Bound.

This is an important topic because it's clear that investors still believe that the Fed is engaged in active monetary policy (whether that might be setting the Fed Funds Rate, quantitative easing, or adjusting the interest rate paid on reserves) and that active monetary policy will play an important role in the outcome of the recovery. And this faith in the Fed that investors have, although unquantifiable, has certainly played an important role in the performance of stock markets over the last few years. After more than a decade of Greenspan's Put, and Bernanke's do-what-ever-it-takes attitude in protecting investors from taking appropriate losses, investors have been conditioned to believe that the Fed has their back. This faith in the Fed also must be playing a role in the valuation of the stock market, considering that investors are pricing stocks nearly 40 percent above long-term valuation levels (using normalized earnings) during an economic recovery that is by almost any measure lagging far behind the typical post war recovery.

That conditioned faith that investors have in the Fed is what makes Bullard's paper so interesting and timely. He is essentially suggesting that the Fed's promise to investors to keep rates low for a long period of time – something stock investors typically cheer over the near-term – will in the end increase the probability that the Fed at some point will find itself powerless to the expectations of the private sector and financial market participants.

Investing within the Paradox

Deflation and steep disinflation come in different forms. A lower price level that is brought about by a capital investment boom that improves productivity and efficiencies is generally considered good deflation. The build-out of the national railroad system in the US helped move goods around the country more efficiently, causing a drop in commodity prices, which helped create a period of wide-spread deflation during the second half of the 19 th century. Prices also fell in the 1950's, but the price declines were shallow and short lived, leaving the economy unaffected.

A more damaging form of deflation comes about from a fall in aggregate demand, which pinches corporate profits, and then wages, which can create a feed-back loop, sending prices lower again. This was the deflation the US experienced during the 1930's. The modern-day example of this is the deflation that Japan has experienced since the mid 1990's.

Because deflation's causes and effects differ, stock returns have also differed during periods of falling prices. Stock returns were positive but below average in the second half of the 19 th century during periods of deflation. The deflation of the 1930's coincided with losses on average for investors.

Using Japan's experience with deflation, there are a couple of inter-market relationships that may change if the US economy were to fall into a period of sustained deflation. First, the signaling of interest rates would likely change. Typically, falling interest rates support stock prices. Falling rates typically highlight an easing of inflation concerns (especially if real yields remain unchanged), which can be supportive of stock prices. So, typically, bond yields and stock prices move in opposite direction (although this inverse correlation can break down during periods of heightened risk aversion).

As the graph below shows, this was the typical pattern between stock prices in Japan and government bond yields prior to the bursting of the country's stock and real estate bubbles. But as deflation took hold, the correlation of the two has increased. Essentially the typical relationship between changes in bond yields and stock prices has reversed. In periods where the economy gets stuck in the “unintended” state, long rates become the primary signal for the expectations of growth and inflation. Lower rates imply an expectation of deflation and economic weakness, and become associated with weaker stock prices.

For example, in Japan, prior to the onset of deflation when rates were falling (let's say, they were lower than 6 months earlier) the average annualized stock return was 23 percent (this period includes a stock-market bubble). When rates were rising, stocks fell on average 4 percent. But since 1995 during periods when rates were falling, stocks have fallen 12 percent on average. During periods of rising interest rates – that is, where investors were optimistic that both growth and inflation would materialize – stocks climbed 11 percent on average. When the economy falls into the Zero Bound area, investors become optimistic about the possibility that prices will rise because market participants have come to expect continued deflation.

Another signaling mechanism that breaks down when policy rates are set low for an extended period of time is slope of the yield curve. Typically, investors will wait for the yield curve to become inverted – signaling an approaching recession - prior to becoming defensive in their stock portfolios. In the Zero Bound area, that signal might never come. I've noted that following the stock market crash of 1929, over the next twenty years, as short and long-term bond yields stayed at very low levels, the yield curve was unhelpful in forecasting recessions. Its record improved after the normalization of yields toward longer-term levels. The Japanese data show the same pattern. In the graph below I've plotted the spread between long-term bond yields and shorter-term bond yields in Japan. Prior to 1995 the yield curve had a strong record of forecasting recessions or that the economy had just entered into a recession. It missed signaling only a single a recession, the one beginning in 1976. Post 1995, when deflation began to look more persistent in Japan's price gauges, the yield curve's track record deteriorated. It hasn't forecasted any of the three recessions that have occurred since the mid 1990's.

The longer that Japan has kept its policy rate low, and continued to promise to keep rates low, the more persistent and intractable the pattern of deflation has become in Japan. In the US, the risk is not only the detrimental effect to the economy if we enter an “unintended” state, but also the effect that an erosion of the faith in the Fed would have in pricing stocks. The answer to Fed President Bullard's question to policymakers is as equally as important to Bernanke as it is to investors. Will the policy currently in place to protect the economy against slipping into deflation end up being the primary culprit for that same outcome?