In a recent Market Update to my subscribers, I said that the talk about the Fed pushing up the stock market is totally unverifiable. If the Federal Reserve Bank is buying $40 billion in mortgage backed securities and $45 billion in treasuries per month; how is Fed money stimulating the stock market? The money is obviously going into the real estate market and bonds. A case could be made that the Fed may be stimulating those markets, but it is unjustifiable to assert that stock prices are subsequently being pushed higher without providing evidence.
Even still proponents of a Fed led stock market maintain that although the money is going elsewhere, the Fed is artificially reducing interest rates thus forcing investors to put their money into the market for a better return. If that is the case, who is forcing investors into the bond market at historically negative returns? Another equally erroneous assumption is that the Fed is keeping interest rates artificially low and causing mini-bubbles. Daily we hear allegations of this, including assertions that bond and stock market rallies are Fed led.
Below is a chart from Casey Research of the US 10 year treasury rate and Germany and Japan's equivalent rate. No one talks about this correlation of rates because it would blow up so many theories about interest rates.
Notice the spike in US interest rates in the late 70s and early 80s. Notice that the US interest rate averaged about 12%, while Germany was at 8% and Japan at about 4%. Now look at the end of the chart during the late 2000s. Germany and the US are both at 2% and Japan is closer to 1%. If all three nations' interest rates fell through the decades in a similar pattern, then what causes high or low interest rates?
This is not just an academic question. Stock market investors who take an active role in what, where and when they invest, need to correctly identify what is causing the market to rise or fall over time. I maintain that it is mainly company earnings that push the market higher. By any standard, earnings and stock prices have correlated up and down almost precisely for decades.
The one thing that explains all three countries' simultaneous falling interest rates is falling inflation, and in the last five years, very low growth rates. Add to this the element of "fear" and you have what amounts to historically low long-term interest rates. Arguing that the Fed is responsible for artificially stimulating the stock market through its interest rate policy is to imply that it is the government that creates wealth, not the private sector. Yet the private sector has done exceedingly well over the last five years since the recession's end.
Isn't it interesting that it is conservatives, libertarians, and gold bugs who've argued over the years that it was the Fed, and not the private market, that caused the prosperity of the last couple of decades? Their argument that what the US experienced was an artificial boom is essentially an argument for the Fed getting credit for the stock market boom! The Dow increased from 776 in 1982 to 14500 today, yet you never hear pro capitalists attributing this to free enterprise.
The implication is that Reaganomics was an accident, or worse a "con." That it wasn't the application of free market policies that led to massive amounts of profits and cash in corporation reserves, but government intervention. No credit is given to free enterprise. Instead fingers are pointed at the Fed for policies that prevailed through the greatest period of growth since the Industrial Revolution.
For more, please see my article The Fatal Flaw.
Most agree that the Fed controls interest rates by printing money and artificially keeping the Fed Fund's rate low. The Fed can control the shortest term interest rates, such as the overnight rate borrowed by banks, but that's the extent of their power when it comes to interest rates. It has no direct control over long-term rates over time.
The correlation of various nations' interest rates as shown in the chart above proves this. It blows a hole in the theory that the present bond and stock market booms, let alone the real estate booms of the past, are due to monetary policy. Which is why it must be answered, how is it possible for interest rates to fall in the United States where we are pursuing an alleged inflationary policy, while also falling in Germany where they have pursued a tight money policy, to say nothing of Japan where they have pursued a deflationary monetary policy?
An interest rate theory that tries to explain the level of interest rates solely by monetary policy runs right up against reality. If this theory were true, that increases in money supply increases stock prices, why didn't the stock market soar during the 70s when the Fed was increasing the money supply progressively higher for a decade? Why did the market instead stagnate for years with all that money around? And how do you explain Germany's soaring stock market given their continuous tight monetary policies?
So if monetary policy doesn't determine interest rates, then what about fiscal policy? Well, once again we see Germany with its pristine balance sheet and the US with deficits running at 100% of GDP both with interest rate levels at 2%. And there is Japan with a 200% debt to GDP ratio with a 1% interest rate. Wherever we find contradictions we must check our premises-especially as prudent investors.
The real determining factor for interest rate levels is simply the demand for and the supply of money and credit. That and the premium or discount debtors and creditors place on money above or below the expected future inflation rate. In times of deflation and recession, or disinflation and slow growth, the demand for credit falls while the demand for cash rises. The reverse is true in times of inflation and booms. Since 2007 we have had a huge demand for cash and little demand for credit.
The one thing all three nations have in common today is that they are seeing economic growth fall, fears of defaults from both the private and the government sectors rise, and disinflationary/recessionary trends persist. It is not inflation that causes low interest rates, it is disinflation as in the case of Germany and the US, or actual deflation as is the case in Japan.
Most of today's theories of money and credit, being espoused by all sides (liberal, conservative hard money theorists, and libertarians) are literally upside down. After almost every example of quantitative easing economists and commentators claimed it would lower interest rates. But each time interest rates rose. And each time the Fed ceased QE it was assumed that interest rates would rise but they fell or remained basically unchanged.
QE1 began November 2008. The 10 year bond was 2.5%. By June of 2010 the Fed's balance sheet grew to an unprecedented 2 trillion dollars. Yet the ten year bond had climbed to 4%! Fears of inflation and an artificial boom sent them higher; the exact opposite occurred than was expected by the vast consensus. When the Fed ended QE the interest rate fell back to 2.5%. Again the opposite as was expected. In November of 2010 QE2 was then launched and interest rates moved either side of 2% having no effect on the rate of interest, the economy, or unemployment. So the Fed ended its bond buying program for a year and the money supply flattened. Interest rates fell to 1.5% on concerns of possible recession and possible deflation.
In September of 2012, the Fed announced QE3 and interest rates moved up from 1.5% to 2%. This makes sense in light of a flat economy, low demand for credit, and fears over defaults throughout the world. Japan and the US during the 30's are also examples of tight monetary policies. Japan's rates fell from 6% in 1992 to zero for over a decade. This was not due to the Bank of Japan increasing the money supply to artificially suppress interest rates, but just the reverse. Japan allowed deflation to exist just as the US did in the Great Depression through an intentional tight money policy.
The fact is that the Fed has never been responsible for the rising stock market or creating booms and busts -- at least not since Paul Volcker. Yet economists and commentators will continue to insist that it is the Fed who is responsible for stock prices, real estate prices, bond prices, and natural booms and busts. They may have been in the 60's and 70's but not in today's world.
Far too much importance has been placed on the Fed's QE operations and the fear of exiting them. Of far more importance to interest rate movements, stock prices, home prices, and bond movements is the velocity of money and if and when more money begins to chase goods and bid prices higher. That will be the real game changer and it will be then that all central banks will need to take notice and change their policies in response to what the markets demand.