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By Joseph Morrison

Inflation Pressure

Since 2008, there has been a world war raging pitting the world's central banks against global economic meltdown. The central banks' main weapon has been some of the loosest monetary policies in history. Thus far, it is too early to determine whether the central banks will be victorious. What is clear is that the initial policies of the U.S. Treasury and Federal Reserve saved the banking system from collapse as well as buoyed the United States economy. The subsequent maneuvers still have to play out before being judged fully for their effects on the economy. At this point, it is certain that the Quantitative Easing policies of the U.S. Federal Reserve [Fed] as well as the easing by other central banks have potentially led to asset bubbles.

Inflation is the goal of the central bank actions, no doubt and this is a straightforward process. The central banks buy treasury bonds, thus driving the risk-free rate to such a low level that it is not profitable for large investment, thus driving investment in other sectors of the economy. In theory, this works well since it adds liquidity to the capital markets, firms are more able to get equity investments at higher prices and this leads to greater hiring which leads to greater consumption and increased profitability in the economy. At this point, the central bank can unwind the position and allow the risk free rate to rise because the growth is now self-sustaining due to the higher employment rate and it is actually smart to raise the interest rates to draw some liquidity out of the economy and thus ease inflationary pressures.

As with most theories of academia, they do not work so well in practice. Investment needs to exist in order for this to work and it needs to be in the correct sectors of the economy for this theory to work. In China for example, a large portion of investment went into the housing sector. There is a bona-fide housing bubble in China so bad that even the typically secretive government has acknowledged it and is taking pro-active measures such to stem speculation and pop the bubble before it gets out of control. This illustrates a problem with asset bubbles, they are difficult to fix. Investors understandably do not take kindly to the government voluntarily deflating an asset bubble when there is massive investment locked up in the inflated asset class. This can only really be accomplished when there is a one-party government which does not have to worry about being thrown out of office in the following election or have the action declared illegal. In addition, there are no guarantees that the actions will even work. China is imposing a transaction tax designed to stop speculation but if the speculators believe that the rate of return will be greater than the tax, the asset inflation will continue.

In the United States, there has been much debate over whether there has been an asset bubble and if so, where it exists. Pundits speculate over topics such as whether there is a new housing bubble or a commodity bubble, or bubbles in a variety of other asset classes. One investment where it is clear that there is going to be a problem, however is corporate bonds. As companies issue debt now, they are able to borrow at incredibly low rates.

Bond Bubble

As any student in any business program can attest, the typical way to value a bond is to price it as an annuity using the yield-to-maturity [YTM] as the discount rate. There are a few issues with this, however. Firstly and most importantly it neglects a risk premium. There is a risk of default with a bond, as reflected in the credit rating of the bond. Each of the agencies has made public the historical default probabilities of their respective ratings. This should be used as the probability to calculate an expected cash flow when valuing a bond rather than taking for granted that a bond will pay the coupon. Additionally, the current valuation of a bond does not take into account the risk free rate. If the risk free rate matches a corporate bond rate, why would any investor not take the risk free rate and erase any uncertainty of being paid for each coupon? With this in mind, I have created a calculator which takes these factors into account and produces a real profit calculation given the expected cash flows and risk premium given the risk free rate. Citigroup (NYSE:C) has a bond which matures October 31, 2033 with a 6% semi-annual coupon. The comparable Treasury carries a 2.75% interest rate. We see that with these parameters, this is a valuable bond with a $53.21 expected profit.

At some point however, the Fed will have to raise interest rates. It is inevitable. In order to illustrate the impact of the risk-free rate on how a bond should be valued, this analysis was run again using the same parameters but raised the interest rates 200 basis points to 4.75%. The value of the bond was more than cut in half with a $19.99 expected profit.

This example should illustrate what is going to happen to the bond market when the Fed raises rates. Current bondholders will be holding bonds which will not yield much over the risk-free rate, rendering them beyond worthless. The more time passes, the closer to par a bond is worth but given inflation, $100 paid now is not the same $100 10-years from now hence why bonds will trade at below par. Bonds currently held by bondholders will trade further below par as the risk-free rate increases and liquidity in these assets will not be there. For the bondholder, there is still a coupon which is an influx of money but there is absolutely no risk premium being taken in anymore for taking on debt riskier than the risk-free asset. Additionally, corporations will issue new debt far above the current rates in order to attract lenders, further detracting from the value of current debt.

There is no way in sight to head this off. Corporations which have issued callable debt who have the intention of exercising this call would do so at these interest levels in order to reissue debt at a lower level. When the rates are higher, no company will exercise a call provision. This leaves current bondholders in a predicament. Sell the debt now and wait for higher rates but will those rates rise anytime soon? Everyone who is a Fed watcher tries to read the tea leaves of the Fed between speeches and the FOMC meeting minutes and there is no clear indication when these rates will rise. If an investor sells this debt, the next question is where to put this money to ensure growth beyond inflation until rates are at a rate to reinvest at a higher yield? Seemingly, the whole world is flocking to stocks. From Alan Greenspan to Mila Kunis, the stock market has become the new asset to own. This is understandable since the Dow (NYSEARCA:DIA) has now closed above 15,000 and smashing records daily. One must now ask, is the S&P 500 (NYSEARCA:SPY) another asset bubble caused by the Federal Reserve?

Stock Bubble

The United States stock market has been the hottest asset class since the financial crisis. The bull market has just entered the fifth year and shows no signs of slowing down. Interesting that this would occur at the same time that the Fed has been keeping rates low. This is precisely how this program of Quantitative Easing was supposed to work by keeping riskless interest rates low and spur investment in capital markets. There is a glaring problem, the growth in this program is not real economic growth, nor is it the self-sustaining growth that the Fed is looking for. This is evident by the 4th quarter economic contraction and the unemployment rate still around the 8% mark, real unemployment notwithstanding. The Fed therefore will continue easing until these levels improve, at least that is what Fed Chairman Bernanke publicly commits to. The FOMC minutes indicate that certain members of the committee are more hawkish about Fed policy and Chairman Bernanke will soon be retiring from his post at the Fed. What this means for interest rates is anyone's guess. What is however clear by this is that the stock market is no longer an efficient indicator of the United States economy. What this truly means is that at any point, investors could get spooked and it would not take much for a run on the market.

The debate persists, however as to whether there is a true asset bubble in stocks or whether the market is working as an efficient indicator of the economy. There can be no debate, however that the Permanent Open Market Operations [POMO] of the Fed have led to investment in stocks. The question by investors, however is where has this impact been strongest? The way to determine this is by use of statistics at a granular level. It is easy to look at a chart and point out that as the Fed's balance sheet has risen, so has the S&P 500 and the Dow Jones Industrial Average and the NASDAQ composite (NASDAQ:QQQ). There is a correlation that does not need to go much beyond an eye test. There are statistical correlations, however between certain stocks which have consistently beaten the averages on the days which the Fed has conducted asset buying. To determine these correlations, a linear regression of every stock in the S&P 500 was conducted and compared relative to its sector ETF as well as the S&P 500 ETF to determine which stocks beat the averages. Two time frames were used in this analysis, one was since the beginning of the Fed's POMO until February 1, 2013 and a lesser time frame was used, since the beginning of 2012 until February 1, 2013. The reason for this is to determine if there is a long-term correlation and if so, determine if it has strengthened or weakened over time. The results are below:


(Click to enlarge)

This chart of correlations illustrates that the market is in a bubble and is not acting efficiently. The first and most glaring observation is that the Consumer Staples ETF (NYSEARCA:XLP) is the best sector ETF both over the short term, yet does not have a single stock on the list. What this tells me is that since 2012, there has been massive buying in this ETF but not in the stocks vis-à-vis Fed POMO days. Additionally, the number of stocks that have beaten the market is only about 1/10th of the S&P 500. This is illustrating to me that the market is up irrationally as a result of buying in the ETF's for the market and the sectors on the days on which the Federal Reserve is conducting POMO.

Conclusions

The Federal Reserve has undoubtedly spurred inflation in given assets. The bond market and the stock market have both bore the brunt of the massive inflation which has occurred as a result of the Fed's operations. While inflation in the stock market is generally looked at as a good thing relative other sectors of the economy, I urge caution to the retail investor to jump into the market with the high-net worth celebrities. The common theory is to not fight the Fed and I agree with that. The trouble is, by investing now, you may be fighting the Fed as the rates get raised and the market gets squeezed.

Bonds are not a safe place to be either. The Fed will raise rates and the bonds being held will lose value relative to the market and inflation. Liquidity will be sapped from the market and the currently held bonds will be held with a minimal or no premium for the risk being taken vis-à-vis the risk free asset.

For any investment a person is going to make, there can be no mistake. The fundamentals of the market are now secondary to the Federal Reserve. Before deciding to invest in either stocks or debt, look to the Federal Reserve first and take your cues from there. If you believe at all that rates are going to rise, bring your cash to the sidelines and wait for conditions to level off.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Business relationship disclosure: The article has been written by Wall Street Trading, a group of junior market analysts. Wall Street Trading is not receiving compensation for it (other than from Seeking Alpha). Wall Street Trading has no business relationship with any company whose stock is mentioned in this article.

Source: Asset Inflation And Bond Bubbles, Fed Policy At Work