"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Chuck Prince, ex-Citigroup (C) CEO
One of the chief drivers of this bull market off the March 2009 bottom has been the Federal Reserve's liquidity programs. Late last year, the Fed took on a new strategy by tying its bond buying to economic targets to provide more transparency to financial markets.
In the short term, the Fed has been successful in terms of preventing a recession or depression while not igniting inflation, but not very successful in terms of restoring employment to pre-recession levels. Of course, only time will tell if there are any longer term repercussions to the Fed's activities.
In this article, I want to provide some evidence against the notion that the Fed is attempting to raise rates due to a strengthening economy and show the real reason for the Fed's actions - a concern and attempt to tamper down on excess speculation.
Economic Data Remains Weak
There is no doubt that the stock market has benefited from its program as the SPDR S&P 500 ETF Trust (SPY) is up more than 140% off its March 2009 low. This has also led to criticism that the Fed's policies are disproportionately helping those who own financial assets. And this is true.
More recently, the Fed has begun publicly discussing reducing its bond purchases. Based only on this, money has already begun to tighten with yields on treasuries rising. Of course, the Fed must have been aware that this would happen, so I am assuming that this is the desired effect.
An ETF to track treasuries is the iShares Barclays 20+ Yr Treasury Bond ETF (TLT).
One strain of argument has been to shrug off the rise in yields as it is a reflection of the market expecting better growth in coming months. Based on this interpretation, this recent action is positive for the stock market. I believe this argument is false.
Other than yields, there are not many other market based measures that show traders are anticipating better conditions in the future. Further, looking at recent economic data reveals an economy that is far from being healthy and on a self-sustaining path to recovery. In fact, looking at the data in a vacuum, I would wonder why the Fed is not being more aggressive, especially in light of tepid inflation data. In a previous article, I discussed how Alan Greenspan's favorite economic indicator is not confirming the rise in stock prices.
Three barometers of future economic conditions I follow are not reflecting the favorable interpretation of rising yields - small caps (IWM), cyclical stocks, and commodities (DBC). These measures remain in downtrends over the longer term, and in sideways patterns over the very short term. Previous instances of strong recoveries coincide with these indicators exploding higher not meandering around.
Additionally, economic data remains weak:
Despite the less than stellar economy, the stock market has remained quite robust due to a perfect combination of OK but not great data that has kept the liquidity flowing from the central bank.
There has been considerable concern from Fed officials about potential excesses in the market exacerbated by the easy money policies. It is my theory that "tapering" is more about preventing these excesses from becoming a bigger issue that cannot be dealt with down the line. Bernanke has previously discussed the issue of using short term loans to buy long term assets. Of course this works tremendously great when prices are rising, but it can be disastrous when prices go the other way, as we learn over and over again after every cycle.
Another persistent criticism of the Fed has been in its enabling of the technology and housing bubbles, lack of effort to cool it off, and lack of foresight in anticipating the outcome. Another bubble would be disastrous for the Fed's future credibility, undermine the recovery, and lead to even more political discussions to alter the Fed's role and capacities.
Fed Governor Jeremy Stein in a speech from February said, "The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to 'reach for yield.' An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk. A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise."
If you have the time and inclination, I would highly recommend reading the full text of the speech. He goes on to discuss specific markets and whether or not there is evidence of "overheating". He specifically points out mortgage securities and junk bonds as areas with froth. And take note, this is from February and things have only gotten more heated since then, prior to late May.
Another damper on the party for bulls is Bernanke's recent comment on May 10, "In light of the current low interest-rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals." This is another piece of evidence clearly stating that the Fed has become concerned about excesses in the market.
Am I calling a top? No. In fact, given the lackluster inflation, the only restraint to the Fed's programs will be its own will. I think the Fed will continue to be aggressive in fighting off deflation even at the risk of a bubble. I expect the next Fed Chair to be Janet Yellen, who by all accounts is more dovish than Bernanke. And on the contrary if the Fed is successful in its attempt, it will provide more ammunition and credibility for future efforts, if the economy remains weak.
As Bernanke likes to remind us - monetary policy is a blunt tool. Rising yields are necessary to prevent these signs of excess risk taking from morphing into something bigger that can send shockwaves through the rest of the economy. In this instance, they are not reflecting an economy on the verge of a powerful recovery.
I think the environment that we have had for the first 5 months of 2013 should not be expected to return until these objectives are met. We are entering a challenging period. As the Fed attempts to wring out the speculative excess in the markets, I believe the focus needs to shift from earning returns on capital to preserving capital.
Don't fight the Fed.