When I see a market move that is wholly irrational and unnatural as was Thursday's ramp, I begin to ask myself why did that happen and who made it happen. After pondering the matter for a time Thursday afternoon, it occurred to me that it might not have much at all to do with an appetite for fresh stock positions amongst the "buy the dip" crowd. In fact I think it had more to do with the need to prop up bond prices. Before rejecting the notion, at least consider my thesis. To start with, here is what Thursday's 24 point S&P 500 ramp looks like:
I'm not suggesting the 24 point climb in the S&P was unwarranted - I am suggesting it was unnatural and very contrived and typifies the kind of stock market action that we've seen since the first of the year. My contention is that the Fed - through their primary dealer banks - has engaged in carrying out open market policy in stocks and in particular since the beginning of QE4. Thursday's ramp was just the kind of stock market action that strongly suggests the Fed is back at it after having withdrawn from such activity since the high in May.
Here's my point - the stock market has returned to more normal pricing action since putting in a high on May 22 at 1687 on the S&P. We actually had 3 consecutive down days in the Dow this week before pushing back to the upside on Thursday. That is not unusual in a normal market - even a bull market - but it hasn't occurred this year until this week.
So why then did the market go parabolic on Thursday? I think it has more to do with bond prices than stocks. Here's the point - I am certain that Bernanke is concerned about the euphoric mindset of traders and investors as it relates to stocks. We know what happens when a market gets ahead of itself based on ill conceived and overly optimistic expectations. The Nikkei has provided us a road map. Here is what happens:
So it seems rational that Bernanke is doing what he can to dampen the euphoric mindset of traders and investors in order to prevent a bubble in equities. In so doing, he has suggested - mostly through messengers - the Fed may consider tapering. In other words, slow down a little on the Fed's massive QE bond and MBS buying. Most assumed that meant interest rates would normalize - in other words move higher - and bond prices would sell off.
It occurred to me that Bernanke may want stocks to normalize but not bonds. If stocks correct by 15% or 20%, that may end up being a more realistic valuation than current price based on an economy that is just not getting the job done. In other words, an orderly and normal market correction could actually be a healthy thing but a collapse in bonds could be devastating. Consider the pre-recession yield curve in the chart below:
Now consider the debt to GDP ratio:
Here's the point - our national debt as a % of GDP is at historic highs and the total debt number is $16.796 trillion as of the end of the 1st quarter of 2013:
What happens then to the cost of carrying a debt of roughly $17 trillion if bonds collapse and rates move back to pre-recession levels? Assuming an interest rate of 5%, the cost of carrying $17 trillion in debt is $850 billion a year and clearly rising as there is no way to pay the interest in today's economy except through increasing the deficit and therefore the debt..
Here's what the CBO says we are looking at for 2013 as far as the budget deficit is concerned:
If the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $642 billion, CBO estimates, the smallest shortfall since 2008. Relative to the size of the economy, the deficit this year-at 4.0 percent of gross domestic product (GDP)-will be less than half as large as the shortfall in 2009, which was 10.1 percent of GDP.
Do you really believe we can keep the deficit at that level in 2013? Maybe, but we can't do it if interest rates normalize. So here's Bernanke's problem - we sure don't want to see a parabolic spike in equities like we've seen in the Nikkei, but the last thing Bernanke wants is for the bond bubble to pop. That would reverberate throughout the domestic economy and the world in a way that would take any chance of controlled deleveraging off the table.
So, back to the matter at hand - Thursday's ramp up in stocks. Let's take a look at what's happened in recent weeks with bond and stock prices:
The chart above demonstrates Bernanke's conundrum - to slow down stocks and prevent a Nikkei like stock bubble the Fed has attempted to talk the market down with hints of QE tapering but that same rhetoric - it can be argued - has also caused the bond market to fall by roughly 8%.
That leads me to the conclusion that the sharp spike higher in stocks on Thursday was an attempt to reverse course and stop the bond markets' slide. By the way it worked - at least for now. TLT managed to close the week pretty flat with last Friday closing at 113.60 and this Friday at 113.82. The S&P (SPY) finished the week at 1626.73 compared to last Friday's close at 1643.80. In my opinion that was a pretty masterful manipulation - at least for the time being - as bonds did stabilize and stocks have backed off a little.
Here's the point - Bernanke has been trying to micro manage both bond and stock prices for 4 years now. There can be no doubt this Fed chairman is the most active man to hold that post in the history of the Fed. My guess is he is about to lose control of one of the two markets and we can only hope he doesn't lose control of both.
What does Bernanke do for an encore?
Here is where we are - we have bonds and stocks just off the highs. The Bernanke agenda was designed to flood the system with liquidity to spur growth. That hasn't worked as growth is moving at stall speed and likely to stall out completely in the coming weeks for the following reasons:
- The economy has been dependent on deficit spending for growth and the recent decision to cut the deficit is proving hazardous to economic health.
- PCE - one measure of inflation - is at historic lows and it is pointing toward deflation, a concern that Bernanke has voiced repeatedly in defense of his QE/ZIRP policy.
- The Euro Zone is in deep recession and impacting growth in China and the US.
- China's slowdown is impacting the Euro Zone and the US.
- Japan's grand QE experiment has failed.
- Total jobs numbers in the US peaked in July of 2012 and have fallen since that date by approximately 1.7 million total jobs.
- The quality of the jobs today is sub-standard and not conducive to growing GDP.
In short the economy is not getting better and the decision to pare the deficit with tax hikes and spending cuts is making the problem much worse. Additionally, the Fed's "virtuous circle" plan that assumed as stocks moved higher and higher that the "wealth effect" would result in increased spending, jobs growth and GDP growth has failed to produce any of the desired effects.
Today the Fed must acknowledge that QE is a failed policy and even if they are determined to continue the policy as they may well do, there is a serious problem of asset supply. Keep in mind a deficit of $642 billion as forecast by the CBO means that the Fed's current $45 billion a month treasury purchase schedule means the Fed will absorb 84% of all new treasuries the government issues in 2013.
I readily admit to some confusion as to where the bond market goes from here. I do think stocks will eventually begin to price in reality and fall sharply. That said, the euphoria hasn't really been squelched, and if the Fed says the wrong thing next week, the rally is likely to resume - perhaps into a parabolic rise much like the Nikkei. On the other hand, if the Fed gives more hints of tapering, then it can be argued that both bond and stock markets will move lower- at least in the short term.
What is most troublesome is that a sharp sell-off in bonds and a spike in rates will have a significant dampening effect on the real economy and push deficit spending up at a time when Congress is doing what they can to push it down. Furthermore, the practical side of the argument has to do with supply. The matter of supply will of course be solved if rates spike as the debt ceiling will need to be hiked in order to issue new treasuries to pay the increased interest resulting from the higher rates. That of course begs the question - why would the Fed continue to pursue an aggressive bond buying program if rates are climbing anyway and the fresh liquidity is doing nothing to stimulate growth?
I readily admit that in the short term anything can happen, but in the intermediate term, I think the Fed will favor low rates and high bond prices in lieu of an overextended bubble like parabolic rise in stocks. The question is this - can Bernanke construct comments in such a way that talks stocks back off the cliff without crashing bonds in the process?
I have my doubts in the short term, but I do think the most healthy scenario out of those scenarios available would be a major stock market correction. If that does occur, then it is reasonable that the cash hating investment industry will be forced into bonds as the only place to hide. That should put downward pressure on yields and keep bond prices relatively high.
I think it is reasonable to expect a recession at some point this year and that will force deleveraging which will result in a strong dollar and a high demand for dollar assets - both domestically and as a reserve currency asset. That should result in a strong demand for bonds and actually allow the Fed to unwind without fear of crashing the bond market.
Here is the point - Fed policy has not worked to stimulate the economy and the sheer magnitude of the stimulus applied to invigorate the economy has actually made matters a bit worse in the end, but I do see an out for the Fed. Quite simply, we should have allowed the much needed deleveraging that was halted with QE to continue once the banking system was stabilized. If we do enter recession now and stocks correct significantly, the demand for treasuries should be high and that will allow the Fed to rapidly unwind their balance sheet without adverse effects to interest rates.
I admit that I have underestimated Bernanke's resolve regarding QE and ZIRP. I was stunned when he announced QE3 and speechless when he followed that with QE4. I was equally stunned when the BOJ went into turbo charge mode with QE after decades of failure with just that policy. For those who have forgotten, here is a look at the 30 year Nikkei chart. I think it tells all and one wonders what exactly made Bernanke think QE would work in the first place?