John Hussman: The Fed Or Investors -- Who Drives the Market?

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the US market:

With regard to the sudden dollar weakness, it's not evident that there's been any particular surge in the supply of U.S. dollar liabilities, so it's reasonable to assume that foreign demand has shifted -- at this point probably a reduction in the pace at which foreign central banks are purchasing U.S. Treasuries. My guess is that China and Japan are diversifying their central bank reserve assets into the Euro. If that's the case, we'll observe it in the next few months as a surprising “improvement” in the U.S. current account. Now, if a reduction in foreign demand was the whole story, we would also probably be seeing weakness in the U.S. Treasury market, which hasn't been the case. So it stands to reason that at least for the time being, the eagerness of U.S. bond investors to accumulate bonds, based on evidence of a weakening economy, has been more than enough to offset the lost foreign demand. The question then becomes whether this is sustainable, and whether it is reasonable.

From the perspective of someone who doesn't place much faith in the Federal Reserve, my impression is that the bond market has now allowed itself little room for error even if the economy slips into recession. At this point, the Fed could cut rates repeatedly with the only effect being a normalization of the front-end of the yield curve. The Fed's actions clearly determine the Federal Funds rate, but that's the only maturity on the yield curve where they do have effect. If you look at the yield curve, you'll see that it drops from 5.25% for overnight money and the very shortest-dated Treasury bills, down to about 5% for 3-month T-bills, and quickly down to about 4.5% for longer term bonds. The Fed Funds rate is now an outlier – market rates are, if anything, leading the Fed. Now, one might argue that the reason the yield curve is inverted in the first place is only because the bond market believes that the Fed is going to cut interest rates in the future on the basis of a soft economy, but given the evidence that the Fed's open market operations (and total bank reserves themselves) are tiny – minuscule – relative to the Treasury market and foreign investment flows, why insert the middle man? Why assume a powerful cause-and-effect link from the Fed to the markets, where we can find no materially relevant mechanism other than words and the belief that the Emperor has clothes? Are we really so afraid to think that we, as investors, collectively drive the markets?

In any event, the bond market has priced in not only a weak economy but also an easing of inflationary pressures. It now matters enormously whether or not inflation slows -- particularly core, PCI and wage inflation, where to this point we haven't observed much progress...

Having priced in favorable news, the bond market seems to present a fairly asymmetric return/risk tradeoff. If the favorable news arrives, there may not be much benefit because it's so heavily discounted already. In contrast, bonds could prove to be very vulnerable in the event of unfavorable inflation figures.

Read more John Hussman weekly essay excerpts on Seeking Alpha.