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As I sat on the beach this morning watching my kids play in crystal blue oceanic waters, my thoughts drifted to the ongoing confusion regarding interest rates. The central premise is as follows:

How can rates be falling when it is so evident that economic growth has finally taken hold?"

It is an interesting question that I thought deserved a deeper discussion.

There is scant evidence that economic growth has gained enough momentum to break out of the roughly 2% annual growth rate that has existed since the turn of the century. The latest reports on factory orders, inventory builds and employment expectations have been less than exuberant. Furthermore, as shown below, the annualized rate of growth in real, inflation-adjusted, final sales in the economy are at levels normally associated with recessions rather than economic expansions.

(click to enlarge)

The same goes with gross domestic incomes which plunged in the first quarter to levels, as with final sales above, normally only witnessed during economic recessions.

(click to enlarge)

While I am not suggesting that economy has plunged into a recession and that the "end of the world is nigh," I am suggesting that there is more to the interest rate story than meets the eye.

As I discussed earlier this week, interest rates, inflation and economic growth are all very closely related as shown below.

(click to enlarge)

Since the level of interest rates are a function of demand by borrowers, it is only logical that it would take a much stronger level of economic growth, which would lead to rising inflationary pressures, to substantially increase the level of borrowing costs due to rising demand. When taken in this context, the incoming economic data hardly supports the unanimous belief by economists that interest rates and inflation are set to surge higher in the months ahead.

Since the end of the financial crisis, the Federal Reserve has been intervening in the financial system by artificially suppressing interest rates and injecting liquidity to boost asset prices. The belief, as stated by Ben Bernanke in the summer of 2010, was that rising asset prices would boost consumer confidence and fuel an ongoing economic recovery.

What Bernanke did not realize then was that the system would become dependent on the "financial heroin" and without it would quickly slip into a state of withdrawal. The other problem that developed from the ongoing "quantitative easing" programs is that it only affected a relatively small portion of the population that owned financial assets. While asset prices surged, creating an ever-widening "wealth gap" between the rich and poor, it largely bypassed a majority of the population that continue to depend on social welfare support and live paycheck to paycheck. Since the economy is nearly 70% dependent on consumption, it should come as no surprise that economic growth has remained sluggish despite surging asset prices.

Not surprisingly, interest rates have been a near perfect reflection of the Federal Reserve's ongoing interventions in the economy and the financial markets. The chart below is the 6-month rate of change in the 10-year Treasury rate since the turn of the century. I noted the three primary quantitative easing programs in 2009, 2010, and 2012 to present.

(click to enlarge)

As shown, each time the Federal Reserve was engaged in a liquidity program, interest rates rose as market participants shed safety to take on increased risk in the financial markets. Economic growth rose during these periods as the programs did, as expected, increase consumer confidence and "pull forward" future consumption.

However, at the end of each previous program, and likely as we are witnessing now as the current program is wound down, confidence is waning in "risk-taking" and safety is once again being sought. Consequently, the extraction of liquidity is also beginning to impinge on economic growth.

What strikes me as most interesting is that there is an inherent belief that economic growth, since the end of the financial crisis, has been organic in nature. There is a near complete dismissal of the fact that it was the deep suppression in interest rates that spurred the nascent recovery, the surge in asset prices and a return of speculative frenzy in the highest risk asset classes. In reality, had it not been for the Fed's unprecedented monetary actions it is likely that the post financial-crisis recession would have been far worse.

Literally 100% of economists currently believe that when the Federal Reserve tapers its bond buying program that rates will rise. As I have shown, there is no evidence to support that case. However, all of evidence points to the fact that when the Fed extracts liquidity - stock prices and bond yields do fall. Therefore, if the Fed wants interest rates and inflation to rise, they need to launch another "bond buying" scheme sooner rather than later. Otherwise, we are likely to see economic growth continue to drag in the months and quarters ahead which will continue to pressure interest rates lower. Such an outcome would be met with much disappointment by the many economists who continue to "hope" that an economic revival has finally arrived.

The case for being a bit more "nervous" about the stock market is clearly being built. The point here is that as a contrarian investor, when literally "everyone" is piling on the same side on any trade, it is time to step back and start asking the question of "what could go wrong?"

With economic data still very weak, valuations high, leverage extended and market internals weakening - the answer to that question is "a lot."

Source: TFTB - Likely Rates Will Continue To Fall