John Hussman: A Fed-Induced Speculative Blowoff

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (12/27/10):

Why are Treasury yields rising despite hundreds of billions of Treasury purchases by the Federal Reserve? There are two possibilities in the current debate. One is that the Fed's policy of purchasing Treasuries has scared the willies out of the bond market on fears of higher inflation, and that the policy is a failure. The other is that the policy has been such a success at boosting the prospects for economic growth that interest rates are rising on anticipation of a better economy.

From our standpoint, neither of these explanations hold much water. On the inflation front, the recent bond selloff has hit TIPS prices as well as straight Treasuries, which isn't something you'd expect to see if inflation expectations were being destabilized. And although precious metals and other commodity prices have been pressed higher, the commodity run can be more accurately traced to negative real interest rates at the short-end of the maturity curve, coupled with a downward trend in long-term yields that has now reversed dramatically (more on that below). I've long argued that unproductive government spending and profligate fiscal policy are ultimately inflationary (regardless of how the spending is financed, and particularly if it is monetized), but I continue to view persistent inflation as a long-term, not near-term concern. A rise in T-bill yields of more than 15-25 basis points would change that assessment. Until then, velocity can be expected to collapse in direct proportion to changes in the monetary base, with little impact on prices.


In short, the main effect of QE2 has not been monetary but has instead been rhetorical - and that rhetoric may very well be nearly empty.

The key event related to QE2 wasn't its formal announcement, but was instead the Op-Ed piece that Ben Bernanke published a few days later in the Washington Post, which essentially advanced the argument that the Fed was targeting a "wealth effect" in stocks and other risky assets, in hopes of getting people to consume off of that perceived wealth. At that moment, Bernanke unleashed a speculative bubble in risky assets, and a selloff in safe ones. This has rewarded risk-seeking and punished risk-aversion, but it has also unfortunately driven the markets into an overvalued, overbought, overbullish, rising-yields condition that has historically ended in steep and abrupt losses.


In short, we are observing what can only be described as a Fed-induced speculative blowoff. While this has been avidly encouraged by the Fed, it is important to recognize that there is no actual economic mechanism at play here other than words. Investors are chasing stocks because Ben Bernanke told them to, and despite the fact that we have seen two plunges of more than 50% each over the past decade, investors are at least temporarily willing to believe that the Fed will "backstop" their risk-taking by preventing the market from falling. As for any "transmission mechanism" attributable to QE2 itself, Treasury yields and mortgage rates have increased sharply since the Fed first announced QE2, and the additional reserves created by Fed purchases have simply added to the already massive and idle pool held by banks. Unless one twists logic into a pretzel so that up is down, one can identify nothing of substance in the Fed's policy that is supporting the markets. Stocks are being buoyed solely by a combination of words, sentiment and superstition. As Stevie Wonder put it, "When you believe in things that you don't understand, then you suffer."

From a longer-term perspective, the simple fact is that Fed-induced bubbles do not change the long-term mathematics of investment returns, which are based on deliverable cash flows. Over the short-term, Fed actions can undoubtedly postpone market declines. But as we've repeatedly observed, the Fed can do so only by making those losses far worse when they arrive.