Erik McCurdy's  Instablog

Most mainstream analysts praise the programs implemented by the Federal Reserve during the last several years under the leadership of Chairman Ben Bernanke. Many believe that the historic amount of monetary stimulus injected into our economy has helped it to heal following the severe recession in 2008. Unfortunately, the reality of the situation is that the structural deficiencies that plunged our economy into the worst recession since the Great Depression still exist. Instead of addressing the underlying problems, the Federal Reserve has chosen to provide superficial, short-term fixes in an attempt to create the appearance of substantive economic recovery. However, until the excessive debt problem is addressed in a meaningful way, our economy will continue to struggle, experiencing substandard growth and remaining vulnerable to shocks. Additionally, the short-term fixes applied by the Federal Reserve have significant unpleasant consequences that will also need to be addressed. Fund manager John Hussman discussed those consequences in his latest weekly commentary and we have reprinted an excerpt below.

Government intervention in the U.S. economy is approaching the point where probable long-term costs exceed short-term benefits - straining to maintain the pace of extraordinary fiscal and monetary measures that have repeatedly nudged the U.S. economy from the border between new recession and tepid growth for three years. U.S. Treasury debt now exceeds 105% of GDP (publicly held debt approaching 75% of GDP). Meanwhile, the Federal Reserve has expanded the monetary base to more than 18% of GDP (18 cents per dollar of nominal GDP), where a century of U.S. economic history indicates that a normalization to Treasury bill yields of just 2% could not tolerate more than 9 cents of monetary base per dollar of GDP without inflation.

The federal government continues to run a deficit of about 7% of GDP, which the $85 billion sequester would reduce to about 6.5% under the unlikely assumption that economic activity and revenues don't contract somewhat. Current Federal Reserve policy absorbs about $45 billion per month in new government debt as part of QEternity, but even the Fed continues this policy indefinitely, U.S. publicly held debt is still likely to expand by several percent annually assuming no recession occurs. Any eventual normalization of Fed policy would dump Treasuries back into public hands (or require public purchases of new debt in the event the Fed decides to let the holdings "roll off" as they mature). Massive policy responses, directed toward ineffective ends, are scarcely better than no policy response at all.

To offer a visual picture of where monetary policy stands at present, the chart below depicts the current situation, as well as data points since 1929. As of last week, the U.S. monetary base stands at a record 18 cents per dollar of nominal GDP. The last time the monetary base reached even 17 cents per dollar of nominal GDP was in the early 1940's. The Fed did not reverse this with subsequent restraint. Instead, consumer prices nearly doubled by 1952. At present, a normalization of short-term interest rates to even 2% could not be achieved without cutting the Fed's balance sheet by more than half. Alternatively, the Fed could wait for nominal GDP to double and "catch up" to the present level of base money, which would take about 14 years, assuming 5% nominal GDP growth.

Of course, 5% nominal growth would likely make it inappropriate to hold short-term interest rates below 2% for another 14 years. So either the Fed will reverse its present course, or we will experience unacceptable inflation, or we will experience persistently weak growth like Japan has experienced since 1999, when it decided to take Bernanke's advice to pursue quantitative easing. My guess is that we will experience unacceptable inflation, beginning in the back-half of this decade.

 

 

(click to enlarge)

Because of the strong relationship between the size of the monetary base (per dollar of nominal GDP) and short-term interest rates, it appears likely that short-term interest rates will be suppressed by Fed policy for some time, until Fed policy normalizes or inflation accelerates. The Fed is now leveraged 55-to-1 against its own capital. With an estimated duration of about 8 years on $3 trillion of bond holdings, every 100 basis point move in long-term interest rates can be expected to alter the value of the Fed's holdings by about $240 billion - roughly four times the amount of capital reported on the Fed's consolidated balance sheet.

Ultimately, the normalization of the Fed's balance sheet - outside of weak economic conditions - is likely to press long-term interest rates markedly higher. This would be particularly true in the event that inflation accelerates and forces that attempt to normalize, which we expect in the back-half of this decade. As a result, the next economic recovery will very likely be associated first with a significant steepening of the yield curve, and only later by an inversion as the Fed scrambles to tighten. But in my view, the time to expect higher interest rates is not now.

I continue to expect that the course to the next economic recovery is likely to be punctuated by a global recession that is already underway in the rest of the developed world. At best, U.S. participation in that downturn has been kicked down the road for a quarter or two by QEternity. It also remains possible the final revised data will indicate that the U.S. entered a recession sometime in the third-quarter of last year. Meanwhile, immediate inflation risks do not appear pressing (despite the increase in longer-term inflation expectations), and the overwhelming negative sentiment toward bonds seems likely to be replaced by a flight to Treasuries as a safe haven. The same should not be assumed for corporate or high-yield debt, where yields have plumbed historic lows and current risk premiums appear barely sufficient to cover actuarial default risks.

By varying the amount of monetary base relative to nominal GDP, the Fed has very tight control over short-term Treasury yields and some control over the long-term yields that reflect expectations of the future course of short-term rates. But quantitative easing has also had an effect in suppressing risk premiums in securities that have much less dependence on the course of short-term rates - particularly junk rated debt, corporate debt, and stocks. The apparent blind faith in an automatic link between Fed easing and diagonally rising prices is not supported by the data, however much an uncorrected rally makes it seem otherwise.

The present syndrome of overvalued, overbought, overbullish, rising-yield conditions is the same basic environment that concerned us in 2007, and in 2000 (as well as May 2011, just before the market experienced a near-20% swoon). While the Fed continues its policy of quantitative easing, that policy is fully recognized and investors now fully rely upon its continuation. It is also an element of common knowledge that "everything will be fine until the Fed reverses course," at which point everybody will presumably be able to sell to nobody. Unfortunately, the support for such complete confidence in Fed policy is vastly overstated.

The long-term cycle of the stock market has a period of approximately 48 months. Prior to the market crash in 2008, long-term cycle lows (LTCLs) occurred as expected about every four years. However, extreme market events such as a crash often result in time compression, causing cycles to be shorter than normal. The 2008 crash was no exception and the last LTCL in early 2009 formed only three years after the previous low.

 

 

(click to enlarge)

The cyclical bull market that began at the last LTCL is now four years old, a duration that is much longer than the typical cyclical uptrend that occurs during a secular downtrend. Therefore, the latest cyclical top is long overdue and it could form at any time. The violent advance off of the 2009 low has been fueled in large part by a historic amount of government intervention as the Federal Reserve has sought to inflate risk assets such as stocks by driving investors away from safety. However, the massive injection of liquidity during the last few years has created proportionally massive market imbalances, and, unless one subscribes to the notorious "this time is different" philosophy, hundreds of years of market history suggest that the inevitable corrective move of the next cyclical bear market will also have a violent, extreme character.

 

 

(click to enlarge)

Of course, when an advance becomes this speculative in nature, the move can remain overbought for an extended period and predicting the timing of the inevitable turn with a high degree of statistical confidence is difficult. However, the judicious application of chart analysis enables us to identify conditions that favor the development of a cyclical top. For example, the current intermediate-term cycle from November has struggled to advance during the last four weeks and a cycle high setup has been in effect since last week, indicating that the latest intermediate-term cycle high (ITCH) may have formed in late February. This would be an important development because, given the extremely long duration of the current cyclical bull market, any confirmed intermediate-term high is also a potential cyclical high.

 

 

(click to enlarge)

Regardless of when the latest ITCH develops, the short-term view suggests that we are on the verge of a substantial correction. Moves that occur in the direction of the primary trend, which in this case is up, often take the form of a five-phase wave. The advance off of the low in November is a typical example of this type of move and the fifth and final phase is likely in progress. Therefore, the short-term uptrend will likely terminate at either the alpha high (AH) or the beta high (BH) of the short-term cycle that began last week.

 

 

(click to enlarge)

 

 

(click to enlarge)

It is the character of the forthcoming correction that will provide the next assessment of bull market health and determine if the latest ITCH is also a likely cyclical top. Therefore, it will be important to carefully monitor market behavior during the next several weeks.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The S&P 500 index reversed early gains to close sharply lower today, retreating further from recent highs of the cyclical bull market from 2009. The index has declined nearly 3 percent during the last four sessions, retracing the gains of the previous 20 sessions. This is the type of violent overbought correction that we have been expecting and it is likely that price behavior will return to support at the lower boundary of the short-term uptrend from November currently near 1,470.

 

 

(click to enlarge)

With respect to cycle analysis, the beta phase decline continues to develop as expected following the cycle high signal on February 20.

 

 

(click to enlarge)

Although the decline from last week has been predictably violent, it is important to note that the current cycle from late December continues to exhibit a very bullish translation. Therefore, it will be important to monitor the development of this beta phase decline closely for the next assessment of uptrend health.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.