The Ultimate Wall of Worry
02/28/06
The Federal Reserve started raising interest rates in summer of 2004. The goal was to withdraw in measured steps the monetary accommodation from the financial system that had been provided through a series of interest rate decreases after the tech bubble burst in 2000. These interest rate decreases and the necessity to fight deflation (the speech which made Bernanke a household name was entitled: "Deflation: Making Sure "It" Doesn't Happen Here") provided this country and by extension the rest of the world with interest rates that had not been this low in half a century. Throughout this 350 basis point journey, the stock market continued to rally through each and every additional rate increase. It was not always pretty, we saw plenty of setbacks and there was always worry about how much setbacks the economy could stand. In the end however, some 2 years later, all major indices have reached new highs for the post bubble recovery. The question arises, how can it be possible that stocks rise throughout an entire tightening cycle, contrary to what happened in earlier tightening cycles, where the mantra was always: "don't fight the Fed" . This mantra was ingrained in people, it actually was beaten into us by the experienced investors of their time. This mantra after all kept your capital losses small and your portfolio intact during times when the Federal reserve did their dirty job and stock prices declined. In 1994 for example, Mr. Greenspan's tightening campaign send long bond prices tumbling and long-term rates soaring, which caused enormous losses in bond funds and ultimately led to the bankruptcy of Orange County. The NASDAQ had lost over 15% by the middle of that year. Not so this time around. If you would have stayed out of the market as soon as the Fed started raising interest rates, you would have been missing out on plenty of capital gains.
The picture above shows the Fed Funds Rate, which is the overnight lending rate between banks and is directly determined by the interest rate policy of the Federal Reserve (blue) and the yield on 10-year government bonds which is determined my the free market forces of supply and demand (red). You can see that 10 year yields experienced a parallel shift in 1994 and in 1999/2000, because they rose by the same amount as Fed Funds.
However, each time they started from a lower base. In 1994 They started from 5.5% and ended up at 8%. In 1999/2000 they started from 4.5% and ended up at 6.5%. In 2004 they started at 3.5% and are currently at 4.5%. There are many reasons for this "unorthodox" (or is it "newly orthodox") behavior of bond markets, which we discussed in earlier newsletters.
1. Excess global savings, accumulated under rough conditions in emerging markets are looking for a safer home, where the rule of law is not constantly challenged and where the risk of political instability is minimal.
2. Under-funded pension plans in the US, Japan and in Europe need to catch up in order to stay in compliance with tougher regulations. They need to be able to guarantee the liabilities that will arise in
10 - 20 years with corresponding assets in the form of fixed income instruments.
3. The global labor arbitrage compresses wage inflation, causes a decline in inflation expectations and lowers yields on long term instruments.
4. Excess manufacturing capacity in the developed world and the lack of new profitable manufacturing projects leads to the accumulation of excess capital in corporate coffers, which is being invested in government obligations.
All these factors have conspired to keep interest rates low for longer than anyone would have thought possible.
The picture above shows the amount of government securities held by the Federal Reserve on behalf of other foreign central banks. As you can see, the trend is still up and has been accelerating recently. So let us not forget about these Zombie buyers. They are still building foreign currency reserves in dollar denominated fixed income instruments. Their buying also has kept the 10 year yield low.
So what is going to happen when the Fed stops raising interest rates? I think it will mark the top in the stock market as well. Once demand in the developed world for cheap imports declines, the emerging markets will no longer be able to grow through exports. Their growth will falter along with ours and along with it their current account surplus and the demand for US bonds. Once the Federal Reserve realizes that the economy is slowing to much, it will be too late. The recession will be at hand and the Federal Reserve will have ovderdone it again. When will all this happen? I don't know, but as long as Bernanke raises interest rates, the stock market should be OK thanks to excess liquidity and worldwide growth. Our capital market depends more than ever on the well being of the global economy. Let's hope that our protectionist politicians learn that lesson soon.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
