On Friday, the Bank of Japan promised a fresh round of quantitative easing, prompting a collapse in the yen, a surge in the U.S. dollar and marginal new highs in several stock market indices. Presently, internal dispersion and credit spreads remain wide – keeping our measures of market internals negative, at least for now. As I noted last week, “We remain quite agnostic about near-term market behavior. The next several sessions could contain a significant further short-squeeze or a vertical collapse, and we have very little predictive basis for that distinction.” That view hasn’t changed.
Last week’s advance brought the recent spike beyond the short squeezes that normally clear the first “air pocket” breakdown in market internals following overvalued, overbought, overbullish conditions (see Fast, Furious, and Prone-to-Failure). Those squeezes normally don’t take the major indices to fresh highs, though two central bank events in a single week undoubtedly played a role, and neither the Russell 2000 nor the NYSE Composite confirmed. The closest historical correlation to the recent short-squeeze is the spike that quickly brought the market from its May 1901 “air pocket” low to a fresh high in June of that year. That peak reached a Shiller P/E of 24 (S&P 500 divided by the 10-year averaged of inflation-adjusted earnings). The stock market still went on to lose half of its value from that June high (a fact that Steven Hochberg at EWI has also noted in a slightly different context). From a full-cycle perspective, we continue to view present conditions as among the most hostile in history. But we have no view at all about the near-term outlook except that the growing instability should be taken seriously, volatility may be quite high, and direction may shift on a dime.
At present, the entire global financial system has been turned into a massive speculative carry trade. A carry trade involves buying some risky asset – regardless of price or valuation – so long as the current yield on that asset exceeds the short-term risk-free interest rate. Valuations don’t matter to carry-trade speculators, because the central feature of those trades is the expectation that the securities can be sold to some greater fool when the “spread” (the difference between the yield on the speculative asset and the risk-free interest rate) narrows. The strategy relies on the willingness of market participants to equate current yield (interest rate or dividend yield) with total return, ignoring the impact of price changes, or simply assuming that price changes in risky assets must be positive because low risk-free interest rates offer “no other choice” but to take risk.
The narrative of overvalued carry trades ending in collapse is one that winds through all of financial history in countries around the globe. Yet the pattern repeats because the allure of “reaching for yield” is so strong. Again, to reach for yield, regardless of price or value, is a form of myopia that not only equates yield with total return, but eventually demands the sudden and magical appearance of a crowd of greater fools in order to exit successfully. The mortgage bubble was fundamentally one enormous carry trade focused on mortgage-backed securities. Currency crises around the world generally have a similar origin. At present, the high-yield debt markets and equity markets around the world are no different.
As we’ve detailed previously, zero-interest rate policy has very little historical evidence or compelling theory to recommend it. Rather, the policy is based on 1) the misguided belief that people consume on the basis of fluctuations in volatile asset prices and other transitory forms of income (a concept that Milton Friedman won a Nobel Prize largely for debunking), and 2) a view of the global economy as nothing more than one big interest-sensitive demand curve. See Broken Links: Fed Policy and the Growing Gap Between Wall Street and Main Street to review the reasons why suppressed interest rates have had such weak impact on global growth, despite fueling the third equity market bubble in 15 years.
Are suppressed interest eates 'stimulative'?
The Federal Reserve ended its program of QE on Wednesday. Even here, however, the members of the FOMC appear to believe that below-equilibrium short-term interest rates are somehow supportive to the economy. It doesn’t seem to even cross their minds to examine the historical evidence that no such relationship exists in the data.
For example, go ahead and estimate the quarterly change in U.S. real GDP using lagged (prior) quarterly changes in real GDP, lagged changes in short-term interest rates, the current level of short-term interest rates, the year-over-year CPI inflation rate and the unemployment rate. Now, completely drop the current level of short-term interest rates and those lagged interest rate changes from your explanatory variables.You’ll get a nearly identical fit. In other words, information about short-term interest rates has no incremental ability to predict subsequent economic growth. Whatever relationship interest rates have to subsequent economic growth is already contained in prior changes in GDP, unemployment and inflation. Interest rate changes are largely the results of prior measures of economic activity, not the causesof future economic activity.
Now, it’s certainly true that the Fed has lowered actual interest rates far below what GDP, employment and inflation would indicate. In fact, given present economic conditions, one would expect from historical relationships that short-term Treasury bills would otherwise be about 2.4% here. So zero interest rates are obviously the Federal Reserve’s doing. The question, then, is do deviations of actual short-term interest rates from expected interest rates provide information about subsequent economic growth? That is, can we find evidence that driving interest rates down more than justified by economic conditions is stimulative to economic activity? The answer: not at all. In fact, those deviations have literally zero explanatory power about subsequent economic activity.
The fact is that financial repression – suppressing nominal interest rates and attempting to drive real interest rates to negative levels – does nothing to help the real economy. This is certainly not a new revelation. In part, this fact can be understood by thinking about how interest rates are related to the productivity and quantity of real investment in the economy.
More than a decade ago, economist Alan Gelb (Financial Policies, Growth and Efficiency, 1989) examined historical economic performance for thirty-four countries, and found that the productivity of real investment (as measured by incremental output per unit of capital) is highly and positively correlated with real interest rates. Notably, however, the level real interest rates had very little to do with the observed quantity of real investment as a share of GDP (if anything, in U.S. data, we actually observe a tendency for fluctuations in gross domestic investment/GDP to precede changes in short-term interest rates with the same direction). Gelb demonstrated that real interest rates have an ambiguous relationship with the amount of investment that occurs in the economy, but higher real interest rates are clearly associated with higher productivity of investment and faster economic growth.
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