The backwards logic of QE’s supposed wealth effect

The Federal Reserve has recently admitted, through various policy speeches and interviews, that quantitative easing’s primary goal was to foster a wealth effect by raising asset prices across the board.

If that’s true, then why did the middle class largely evaporate over the same period?  Because the middle class does not own large amounts of financial assets.

Numbers don’t lie

Income inequality and wealth inequality are significant issues. The problem is growing and will continue to do so because the monetary policies enacted thus far have exacerbated the underlying imbalances in the economy.  Growing the wealth of the wealthy at the expense of the rest of the population is not only counterproductive, it’s actually dangerous.

The primary driver of US economic activity is consumption.  That means that a prosperous middle class is critical to a flourishing US economy.  Spenders that have an increased sense of wealth and rising incomes will buy larger homes, make more discretionary purchases, be better equipped to support larger families and ultimately that adds to our GDP.

Economic sanity must be restored

Favoring the wealthy and large corporations has created the problems that our economy will face in the future.  Adding to that, the enormous student debt owed by today’s generation of new entrants to a workforce with less high paying jobs will significantly hinder their ability to buy a home, car or make large discretionary purchases.  Thus robbing future demand from the economy.

This is a significant headwind for the US economy as we move forward in to a future that has been defined by the actions of today.  The only means of reaching an escape velocity whereby the middle class can thrive again is to re-examine the current economic paradigm with a focus on the future.  And I don’t mean in terms of 4 years or the next election cycle.

We can decide our destiny

The future of our country can be a wonderful one should we so choose to exert the effort necessary to make it so.  But that will mean difficult choices about spending priorities, it will mean forgiving large amounts of student debt and favoring the individual over the interests of the corporation (as a change).  It will mean bringing back regulation that strengthens oversight of Wall Street and banks (Glass-Steagall would be a good start).

Most importantly, though, we need to focus on our country.  Minimizing participation in global conflict and putting forward programs to rebuild our nation’s infrastructure.  Our roads, trains, power lines, water pipes and broadband delivery systems can all use a massive investment to bring the US back to being a global leader. A position we have earned, but have failed to maintain.

Seesaw market creates opportunities in volatility

There is a lot of emotion charging the market, creating exaggerated moves both up and down.  One day everything is fixed, the next everything is broken.  Manic depression wouldn’t even begin to describe the back and fourth being witnessed.

But with chaos comes opportunity.  And the opportunity here is finding beaten up, misunderstood and frankly cheap assets.  Right now the areas that seem to be most attractive are commodities, commodities companies, energy and energy companies.

The global markets are pricing in worldwide depressed demand.  Oil producers are pumping at frantic rates, more concerned about the flow of cash than the margin on each sale.  This has created a glut of energy supply — and with little demand oil prices have crashed below $30.00 to about $28.00 a barrel for West Texas Intermediate Crude (WTIC).

Consider the following opportunity: The US dollar has had a rally which induced a de facto tightening even before the US Federal Reserve raised interest rates.  As such, one can reasonably expect that the actual pace of interest rate tightening, with the backdrop of a softening US economy, will likely be subdued.

Markets have priced in a more aggressive interest rate hiking cycle, which is putting pressure on everything that’s priced in dollars.  Even stocks.

I think that we’re getting ahead of ourselves here.  The Federal Reserve is unlikely to let this situation turn in to a full blown 2008 panic again, unless there is a desire to bring back all the calls to audit the Fed and the political upheaval that protests and social unrest would bring.  Instead, especially given that it’s a critical election year, I believe the Fed will tap the breaks and ease off the gas, leaving interest rates at 0.25% and possibly cutting them to negative levels if the global slowdown increases in momentum.

It may be the worst time in US history to buy real estate

The prevailing belief that helped to spark the last housing crisis was that homes are an investment.  That price will keep going higher.  We’re now 8 years out of the peak of the last housing bubble.  But have we formed a brand new one with reckless monetary policy?

US home prices rose 35% in the last four years

CASE SHILLER

The S&P Case Shiller housing index (above) shows an ominous chart of home values.  The first take away is that even 8 years after the previous housing crisis, prices have not returned to their previous highs, despite a large increase.  And this is with the backdrop of the most accommodative monetary policy in US history — with specific support for mortgage backed securities to help lower interest rates on borrowing.

Adjusted for inflation that gain is muted

Prices, when adjusted for purchasing power, are not responding to stimulus as policy makers may have hoped.  This means that while housing prices have gained in notional value, the purchasing power of the dollar has weakened during that period enough to offset much of that gain. So much for being a promising investment.

Cheap debt is the key to this bubble

The largest support mechanism in place for the current housing market’s uptrend has been very, very low interest rates. Some would say this presents a fantastic opportunity to buy a home with a lower monthly mortgage rate.  But what’s not factored in to that logic is everyone else has the same idea — and thus there is an extremely high amount of artificial demand pushing prices up from borrowers who otherwise could not afford to take out a mortgage on a property that is overpriced.

rates

The normalization of interest rates would turn this support mechanism on its head and begin to drain excess demand from the housing market.  Whether that happens because the Federal Reserve begins a tightening cycle or because mortgage backed security holders become nervous and begin to sell their assets remains to be seen.

Knowing that the primary support mechanism for the current housing price boom is entirely artificial, and has been for the better part of the last decade, is an important foot note at the very least.  It may even prove to be the signal that tells us when this latest housing bubble may pop.

Once more, the housing market is entirely dependent on the stability of and confidence in global financial markets.  Any market meltdown will have a profound effect on the housing market.   And every financial market is interconnected to such an extent that a problem in Shanghai can become a problem on Wall Street very quickly.

In conclusion

Prices are artificially high because of monetary stimulus, not a booming economy.  Affordability is near all-time lows for similar reasons.

These gross distortions have created an unsustainable paradox: Houses priced beyond the reach of most Americans — while wages stagnate, labor force participation is at multi-decade lows and the next generation of consumers has an enormous student debt load preventing them from buying a home.

If you are selling a home, this is probably the best time in recent history to exit the real estate market to reduce risk.

If you are buying a home, be extremely careful.  And be prepared to lose a good chunk of that home’s value (or wait until prices normalize and buy in at what will likely be a much lower price).

Psych! No hike.

With all the prognostication of an interest rate increase happening from Fed watchers and certain economists, I feel a sense of Deja Vu for previously expected rate hikes in this business cycle.  There was no hike, no easing — just more of the same.  What does it all mean?

It’s the economy, stupid.

We’re not recovering. The Fed can see that in its magic crystal ball of financial and economic data. There are even hints of deflation in consumer prices.  Oh no, perish the thought of things getting cheaper when people have less to spend!

What about December?

Hiking near Christmas would make the Fed the Grinch Who Stole Christmas!  It won’t happen.  The next chance is going to be in 2016.

How did markets react?

The Dow briefly turned negative, the S&P shrugged off some of its modest gains and the US dollar dropped.  Some commodities are gaining — as they should — because the dollar’s strength was pushing them down.  And that strength was built on the rumor of a rate hike.

Where do we go from here?

Expect more jawboning about rate hikes, but a hesitant trigger finger.  I don’t think global markets, let alone our own, can withstand higher interest rates.  Ultimately, however, the Fed is losing credibility here — and fast.

Markets mixed ahead of Fed

A little up, a little down. No real certainty to go around.

Things are going to be quiet until the big decision day.  Economists and market mavens can’t decide whether the Fed will engage in more QE, keep rates as is or hike (and if so by how much).

This means the Fed is doing part of their job well.  Forecasting everything ahead of time would leave market participants tempted to front run events like interest rate hikes with their bets.

On the other hand, the lack of certainty also shows that the recent market volatility may have the Federal Reserve Board divided as to how tight financial conditions may be with an interest rate raising cycle coming on to the horizon.

There’s going to be a lot of volatility when the decision comes out. Probably best to expect large price moves with air pockets in the volume of trade — meaning a whipsaw effect up and/or down as the news breaks.

It’s generally a good day to sit on the sidelines and watch the markets rather than participate.

Reaching escape M2 velocity

Velocity of money is the measure of the speed in which money is changing hands. Higher levels of velocity indicate more economic activity and may also indicate more confidence to spend money in to the economy.

m2m

In the last 15 years the velocity of money, as measured by the M2 money chart above, has dropped significantly.  In an even more dramatic fashion during (and after) the 2008-2009 financial crisis dubbed, “The Great Recession.”

With an enormous amount of liquidity (about $4.5 trillion) injected in to the US banking system, one would expect this chart to be much different in appearance.  Apparently large financial institutions are not lending or investing at the pace in which the Federal Reserve had hoped to engender more economic activity.

One then must wonder what happens in an interest rate tightening cycle to the velocity of money.  How does the United States economy reach escape velocity with deflationary forces firmly in control — and our central bank intent on tightening the supply of liquidity?

Next week should be quite revealing.

US stocks reverse gains to close in red

Reversals lower from a morning that began green often portend to more selling pressure in the coming days.  Today was such a day in the US stock market.  Prices opened strongly higher and closed decidedly in the red.

Reversals show a sentiment change

When buyers pile in the morning and exit with prices lower at the close than they were the previous day’s close, that indicates a change in investor confidence.  Selling pressure exhausted the bid from buyers to the point that many buyers became net sellers.  As a result equity markets went from being positive, to neutral and finally settling decidedly negative from the previous day’s close.

When this sort of change in confidence occurs it is often a multi-day or week event, rather than a one off.  With the much cited Federal Reserve interest rate policy decision just about a week away, there is the potential for increased anxiety across multiple interest rate sensitive asset classes, including stocks.

Bears growl, bulls hide

For the first time since the correction of 2011 the markets are not seeing an immediate buy the dip rally that sustains itself to new highs.

Bears are wrestling for control over price direction with bulls.  Each have differing opinions on stock valuations and are expressing them with their trades and investments.  Where prices ultimately go will depend on whose convictions prove to be correct.

For now the bulls are retreating as the bears show their teeth.

Quantitative deflation? Central planning gone awry.

In what may be a surprise to many, quantitative easing appears to be helping to engender an atmosphere of commodity deflation.

Can printing money cause prices to drop?

The creation of trillions of dollars of liquidity has created an interesting paradoxical effect on commodities. If a business is able to finance a resource extraction project which is sustaining a loss, and that funding becomes cheaper than shutting it down entirely, then operating at a loss may become the ‘new normal.’

As a result, those very same companies are selling their product for less than it costs them to extract it.  Additionally, and perhaps equally importantly, this adds to supply at artificially low prices creating a distortion in prices downward.

Meanwhile, demand dries up because the same monetary policy transfers wealth (and purchasing power) from consumers to what the financial media calls the investing class.

Beyond a mere thought experiment…

This increase in supply and drop in demand appears to be evident across many elements of the commodity spectrum right now, including perhaps most visibly energy and metals.

Extraction of resources continues, perhaps at a slightly slower pace, but at much higher levels than if financing were more expensive (or the cost of idling operations was lower).  This is especially evident in the North American shale gas industry and in many oil suppliers inside and outside of OPEC.

Additionally, many gold miners continue to operate at a loss rather than throttling production or shuttering mines.

Such a paradox has two major problems:

1: Should such activities of pulling future demand in to today’s artificially low prices continue it will cause significantly higher resource utilization, leading to more pollution, misallocation of resources and poor planning.

2: A lack of future resource availability sets the stage for significant structural economic problems.  The misallocation of resources and resulting poor planning would lead to less demand for renewable energy sources and their development, as an example.  In effect the first problem makes the second worse.

Bears set the stage for bulls

When such a fantastic crash in commodities happens, it cannot be ignored.  We’ve seen commodity index prices across many measures crash to levels not seen since the late 1990s.  Part of this has to do with an ailing China, but the other component, the lack of supply destruction, has to do with the aforementioned financing making continued operations more sensible on paper than throttling or shutting down extraction projects.

As a result, it would appear as though we are in the midst of a vicious commodity bear market that could be setting the stage for an incredible bull market in commodity prices.

As misallocation of resources leads to a lack of availability when demand does return, this will in turn cause a significant price shift higher as prices must destroy demand that cannot be met by supply.

Shifting sentiment can take years

The lead time for companies to re-expand their operations and engage in additional exploration generally takes years.  That is to say, the shifting mindset from one of conservation of capital to one of speculation and euphoria will not happen overnight.

When it does, however, this bear market may be seen as a generational opportunity to have invested in commodities and the companies that produce them at a fraction of their fair market value.

Japan’s Nikkei surges almost 8% higher on policy hopes

One of the largest stock markets in the world made one of its largest moves ever on the hope that the Bank of Japan will continue to inject liquidity in to equity and bond markets.

How are prices discovered now vs. then?

There is nothing normal about the price discovery mechanism in global stock markets these days.  Instead of economic activity, earnings and other catalysts the biggest driver of rallies and declines has been central bank chatter and policy.

This disruption to a fundamental component of the financial marketplace renders the ability to use current prices null and void.  Because if prices of assets are reacting more to central planning efforts and rumors than actual meaningful data on the ground, then they are not reflecting reality.  Traditionally price discovery helps market observers determine more information about economic and financial health.

Is this the growl of a new bear?

Bear market rallies tend to be some of the most fantastic moves one will ever see and Japan saw a similarly large rally in 2008 — followed by years of sideways trading until Abenomics came in to existence.

Japanese QE-to-infinity seems to have only two effects.  Reducing the purchasing power of the Yen and increasing the perceived value of Japanese stocks.  Economic activity in Japan continues to ebb lower and the threat of recession looms large.

Be careful and be nimble.

As a result, I remain highly skeptical that we are out of the woods or that this is the kind of activity a healthy bull market should see.

If anything this most recent rally may be faded (sold by traders) as a confirmation that it was merely a bear market pop.