Q1 2011 Market Review: It’s Time to Raise Interest Rates

Since the financial panic of 2008, I have generally been an interest rate and inflation dove. In my view most of the inflation damage was done from 2001 to 2007, not in the time after the financial crisis. The combination of the TARP and Fed policy halted a potentially deflationary downward spiral in prices and asset values. Now, however, the economic need for monetary support is over and business investment, which is and always has been the driver of self-sustaining economic growth, is rising again. Waiting for residential real estate investment and construction employment to recover before declaring economic growth self-sustaining would be as foolish as the mistake of the early 2000s when Alan Greenspan waited for technology investment to recover from the dot com bust even as real estate investment was roaring ahead. Today we effectively have the same situation in reverse. The market is sending its classic signals that global monetary policy is too easy. While I place more blame on the central bankers of emerging market economies like China, there are several market signals that are telling us that US monetary policy is too loose as well.

I have gradually come to the conclusion that our forty year experiment in using monetary policy to manage the economy has failed. Monetary policy has been used to drive up asset prices and support the use of financial leverage while eroding our purchasing power by encouraging inflation. Higher asset prices and supportive credit markets are great for the elites, who can use their knowledge of the financial markets and already ample capital bases to accumulate more assets. This state of affairs is harmful to the middle class, however. As inflation eats up middle class purchasing power, they have turned to borrowing to support their lifestyles. The middle class’ borrowing backfired royally with the housing bust of 2007-2011, yet the Fed’s economic remedy remains the same…encourage borrowing, support the financial sector and prop up asset values with ever-lower interest rates.

It is now time to normalize interest rates. The financial instability of wildly swinging interest rates, asset values and debt levels accrues to the benefit of the financial sector at the expense of the real business sector. If the Fed focused on policy stability, there would be far less need for hedge funds, commodities traders, bond traders, private equity funds and the seeking of profits via financial engineering. There would instead be more focus on trying to earn returns from actual investment in productivity-enhancing business investment. America has one of the most innovative and productive financial sectors in the world, but even I, a member of that financial sector, must admit that it has grown too large relative to the non-financial economy.

Interest rates

Source: Bloomberg, Vanguard Funds, tylernewton.com

The yield curve is telling us that inflation is expected to be well higher than the Fed’s target range of just under 2% for the 10 and 30-year time horizons. 5-year Treasury Inflation Protected Securities (“TIPS”) yields are negative, and treasury yields of less than 10 years are well below their equilibrium levels, signaling that the market expects the Fed to leave rates low for too long and then lose control of inflation.

The long end of the yield curve continues to offer the most value, particularly among treasuries and munis, even with the current market view of inflation. If inflation expectations come down, we could see another rally in long bonds.

The dollar

Source: economy.com

The broad real dollar index has for the first time punched well below 85. It is also trading at the bottom of the range relative to the major currency index as well. It should be noted, however, that dollar bear markets have tended to last about 10 years (1968 to 1978, 1985 to 1995), meaning that cycle timing-wise, the dollar bear that began in 2002 may be due to end and that the dollar may be ready to enter one of its periodic 7-year bull markets (1978-1985, 1995-2002). It may be time for the Fed to tighten if only to focus on strengthening the dollar a bit.

Commodities

Source: economy.com, tylernewton.com

The ratio of commodity prices (CRB futures index) to the Consumer Price Index (CPI) is at the highest level since the early 1970s. Commodity prices are a leading indicator of broader inflation.

Most are aware as well that the price of gold, widely viewed as a neutral currency, has been skyrocketing for some time now.

Source: economy.com

Housing

The housing bear market continues, but may be nearing the bottom. Expect a rounded bottom in the housing market over the next several years, regardless of Fed policy.

Source: Standard and Poor’s, economy.com, tylernewton.com

Stocks

My market valuation model (which uses inflation-adjusted trend earnings) shows stocks to be fairly valued currently.

The 6.8% return implied by today’s S&P 500 is driven by a long term inflation assumption of 2.8%. If inflation expectations drop, so will the stock market.

Conclusion

If interest rates get normalized on a schedule faster than the market currently expects, short and intermediate term interest rates will rise and stocks will likely fall somewhat. I don’t think the housing market would be affected, as the market is not moving higher even with the current ultra-low interest rates. So yes, tighter monetary policy would be a moderate negative for the financial markets. To this I am finally saying, “So what”? It’s time to wean ourselves off our need to surf from financial bubble to financial bubble and get back to the hard work of building the real economy.

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