Brave New World of Suppressed Interest Rates

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
-Ludwig von Mises

"One of the most important things I've come to understand is that most of the processes that go into everyday decision making are subconscious and more complex than is widely understood."
-Ray Dalio

"You can ignore reality, but you cannot ignore the consequences of ignoring reality."
-Ayn Rand

Historically, the return on stocks has far exceeding the return on bonds. But, that isn't true when stocks start from elevated valuations. Warnings signs come in all shapes and sizes. Either you look actively for them, or they come to you. Ultimately, it's up to the investor whether to acknowledge them or not. Given the deceptively strong performance of the market, consumer confidence has gotten a boost. Evidently, investors are choosing to ignore any information that's contrary to achieving high returns. This has induced a feedback loop where strong consumer confidence has helped prop up the market. But that doesn't mean that the Fed and other central banks haven't offered their share of hand-holding.

According to The Wall Street Journal [1], not only are policy makers keeping rates steady, they're already taking action to make low-cost loan financing available to banks in order to stimulate lending activity. In addition, they're implementing measures to exempt member banks from fees imposed by the ECB for parking their excess reserves there.

In the words of Jim Grant [2], what's the zeitgeist? Investor complacency is pretty widespread. The Fed's policy of near-zero interest rates have continued to encourage speculation. As for European investors, they're willing to accept increasingly negative yields, as opposed to cash. Currently, around 20% or $11 trillion worth of bonds worldwide are priced to yield less than zero. To put this in real terms, given that treasuries are the benchmark for inflation (2.4%), these bonds are yielding negative returns. What are the incentives for Eurozone central banks? They're trying to suppress currency appreciation for as long as they can. And investors are happily paying the price. Isn't ignorance blissful?

While self-reinforcing positive feedback loops may dominate the short-run, mean-reversion ultimately takes over in the long-run. Current extremes may be hailed as a virtuous circle to the unsuspecting, but in reality, it's driven by the viciousness of credit. It's the astute investors who watch for the cracks to appear in the form of unfavorable market internals.

Chart #1 - The divergence between stocks and bonds. Takeaway: weakness bond market often precedes weakness in the stock market. Other notable divergences include those between utility stocks and treasuries, with returns for utilities outperforming the "safe haven" asset. Usually when this occurs, recession is near.

Source: WSJ

Chart #2 - S&P 500 "Triple Top." Takeaway: Most US stocks are topping out, and are met with technical resistance when attempting to make new highs. This is a sign of weakness ahead, and it's only a matter of time before it's all downhill from here...

Source: Yahoo! Finance

Chart #3 - Net Flow in and out of Europe equity funds Takeaway: Tell-tale of weakness in European equities. Reminiscent of past cycles where Eurozone crises precede US ones.

Source: WSJ

Chart #4 - Velocity of M2. Takeaway: The velocity of money has dropped below the level that was necessary to maintain to productive economy in 2009. While the Fed has yet to cut rates, it's inevitable that the central bank will undergo some sort of QE or stimulative effort to increase the M2 velocity.

[1] Negative Yields Deepen Along with Europe's Problems - WSJ
[2] The World-Wide Suppression of Interest Rates Has Been Something Very Near to a Crime - the market NZZ

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