It used to be that the bond market was the most reliable place to get a read on the future direction of the economy. I don’t know if that’s because bond investors are smarter than stock investors, or that the bond market is simply much larger and more liquid than the stock market. Whatever the case, many stock investors used to take their cues from the bond market, increasing their risk tolerance as longer-term bond yields were rising and reducing risk as longer-term yields were falling.
The logic is fairly simple. If economic growth rates are improving, both components of nominal interest rates – real rates and inflation – should be increasing as well. First, the real rate of interest should increase because a strong economic backdrop generally brings greater opportunity to turn borrowed money into big profits. At the same time, the demand for goods and services generally increases in an improving economy, putting upward pressure on the prices of those goods and services. Because these two components of nominal interest rates, the real rate and the inflation rate, both generally go up in periods of accelerating economic growth, it’s easy to see why interest rates serve as important tea leaves for the future direction of the economy.
It also used to be a rule of thumb that commodity prices were a fairly reliable indicator of economic trends. The logic here is straightforward as well. Assuming supply remains constant, growing demand for commodities will result in higher prices. As a result, many investors will look to the price trends in oil, copper, agricultural products, precious metals, and many other commodities in order to get a read on demand and therefore economic strength.
So why haven’t these two economic indicators worked during the course of this economic recovery. Interest rates and commodity prices continue to plummet despite US economic data that, on the surface anyway, continue to improve. What’s different this time?
Well, one obvious answer is that we now live in a global economy. The prices of money and commodities are not simply a function of US demand, but rather they reflect demand throughout an increasingly interconnected world. Most notably, the rapid growth of the Chinese economy in recent years has resulted in reduced importance for the US economy. Twelve years ago the US accounted for about a third of global GDP, and that percentage has fallen to about 22%. So for many years, a huge surge in demand for commodities in China drove the prices of oil, construction materials, and other commodities through the roof. More recently, however, growth in China has slowed while Japan and Europe remain in the doldrums and the US economy muddles along at +2.0-2.5%. Therefore, some of the huge recent decreases in commodity prices (while partially attributable to a positive supply shock in some cases) can be attributed to this weakness outside of the US.
The second, and perhaps more important, reason for the disconnect is central bank interference in the free markets. In the case of the market for money, the Fed has a direct effect on the price of money, or interest rates. They have held the Fed Funds rate near zero for several years, and they have aggressively bought longer-term Treasury bonds and mortgage-backed securities so that yields on these bonds would fall as well. By all accounts, the Fed was enormously successful in its market manipulation, taking interest rates down to nearly unprecedented lows. Now that the Fed has wound down its Quantitative Easing, longer-term rates in the US are still being affected by monetary easing, just not by the Fed. The central banks of Japan and Europe, while a bit behind the curve, are seemingly ready to put the pedal to the metal (Japan has already done so). The spread between yields on US bonds and yields on foreign bonds can only get so large because of arbitrage. So even as uninspiring growth of 2.0-2.5% and an unemployment rate of just 5.8% in the US would normally lead to higher interest rates, they remain artificially low due to outside interference.
For other asset classes, the effect of easy money is not so direct. Consider the case of the oil price. The sharp drop is being characterized, fairly I might add, as a combination of lower global demand combined with a sizable positive supply shock. The surge in supply, in turn, is being attributed to improvements in technology and infrastructure, which have led to an energy renaissance in the US. So how is the Fed responsible for this spout of good fortune for the US economy? Well, the rapid ascension of the energy complex in the US is the direct result of easy money. Energy companies throughout the country have invested in equipment and new technologies using money borrowed in the high-yield markets. Therefore, the Fed has contributed greatly to the boom-and-bust cycle in the energy markets just as it contributed to the boom and bust in housing.
When Fed hawks talk about “market dislocations”, this is what they are referring to. According to a paper by Paolo Pasquariello of the Ross School of Business at the University of Michigan, “dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings.” When the Fed keeps interest rates this low for this long, asset bubbles are unavoidable. Investors will naturally seek to use borrowed money for profit if the opportunities present themselves. Given the dearth of assets offering acceptable returns, investors have levered up and invested in assets ranging from commodities to high-yield bonds to stocks. In the process, prices on some of these assets rose to unsustainable heights. We may now be seeing the unwinding of some of the speculative excess.
Having said all this, our opinion remains that interest rates and commodity prices are still effective indicators for economic growth. While heavily influenced by ancillary factors, the bond and commodity markets have been telling us that global economic growth is not so great. In fact, they have been telling us the opposite, and we agree. Economies outside the US are under moderate pressure, and the US economy will continue to struggle for sub-par growth despite unprecedented stimulus in the form of the following:
- A doubling (from $9 trillion to $18 trillion) in gross federal government debt outstanding
- A $3.5 trillion increase in the size of the Fed’s balance sheet
- A 200% increase in stock prices
- A drop in consumer savings rate to around 5% from the LT avg. of about 8.8%
- Government guarantees on the overwhelming majority of new mortgages
- 50% decrease in long-term interest rates (from around 4% to around 2%)
- A massive drop in energy prices
These imbalances and inconsistencies are the inevitable effect of free-market tampering. We advocate a defensive posture as they work themselves out over the next couple of years.