Stock prices showed again on Wednesday how in thrall they are to Federal Reserve action. Seconds before public release of the Fed’s decision (again showing probable advance notice), equity and gold prices exploded upward; bond yields and the U.S. dollar plummeted. The Fed decided against tapering their $85 billion per month bond buying program, and punters celebrated the prospect of no near-term monetary discipline. The Fed’s friendly overture to the market produced about a 240 Dow point rise from the day’s low to its peak with 140 of those points materializing in the first minute while TV commentators were still reading the Fed’s announcement. Needless to say, these buyers were not Mr. and Mrs. Main Street.
Just a half-hour after the announcement, Fed Chairman Ben Bernanke sat before the press explaining the Fed’s hesitancy to initiate the anticipated tapering. In a forum in which Bernanke committed a misstep that unwound a similar powerful price run in his last appearance, he managed to maintain investor confidence this time. Although he dodged a couple of questions, he carefully threaded his way between the need to admit enough economic weakness to justify the extraordinary stream of monetary stimulus and the danger of frightening his audience into focusing on just how precarious economic conditions truly are. The strength of stock prices through the end of the day testifies to his success in hitting a communication home run.
Increasingly the Fed appears to be caught in a precarious position with respect to taking its foot off the monetary accelerator, because the economy is simply not improving enough. It is at a point from which it can’t possibly admit defeat. If the economy doesn’t improve (or worse yet begins to weaken), the Fed now apparently believes that it has to continue its extraordinary monetary policy without regard to future consequences from even more monumental debt burdens.
Helping to obscure potential future problems, respected investment research firms point to the expansion of central bank balance sheets–especially those of the U.S and Japan–as an unqualified good. No mention is made of the ultimate problem of already excessive debt becoming even more excessive, even though a multi-century record points to one to two decade long economic disruptions as the probable outcome of such profligate central bank behavior. We’re witnessing the quintessential celebration of near-term reward at the expense of probable long-term pain.
This Fed inaction brings the U.S., and likely others, even closer to what Lacy Hunt and Van Hoisington term the “bang” moment. That point can appear quickly as investors come to the belief that a country cannot repay its debt without seriously devaluing its currency. Suddenly interest rates skyrocket, as occurred most recently in Greece before European monetary authorities pledged a rescue. It’s timely to recall the words of former St. Louis Fed President Bill Poole to the effect that when you look at the numbers, the U.S. is only a bit behind Greece. And there is no entity big enough to bail us out if confidence in the Fed fails.
Since the end of the 1990s, I have been warning incessantly about the uncontrolled expansion of debt and derivatives. We have already experienced two debt-fueled debacles since the turn of the century, yet investors are once again ignoring the dangers of new record levels of debt. Almost as a parenthetical aside, I have regularly admitted the possibility that central banks could succeed at inflating away massive debts while simultaneously floating stock prices higher on that wave of inflation. That outcome is clearly what central bankers are attempting to orchestrate, but the record of history does not accord such behavior a high probability of long-term success. As a firm that pays close attention to fundamentals, we have been unwilling to make that bet.
Today’s economic and market conditions create a horrible quandary for investors who make decisions on the basis of economic and corporate fundamentals. By judging it necessary to create money at unprecedented rates, the Fed indicates a clear belief that the underlying fundamentals are precarious at best. The only reason for true investors to buy stocks at their all-time highs is a profound faith that these central planners will ultimately be able to overcome lackluster fundamentals with a flood of stimulus unaccompanied by serious negative consequences.