posted on 28 August 2016
by Lance Roberts, Clarity Financial
As Yellen spoke on Friday, the markets surged back into the trading range that we have been locked into for the past few weeks. Despite GDP being revised lower and economic data continuing to remain weak, the hopes for a strengthening economic recovery from the Fed remain.
Here are Yellen's key points:
On those headlines, the market rallied as the expectations for a September rate hike dissolved.
Remember, raising the Fed Funds rate is a tightening of monetary policy which withdraws liquidity from the financial markets. With fundamentals and economics weak, the only supportive argument for higher asset prices, and for "yield chasers" paying 3.5x sales for a 2.5% dividend, is continued accommodative policy.
But it was this statement that sent the markets surging higher:
This, of course, dovetails with my article from Thursday discussing the recent Fed research paper on the possibility of another $4 Trillion in QE to offset the next recession. To wit:
Unfortunately, the post-Yellen speech push higher in stocks was quickly reversed when the Federal Reserve's own Stan Fischer clarified the situation:
So, just as quickly as the rally came, it went away as the specter of a September rate hike weighed on the market.
In a nutshell, the best summation of Yellen's speech came from Macquarie's Thierry Wizman who simply said:
Let's Be Like Japan
But let's revisit Ms. Yellen's comments for a moment. As noted, she made two very interesting points. The first was the call for more "fiscal" policy out of Government. This is essentially a call for more government spending. ($19 Trillion In Debt Is A Problem)
Clearly, more expansive government spending, represented in the chart above by the surge in Federal Debt, is having no substantial impact to economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.
The second, and most important, was the suggestion of expanding monetary policy programs to include other assets.
Japan has been doing this for the last couple of years and, according to Bloomberg, has now accumulated a majority of the Nikkei 225 and about 55% of Japan's ETF's.
But, that spending has done little for the realization of success in Japan economically. Take a look at the chart below which shows the expansion of the BOJ assets versus growth of GDP and levels of interest rates.
With interest rates now pushing into negative territory and economic growth near zero, there is little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.
Yellen has become caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.
This is the same problem that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
The lynchpin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively "game over" as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.
Japan, like the U.S., is caught in an on-going "liquidity trap" where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go - the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.
More importantly, while there are many calling for an end of the "Great Bond Bull Market," this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can't rise in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
Unfortunately, for Ms. Yellen, the reality is MORE spending is unlikely to change the outcome in the U.S. just as it has failed in Japan. The reason is that monetary interventions and government spending don't create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever growing void in the future that must be filled. Eventually, the void will be too great to fill.
But hey, let's just keep doing the same thing over and over again, which hasn't worked for anyone as of yet, hoping for a different result.
What's the worst that could happen?
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