The stock market experienced a remarkable surge last week, achieving its most significant weekly gain in over two years. By the week’s end, the DOW had increased by 5.4 percent, the S&P 500 had risen by 5.6 percent, and the NASDAQ had surged by 6.2 percent.
Several factors contributed to this uplift in stock prices, notably the Institute for Supply Management’s manufacturing index, which improved from 53.5 in May to 55.3 in June. Additionally, the parliament in Greece appeared to pass austerity measures, alongside the conclusion of quantitative easing (QE2), both of which played a role in the market’s positive momentum.
In regard to Greece, European finance ministers are now obligated to fulfill their promise of a bailout following the austerity measures. As for the end of QE2, the markets had anticipated this conclusion for some time. It begs the question: why would investors interpret the official end of QE2 as a signal to purchase stocks?
Despite this uncertainty, we believe that QE is not finished yet. While the stock market saw significant gains, the real changes were happening in the bond market, where treasury yields experienced even more substantial increases…
Interest Rate Cycles
According to a report from Reuters on June 27, the benchmark yield on the ten-year note fell to a low of 2.842 percent for 2011 but has since surged past 3.20 percent. The hike of 0.342 percentage points over five sessions marks the largest weekly increase since August 2009.
It’s important to note that when bond yields rise, bond prices decline. A sudden increase of over 12 percent in one week can put bond investors in a precarious position. Last week, as evidenced by market trends, investors opted to sell treasuries and acquire stocks instead. In the words of Francesco Garzarelli from Goldman Sachs, “We think the rally is over,” referring to the treasury bond rally that began in early April.
Whether the rally has truly reached its end remains uncertain. However, here at the Economic Prism, we are pondering a more significant question: could this signify the culmination of a 29-year treasury bond bubble? It appears that government debt is certainly overdue for a spike in interest rates.
Interest rate cycles have a history of extending over long periods, often ranging from 25 to 35 years. U.S. Treasury yields peaked in 1920 before plunging until the mid-1940s, only to rise again alongside inflation. Franz Pick famously observed that “bonds are certificates of guaranteed confiscation.”
What Pick failed to recognize at the time was that a turning point had already been reached. By early 1982, yields began to climb once more, eventually reaching historic lows in December 2008. Since that time, yields have remained at rock-bottom levels.
The Path of Least Resistance
Despite the extensive money printing that has transpired over the past three years, one puzzling outcome has been the absence of consumer price inflation. An increase in the money supply typically leads to rising prices, and at some point, this will occur. Thus far, however, the funds from the Federal Reserve have mostly circulated through banks and then into government debt. This trend has helped keep interest rates low while simultaneously boosting stock, bond, and commodity markets.
However, when the excess liquidity from the Fed begins to filter into the real economy, causing consumer prices and interest rates to rise, what course of action will Bernanke choose?
According to Milton Friedman’s monetary theory, he should contract the money supply, raise interest rates, and act preemptively against inflation. But will Bernanke have the resolve to take such measures?
Our economy now hinges on low-cost credit merely to maintain stability—where are the jobs? Rising asset prices, fueled by low interest rates and financial illusions, have severely hampered the American economy. Bond King Bill Gross elaborates:
“The past several decades have witnessed an erosion of our manufacturing base in exchange for a reliance on wealth creation via financial assets. Now, as that path approaches a dead-end, with interest rates unable to drop any further, we find ourselves undertrained, underinvested, and overindebted compared to our global competitors.”
In conclusion, as the market forces rates upward and the economy stagnates, we can expect Bernanke to favor the path of least political resistance. He is likely to opt for short-term solutions such as printing more money to lend it to banks, ultimately to be loaned back to the government. This might temporarily reduce interest rates. However, inevitably, the fundamental economic needs will prevail.
Interest rates will rise, inflation will become a reality, and stock prices will eventually retract. There will be no gentle landing for the economy; nevertheless, we might first witness another quarter or two of modest 2 percent GDP growth.
Sincerely,
MN Gordon
for Economic Prism