The Path of Least Resistance

The stock market hopped like a frog last week…jumping higher than in any week in over two years.  When the week was over, the DOW had climbed 5.4 percent, the S&P500 had climbed 5.6 percent, and the NASDAQ had climbed 6.2 percent.

From what we gather, stocks were boosted up by the Institute for Supply Management’s manufacturing index, which rose from 53.5 percent in May to 55.3 percent in June.  Other factors attributed to the stock market’s surge were the apparent passage of austerity measures by Greece’s parliament and the conclusion of QE2.

On the former, European finance ministers must now follow up the Greece austerity with a bailout, as promised.  On the latter, we don’t have much of an opinion. Markets knew all along when QE2 would end.  Why would they take the official end date of QE2 as a signal to buy stocks?

Regardless, we don’t think we’ve seen the last of QE. For while the stock market jumped, the real action was over in the bond market…where treasury yields jumped even more…

Interest Rate Cycles

“On June 27, the benchmark yield [ten year note] touched a 2011 low of 2.842 percent,” reported Reuters.  “It has since catapulted above 3.20 percent.  The 0.342 percentage-point jump in the past five sessions is the largest weekly advance since August 2009.”

Remember, when bond yields go up, bond prices go down.  When bond yields rise over 12 percent in one week, debt investors fall quickly underwater.  Last week, as you can see, investors sold treasuries and bought stocks.  “We think the rally is over,” remarked Francesco Garzarelli at Goldman Sachs in reference to the treasury bond rally that started in early April.

Maybe the rally is over or maybe it isn’t.  Who knows?  Here at the Economic Prism we’re concerned with a much larger question… Could this finally signal the end to the 29 year treasury bond bubble?  Government debt is certainly due for an interest rate explosion.

You see, interest rate cycles span long periods of time…often they last between 25 and 35 years.  U.S. Treasury yields reached a peak in 1920 and then slowly slid until the mid-1940s.  Then, they rose again – along with inflation – and Franz Pick famously declared that “bonds are certificates of guaranteed confiscation”.

What Mr. Pick didn’t realize at the time of his declaration is that an inflection point had been reached.  For in early 1982 yields again ventured over the mountain and slid down a soft slope to historic lows in December 2008.  Since then, yields have skidded along the bottom.

The Path of Least Resistance

With all the money printing going on over the last three years one of the baffling outcomes has been the lack of consumer price inflation.  Expansion of the money supply should result in rising prices…and at some point it will.  Thus far, however, the money from the Fed has flooded into the banks and then into government debt.  This has kept interest rates low and pushed up stock, bond, and commodity markets.

Yet when the excess money from the Fed makes its way into the real economy, and consumer prices and interest rates begin going up, what then is Bernanke going to do?

Monetary theory, as laid down by Milton Freidman, says he should tighten the money supply, raise interest rates even further, and get out ahead of inflation.  But will Bernanke have the guts to do so?

Our economy has become dependent upon cheap credit just to stand still…where are the jobs?  Rising asset prices, pushed up by low interest rates and financial chimera, have handicapped the American economy. Bond King Bill Gross explains…

“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 road approaches a dead-end cul-de-sac via interest rates that can go no lower, we are left untrained, underinvested and overindebted relative to our global competitors.”

In conclusion, when the market pushes rates up and the economy stagnates, Bernanke will take the path of least political resistance.  He will do the expedient.  He will print money and give it to the banks so they can lend it to the government.  He may succeed at reducing interest rates for a time.  But eventually, what must happen, will happen.

Interest rates and inflation will increase.  Stocks will decrease.  There will not be a soft landing for the economy.  Nonetheless, we may first get a quarter or two more of 2 percent GDP growth.


MN Gordon
for Economic Prism

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One Response to The Path of Least Resistance

  1. Russ Kistler says:

    Appreciate it for all your efforts that you have put in this. very interesting info . “The worth of a book is to be measured by what you can carry away from it.” by James Bryce.

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