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Quantitative Easing: The Greatest Con Ever Sold


It would seem that QE is just a PR stunt to engineer inflation expectations and animal spirits.

Last week the bond market continued to be put to the test, and if it could go wrong, it did go wrong. Across the board stronger than expected economic data, including Friday's better than expected employment data, provided plenty off ammo for risk behavior that saw the yen make new lows against the dollar, pushing equities to new highs with the Dow (INDEXDJX:.DJI) making a new all-time high seemingly every day. The upward momentum was not lost on the mainstream media as on Thursday I heard CBS Evening News anchor Scott Pelly refer to the announcement of a new high as sounding like "a broken record."

The 10-year yield, up 20bps on the week, closed at 2.04% near the highs of this leg with the US bond futures contract completely reversing the recent rally, slicing through my pivot level now 141-16 adjusted for the June contract settling right at 141-00 even. This level has acted as previous support throughout the past month of consolidation, but clearly some technical damage has been done.

Nevertheless despite some pretty severe pressure from risk markets the long end of the curve did not break down and the US bond futures contract still remains within the rising regression channel I have been monitoring. Over the next couple of weeks I expect this level to be tested which rises into the 139-16 level, providing the bond market with a critical make-or-break level to hold.

US Bond Futures Weekly Chart

Equity market investors were very proud of themselves this past week and there were a lot of "I told you so" comments from born-again bullish traders and pundits. However I think these people are missing a very important point. In my experience most equity investors are extremely ignorant of bond market dynamics and oblivious to what drives interest rates or how much more money is flowing in and out of that market. The stock market is a sideshow compared to the bond market. If equity investors think that stocks can rise if the bond market is topping, I believe they are in for a rude awakening.

(See also: Where Have We Seen This Market Before?)

I was ridiculed on Twitter this week for suggesting that this market was potentially mirroring 1987, which saw rapidly rising bond yields crash the stock market. One person commented that the equity risk premium was too cheap today relative to 1987. Another said it was silly because interest rates in 1987 were 10%.

I believe these two metrics are shortsighted and highly flawed. The equity risk premium (earnings yields – 10-year yield) when measured against negative real interest rates is a faulty valuation tool. Of course it's going to look cheap. If the S&P (INDEXSP:.INX) were 100x earnings the ERP would still look relatively cheap against a negative yield. In terms of the 10-year yield comparison, it's not the outright nominal yield that matters, it's the relative interest rate and degree of the move that are more important.

S&P 500 vs. 10-Year With 1987 Overlay

Looking at the correlation it doesn't look so silly to me. Off the 1.50% 10-year low to Friday's close of 2.04% you have virtually the exact move on a percentage basis as you did in 1987 when yields rose from 7.0% to 10.0%. When interest rates rise into decelerating nominal GDP, "accidents" can happen. If the 10-year is topping and we get a swift move toward 2.5-3.0% as nominal GDP is decelerating then the stock market that everyone loves to own could suddenly become very risky. This also happened in 2007 when the 10-year took out 5.0% as nominal GDP was decelerating below that level. At that time you heard the pundits and strategists rejoicing that the bond market was discounting a breakout in growth. We all know how it worked out.

(See also: 12 Cognitive Biases That Endanger Investors)

It's important to analyze a rapid rise in interest rates in the context of a market that is extremely leveraged. Not to mention, as I've been writing about ad nauseam, today it represents a significant percentage of commercial bank assets which are also extremely leveraged. Friday's FRB H.8 report showed $2.7 trillion in securities on bank balance sheets representing 27% of total credit assets. Using the 10-year as a proxy, if the current 2.0% coupon went to a 3% yield, you're talking about an 8.0% reduction in price which will trap a lot of capital on bank balance sheets.

Ironically this week's much publicized Fed bank stress test of an "adverse scenario" that most all passed with flying colors doesn't even stress for rising interest rates. Most banks' internal interest rate shock models stress for parallel shifts of +100 to +300 bps but not a face-melting bear steepener. With record low coupons of negatively convex assets a rapid bear steepener would wreak havoc in the credit markets and on bank balance sheets.

Perhaps the Fed isn't stressing an adverse scenario for rising interest rates because they believe they are successfully holding them down. Would you believe me if I told you that today the Fed owns no more US Treasury securities as a percentage of the outstanding stock than it has on average over the past 50 years?

Fed UST Holdings Percent of Stock

The Fed currently owns 14% of the outstanding US Treasury market stock, and while that number has modestly adjusted throughout the years, since 1963 the average is 14.8%. In the 10 years preceding the financial crisis the average was 15%, and as you can see on the chart, between 2004 and 2007 they owned over 15% of the Treasury stock -- while they were raising interest rates, no less. It's not the Fed's balance sheet that has ballooned; it's the US Treasury's balance sheet that has.

By launching QE the Fed is merely playing catch-up to the historical average. They have to know this, so we can only deduce that they have used QE as an excuse to con the markets into thinking they are stimulating asset prices and aggregate demand. In reality they are just maintaining the status quo. It would seem QE is just a PR stunt to engineer inflation expectations and animal spirits.
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