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Analysts Missing Key Ingredient of Economic Growth


Most analysis that portends to forecast bond market trends using fancy models and formulas shares a fundamental flaw: It assumes the Fed controls interest rates.

The 24-hour news cycle, financial media, and blogosphere has to fill a lot of empty space, resulting in chronic information sensory overload. The vast majority of time is spent offering interpretations of cause and effect in the markets. It seems these days much of the focus is more specifically on the cause of monetary policy and effect in stimulating the markets. This didn't just begin with the recent initiatives of quantitative easing (QE) and zero interest rate policy (ZIRP); it began with the bailout of Long Term Capital Management in 1998 that introduced the Fed's put option and launched the era of easy money. Sadly, most market participants today only know and thus rely on this monetary cause and effect reality.

Recently there has been much debate and even more confusion as the true impact the Fed's QE and ZIRP is having on the various markets is seen. As has been the case for the past decade, most of the analysis predicated on an elementary cause and effect conclusion.

The bond bullish thesis presented by many who are long risk-free assets goes like this: The Fed is buying Treasuries and mortgage backed securities (MBSs), interest rates are low, so the Fed's purchases are successfully driving interest rates lower, and as long as the Fed continues to buy, bond yields will remain low.

The equity bullish thesis presented by many who are long risk assets goes like this: The Fed is printing money to inject into the capital markets, the USD is weak, junk bonds and stocks are at new highs, therefore the Fed is successfully reflating risk assets and further purchases will only drive more risk behavior.

Whether you believe the Fed is holding bond yields low or reflating risk assets, you've probably come to the same conclusion. Eventually the Fed will be successful in stimulating nominal GDP to a growth rate that sustains job creation, at which point the Fed will reduce QE and interest rates will begin to rise.

Instead of following blowhard pundits and analysts, most of whom are not even managing money much less understand the nuances of the bond market, do yourself a favor and make a habit of reading Hoisington Investment Management's Quarterly Review and Outlook written by Van Hoisington and Dr. Lacy Hunt. In simple, concise explanations, Hoisington and Hunt break down the basics of what drives trends in economic growth, inflation, and interest rates. You will find that most analysis that portends to explain and forecast bond market trends using fancy models and formulas shares what I believe to be a fundamental flaw in assuming the Federal Reserve controls interest rates. I prefer the basic economic and market principles employed by Hoisington and Hunt that supersede models based on monetary policy.

Hoisington and Hunt have long been very bullish on bond market duration and have made incredible returns for their investors yet their thesis isn't predicated on the Federal Reserve's QE or ZIRP holding long term interest rates down. In fact you might even say they are bullish despite monetary policy. In Hoisington's 2012 Fourth Quarter Review and Outlook QE wasn't mentioned until basically the last page, and it was not exactly a ringing endorsement (emphasis mine).
In 2008, the Fed increased its liabilities by almost 1800%. This Fed process of paying for purchased securities is a mere accounting exercise. With a stroke of a bookkeeper's pen it "creates" funds to pay for the purchased securities. This fund creation is assumed to be inflationary as it is often mislabeled and referred to in many articles as printing money. Increased Fed liabilities and an equivalent rise in Fed assets are not really money. However, it does create the potential for increased money. These Fed actions raise inflationary expectations which result in rising financial speculation and increasing interest rates. Recently, during QE infinity, long-term interest rates have risen, replicating the experience in QE1&2.

Despite the fact that most market participants expected higher inflation after the 2008 monetary explosion, the contrary has occurred. It has now been more than five years since the near 1800% increase in the Fed's balance sheet, yet the economy languishes, and prices remain under downward pressure. Why? The Fed does not control the amount of money circulating in the economy nor the speed at which it turns over.

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