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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.

Feeling better now? More from Hoisington & Hunt (emphasis mine):
The key ingredient to fostering monetary growth, and thus final demand, is an increase in the kind of borrowing which (1) aids future productivity and income and (2) increases financial innovation. Presently, after 60 months of the most massive Fed balance sheet expansion, no evidence of an inflationary spiral can be found. Nor, in our judgment, is one likely to occur. The process of unwinding debt overhangs is a long one, and unfortunately our society continues to pile on debt at near record amounts. This action is deflationary.

I believe this is the essence of their analysis and is where my thesis based simply on the loan-to-deposit ratio and velocity falls short. The Fed can create reserves but it can't create money or increase its velocity. Furthermore, it's not enough just to create credit by itself; it must be productive credit. This is why the collapse in velocity is not just a credit crisis phenomenon but has been trending lower since the era of easy money began. You can see on the chart that velocity has been on a downward trajectory over the past decade despite the fact that this has coincided with extremely proactive monetary policy that has been constantly trying to calibrate aggregate demand. That is because primarily all of the credit created over the past decade was used for unproductive consumption purposes.

Hoisington & Hunt: The Bottom Line (emphasis mine):

Interest rates may, will and have gone up based on periodic changes in psychology. However, underlying fundamentals have insured they have not been able to remain elevated. The fundamentals of insufficiency of demand and its root cause, over-indebtedness, still point to an environment in which long-term interest rates remain on a path to lower levels.

This past week I ran into a friend of mine who manages a multi-billion-dollar money management operation. We engaged in brief small talk about the markets. He commented about the recent move up in the long end of the curve and said that he was staying short duration for fear of the eventual rise in interest rates. He went on to say that things were starting to feel like they were getting better. With eyebrows raised I responded it feels better because the stock market is at new highs. He chuckled in agreement and went on his way.

It's possible the stock market is discounting an acceleration of economic growth, but to corroborate that discount you would need to market interest rates begin to rise significantly, which would signal that banks are expanding credit creation by rotating out of their massive securities holdings and into productive loans. That does not appear to be happening.

The stock market also went on to a new high as interest rates spiked in the summer of 2007 and stocks went on to make higher highs in the summer as confidence that the Fed's easy money was coming to the rescue. In Hoisington's 2007 Fourth Quarter Review and Outlook you can see they were not fooled (emphasis mine).
Present circumstances suggest that quick resolution by monetary and fiscal authorities to overcome these economic conditions is overrated. Of course, this does not mean a depression or a re-visitation to the conditions of the 1930s. Well over 90% of the population will have jobs; individual companies will profit; innovation will continue; the population will expand; certain prices will rise, and shortages of individual materials will certainly occur. However, persistent excess capacity in both labor and capital will erode aggregate pricing power and put greater downward pressure on corporate profits and inflation. If commodity costs manage to rise in this environment, they increase the risk of recession, not inflation. Finally, the intersection of supply and demand for credit will be lower, suggesting a period of sustained low interest rates.

I think we try to make this too complicated. We get caught up in the cyclical wiggles but lose sight of the underlying secular trend. The continued deleveraging of the unproductive leveraged consumption bubble is not over because stocks made new highs or because interest rates broke out of a trading range. It won't be over as a result of fiscal or monetary policy. It will be over when excess capacity is absorbed by real demand based on Hoisington and Hunt's key ingredient.

Twitter: @exantefactor
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