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Bernanke's Date With Deflationary Destiny

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If the market makes critical levels in the 10-year Treasury and US bond futures contract support, and fundamentals continue to deteriorate, we could see a significant rally.

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Due to the lower nominal growth trajectory, even when/if the Fed begins to normalize interest rates they are not likely going very high. I plotted the relationship between the YOY NGDP growth rate and the Fed funds (FF) rate going back 40 years running a regression analysis on the spread. In general you might say that money is tight (restrictive) when the FF rate exceeds the NGDP growth rate and money is easy (stimulative) when the FF rate is below NGDP with a flat "breakeven" spread being neither tight nor easy. This is evidenced by showing that each of the six recessions over the past 40 years occurred when NGDP dropped below the FF rate. However it is interesting to note that the regression line is downward sloping spending the past decade below zero suggesting that the structurally declining NGDP is now so low it is potentially sensitive to interest rates before they exceed the growth rate.

Nominal GDP Vs. Fed Funds Rate



The -1.50% regression spread is extrapolated into 2014, so by using different NGDP growth rate assumptions you can derive what level the FF rate will become restrictive. With NGDP averaging 4.0% over the past decade, and since the recession ended, I think this is a conservative benchmark. A -1.50% spread produces a breakeven FF rate of 2.50%. But if the Q4 NGDP 3.3% growth rate is more indicative of the new longer term trajectory and you average something closer to 3.5%, then the breakeven spread is 2.0%, basically right where the 10YR yield is trading today. Hmmm....

Perhaps there is no more widely held belief than in the assumption that the Fed is artificially holding down long term interest rates. The Fed themselves believe this to be true, and until recently, I have been operating under the same assumption. I have been anticipating that when the Fed begins to withdraw from their asset purchases, long term interest rates will begin to rise, converging back towards their historical mean of the NGDP growth rate.

Having cut my teeth in the bond market I have always looked to the curve and 10-year yield as a forecasting tool for future discounts of growth and inflation. The track record has served me well throughout my career. That changed when the Fed launched QE as I thought the free market had been compromised and manipulated beyond recognition. Furthermore I believed Bernanke had taken the discount out of the discount rate. Now I am not so sure.

Various indicators are beginning to prove the bond market may have been correct all along. Growth and inflation are anemic and appear to be decelerating, anecdotal evidence from retailers point to tepid demand for non-discretionary items, and despite meager net interest margins, banks are continuing to favor securities rather than make loans, suggesting demand for credit is weak.

The outlook for corporate profits doesn't look much better. Last week FactSet reported that recent estimates now point to a decline in YOY Q1 2013 earnings growth.

Based on current estimates, the estimated earnings growth rate for the index for Q1 2013 now stands at -0.04%. There has been a steady decline in the growth rate over the past five months. On September 28, the estimated earnings growth rate was 5.1%. By December 28, the estimated growth had declined to 2.4%. Last week, the growth rate was slightly positive at 0.04%. Today, it stands at -0.04%.

You wouldn't know by the price action in stocks, but if you look under the hood, all is not well. This is not a surprise though; equity investors are usually last to get the memo. Usually the first to get the memo are bond investors, and despite insanity in currency and equity markets that has driven attempts to take out 2.00% in the 10-year and my critical 143-00 level in the US bond futures contract, the bond market remains bid. Don't get me wrong. I will respect a failure of these two levels, but if the market makes this area support as fundamentals continue to deteriorate we could see a significant rally as Bernanke's date with deflationary destiny becomes a reality.

If you want to understand how this story ends, all you need to do is read Hoisington Investment Management's Dr. Lacy Hunt and Van Hoisington. I know you must be tired of me citing these guys, but no one makes the deflationary case more elementary yet effectively than Hunt and Hoisington. In their Q4 letter to investors they provide the bottom line (emphasis mine):

We have been of the opinion that the 30- year Treasury bond rate could not go up and stay up since well before the initiation of QE1. It has been an expensive wait for those expecting higher interest rates, as they have actually declined. Today, with long-term Treasury yields around 3%, our view remains the same. 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.

There you have it.

Twitter: @exantefactor
No positions in stocks mentioned.
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