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Bernanke's Worst Nightmare: Rising Real Interest Rates


What seems to be lost in the monetary debate is that this persistent drop in inflation defies the primary purpose of quantitative easing, which is designed to lower real interest rates.

This past Monday, PIMCO's Mohamed El-Erian wrote an article in the Financial Times titled, "We should listen to what gold is really telling us," which not only breaks down one of the most important issues currently facing market participants but also carries much broader implications about a secular shift underway in the price of money. (Emphasis mine.)

I believe there is an additional insight from gold in a world where central banks, pursuing higher growth and greater job creation, have inserted a sizable wedge between financial markets and economic fundamentals.

Firm and repeated central-bank commitment to asset purchases has done more to push a growing number of investors to add portfolio risk at evermore elevated prices.

Essentially, today's global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth. If this fails to materialize, investors will worry about a lot more than the intrinsic value of gold.

The price of gold can be seen as a proxy for this secular shift; because we are in the early innings, I believe many investors have failed to connect the dots. Two major themes I have written about in recent weeks are functions of this secular shift and were in play last week.

The Yield Curve Adjustment Process

Whether you believe the Fed has successfully manipulated the yield curve or not, just the fact that they are in the market means no one really knows where Treasuries should trade. For this reason, we don't know where asset prices should trade. However, it seems we are about to find out, and I think it is going to be a very uncomfortable process.

I don't think equity investors appreciate how the market will go about re-pricing from a 2.0% to fair value. It might be 2.0% or 4.0% or somewhere in between. We can make some assumptions based on historical relationships to consumption growth and inflation, but nevertheless, the market is not likely to take a smooth trip to get there and the price swings could be significant.

The bond market was under significant pressure with a renewed focus on the eventual Fed taper/exit from QE III despite repeated attempts by central bankers to convince participants otherwise. Many strategists and pundits in the media tried to convince investors that just because the Fed would be tapering asset purchases didn't mean that they would be tightening and that stimulus would remain in place for the foreseeable future. This misses the point.

The bond market doesn't care about how much the Fed buys per se. Whether QE is $4 billion per day or $2 billion per day is irrelevant in a market that trades $800 billion (Treasuries and MBS). With the Fed simply backing off from a full commitment to manipulate the yield curve, the bond market will turn its focus on pricing a natural equilibrium rate of interest. This is the essence of the yield curve adjustment process, and recent price action is just a taste test of how this will unfold.

The Mother of All Short Squeezes

I do believe I have the nature of trade correct, whether short outright or in terms of net market exposure. And just like 2011, once this position gets fully flushed, there will be a violent reversal. However from a technical perspective, unlike 2011 where the market was recognizing long-term pivots now that we are at new highs, there is no such reference. This makes identifying a spot for a final flush and subsequent turn much trickier. For my money, the best technical tools at your disposal are regression and momentum, and by these measures, the market has extended into a zone where at a minimum a reversion to the mean should be expected.

After Tuesday's stock market's reaction to dovish rhetoric from New York Federal Reserve Board President Bill Dudley I tweeted, "If Bernanke and minutes this dovish tomorrow prepare for QE capituation blow off." When Bernanke's testimony hit the tape on Wednesday morning, the immediate interpretation was bullish, and the S&P (INDEXSP:.INX) spiked over 10 points to new all-time highs. However, the equity blow-off suddenly met reality in the bond market, which was pushing yields higher when Bernanke suggested in the Q&A that tapering was forthcoming. The 10-year was probing 2.0% and stocks proceeded to reverse hard, closing down 1.9% off the top.

Was this the final QE capitulation flush reversal I have been anticipating? I don't know, but that's how they happen, and this is how you would draw it up in terms of the equity market's response to the yield curve adjustment process in the context of a larger secular shift in the price of money.

Real 10-Year Yield (PCE deflator)

On Tuesday, with the bond prices under pressure, I jotted down a rhetorical question: Nominal yields rising with inflation falling? What this means, of course, is that the market is not only raising nominal interest rates, but it's also raising real interest rates, i.e., the real cost of money. In reality, though, due to declining inflation rates, real interest rates have been rising since QE II ended in 2011.

In light of this development, Thursday's April personal consumption number and the PCE deflator, which is the Fed's preferred measure of inflation, carry critical significance. The personal consumption number is very important because of its influence on overall nominal GDP, which is tracking at post-recession lows near 3.5%. We have already seen April readings on the YoY PPI and CPI, which both came in weaker than expected, hitting new post-recession lows at 0.7% and 1.1% respectively. The Bloomberg consensus estimate for the April YoY PCE deflator is for a 0.8% increase, which would also be a post-recession low, and on balance, raise real rates even further.

What seems to be lost in the monetary debate is that this persistent drop in inflation defies the primary purpose of quantitative easing, which is designed to lower real interest rates. In fact, with nominal yields rising in the face of falling inflation and thus raising real interest rates, the US economy is now closer to a deflationary death spiral than at any time during the Fed's unprecedented policy designed to prevent just such an outcome.

To give you an idea of how serious this development could get, you have to look no further than comments straight from the horse's mouth. (Emphasis mine.)

Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers...

When the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be… In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn....

Even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.
-- Ben Bernanke: "Deflation: Making Sure 'It' Doesn't Happen Here," November 21, 2002

Is this not what is happening?

When Bernanke gave his famous "helicopter speech," he probably never dreamed that he was drawing up the exact path of his monetary destiny. You would think the decelerating personal consumption (aggregate demand) and decline in the PCE price index (deflation) with the Fed aggressively trying to engineer the opposite environment would be a frightening development for Bernanke. In fact, it was these exact low inflation rates that scared Bernanke into launching QE II in August 2010. However, the parabolic appreciation of risk asset prices seems to be driving a reassessment of the cost/benefit of QE. It is becoming apparent that regardless of economic conditions, the Fed now views the risks of market disequilibrium as outweighing the reward of further quantitative easing.

In framing the deflationary risks, Bernanke was clearly focused on real interest rates, which were no doubt the focus of the QE program after the financial crisis. Between 2009 and the end of QE II in 2011, the real 10-year yield (using PCE deflator) fell 550 bps from 4.50% to -1.0% as nominal yields fell 150bps and inflation rose 400bps. This negative interest rate regime no doubt helped ease financial conditions, providing a favorable environment for asset price appreciation -- however, it was not without a cost.

In 2011, with the QE reflation trade in full force, top line nominal growth remained subdued and the escalating inflation pressure began to take their toll on the consumer. This was clearly evident in commodity prices and reflective in the performance of gold, the most sensitive asset to negative interest rates. During QE I and II, gold appreciated by 190% in value from $680 in late 2008 to a high of $1920 in 2011, equal to an astounding 44% annualized rate.

Gold vs. Real 10-Year (inverted)

When the Fed opted to terminate QE II at the end of June 2011 due to inflationary pressures, the market was forced to unwind the asset reflation trade that had defined the negative real interest rate regime. Essentially the benefits of negative real interest rates in the financial economy through inflation met the limit of aggregate demand of the real economy. This QE crash kicked off a structural shift that removed the Fed's ability to influence real interest rates. A month later, the real 10-year yield troughed -- and not coincidentally, the price of gold peaked.

In spite of the Fed's uber-easy monetary policy, real interest rates have tightened 200bps since the 2011 low with most of the adjustment being the result of falling inflation. This is the aggregate demand side of the equation, tightening monetary policy in an attempt to normalize real interest rates. This is where Bernanke's deflationary death spiral -- ignited by rising real interest rates -- comes into play. Once the deflationary trend is firmly in place, the real price of money becomes more reflective of the deflation rate and less sensitive to the nominal interest rate.

The inflation trend is clearly lower; this week's PCE deflator is likely going to confirm this trend. The Fed has recently brushed off this deflationary trend as "transitory," attributing much of the decline to falling gas prices. However, upon further inspection, this interpretation seems misguided. The current AAA year-to-date daily average price for unleaded gas is $3.54/gallon with PCE inflation running at 1.0%, which is higher than the $3.48 average price over the same period in 2011 when the oppressive PCE was above 2.0%.

PCE vs. Gasoline

PCE vs. PCE deflator

The fact of the matter is that falling inflation is 100% consistent with falling aggregate demand, which is exactly the condition that Bernanke cited as a deflationary trap in his infamous helicopter speech in 2002. (Emphasis mine/)

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank… retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

Though he wouldn't admit it, Bernanke met his match in 2011. The consumer balked at attempts to stimulate aggregate demand via inflationary policy of negative real interest rates, and ever since, has been raising real interest rates by reducing inflation through lower aggregate demand. This is perhaps the most unappreciated yet significant market development since the financial crisis.

Rising real interest rates is Bernanke's worst nightmare. Everything he has worked for in academia and implemented in monetary practice is imploding before his very eyes. Contrary to his assertion in 2002, aggregate demand in the real economy has in fact met the limit of monetary policy, rendering QE's impact ineffective and obsolete. The Fed is not only out of ammunition; it is now waving the white flag.

Participants in the equity market obviously do not realize that the QE negative interest rate wind at their back is no longer present. Just as El-Erian implies, they have fallen prey to the illusion of QE stimulus via rising equity prices. In reality, the price of gold -- and more importantly, real interest rates -- are actually reflective of tightening monetary conditions. Perhaps Wednesday's capitulation flush reversal was indicative that the equity market is finally getting the message.

Nevertheless, as real interest rates continue to normalize in the yield curve adjustment process, investors should expect the sizable wedge between financial markets and economic fundamentals that is a product of the mother of all short squeezes to also normalize. That suggests the current state of stable disequilibrium dominated by central banks will soon find the unstable path to equilibrium dominated by the free market.

PCE vs. S&P 500

Twitter: @exantefactor
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