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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.
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