Can it be this simple?
Financial gurus have come up short in explaining exactly why interest rates are going down, and not up, as everyone expected them to do. The same thing is happening overseas. What gives?
Pundits have been trotting out the same old reasons for why rates are declining. Slow growth economies in North America, Europe and Japan have persisted this year, much to the surprise of everyone. So central banks worldwide are maintaining an easy-money policy, which is driving all interest rates lower. That is at odds with the Fed’s view of economic conditions.
If you recall, back in May of last year, the Fed announced that the U.S. economy was gathering so much steam that they had decided to begin tapering their $85 billion/month stimulus program beginning in January of this year.
Interest rates spiked higher as the bond market anticipated not only the end of stimulus but higher economic growth as well in 2014. The Fed was right, but only in the very short term. The fourth quarter GDP hit 4 percent. But then the economy fell off a cliff.
Economists would have us believe that the Polar Vortex is to blame. I expect when the first quarter is finally revised for the final time we will have experienced a minus sign in growth for the first three months of the year. No question that the prolonged season of cold weather hurt the economy, but by how much? No way was that decline all weather-related, in my opinion.
Through it all, the stock markets have refused to go down, despite the slowing economy, cautionary earnings and revenue forecasts by corporations, the Ukraine and any other bad news. We are in an environment where new highs in stocks are reflecting an expectation that economic growth will not only continue but accelerate.
Historically, when the economy gains momentum, interest rates rise and the stock market goes up. When the economy weakens, the reverse happens. So, my dear readers, either the bond market has it wrong or the stock market does. What or who is the fly in this particular ointment? My guess is the Fed has a lot to do with this.
Think back, what happened when our central bank announced the first quantitative easing plan, known as QE I. The economy gained ground, the recession faded and the stock market took off. When the Fed announced the end of that program, the economy slowed, and stocks plummeted. So the Fed announced QE II. The process was repeated: stocks up, rates down and economic growth. By the end of QE II, the bond market and corporate America had learned a thing or two about central bank stimulus. They learned to anticipate.
Corporations began to pull back their investments. The bond market headed lower, bracing for more sluggish growth and a possible recession and stocks headed lower. Enter QE III. But by then, even the Fed realized something had to change. So they changed the game plan.
As QE III was about to sunset, Ben Bernanke, the Fed chairman at the time, extended QE III indefinitely. He promised that the stimulus would continue until the economy was able to stand on its feet again without assistance that unemployment needed to drop to at least 6.5 percent and that short term interest rates would stay low out to 2015.
The stock market took off and the economy gathered steam once again. Fast forward to today. QE Infinity is winding down at a rate of $10 billion dollars per month. By the end of the year the Fed plans to end their stimulus program entirely. It has already been cut in half year to date. The economy has slowed from 4 percent in the fourth quarter to 0 -to-negative in the first quarter. The data seems to indicate it is slowing still. The bond market’s low interest rates are indicating the same thing.
So something has to give. If bond players are right, (and they tend to get it right more often than stock jockeys) then we can expect even slower growth in the months ahead. Might the Fed reverse course if that were to happen? The consensus says no, but consensus tends to be wrong fairly often. In the meantime, what in the world is the stock market doing at record highs?
Bill Schmick is registered as an investment advisor representative and portfolio manager with Berkshire Money Management (BMM), managing over $200 million for investors in the Berkshires. Bill’s forecasts and opinions are purely his own and do not necessarily represent the views of BMM. None of his commentary is or should be considered investment advice. Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 888-232-6072 (toll free) or e-mail him at Bill@afewdollarsmore.com. Visit www.afewdollarsmore.com for more of Bill’s insights.
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