Lower Interest Rates are creating Illusory Gains

It has been a curious recovery hasn’t it?

Our hypothesis: Fed Induced Lower Interest Rates are creating Illusory Asset Price Gains

From the depths of the 2008/09 lows the S&P 500 has rallied approximately 175% yet it seems a feeling of unease permeates:

  • The unemployment rate has ticked steadily lower since 2008 yet doesn’t take into account those who have given up looking for work or those who need to hold two or more low paying jobs;
  • Surveys of middle-class Americans report, almost unanimously, feeling worse off economically than a decade ago;
  • Commodity prices have crashed and we wonder how that can be if the world is growing and these are the building blocks of growth;
  • A country as indebted as the USA – some estimates pin total debt at $18 trillion which for all intents and purposes is meaningless and will never be repaid – sport such a strong currency?

The answer we believe lies in the Federal Reserve’s suppression of interest rates – close to zero for over 6 years now. This has had the effect of misallocating capital on a large scale. By that we mean bank savings have generally been punished by punitively low rates and moved into speculative investments to generate a yield … causing once safe income investments such as bonds to become incredibly risky.

We think to a large degree this bull market – which coincidentally began 6 years ago coinciding with the suppression of interest rates – is by and large GOOSED up on money printing.

That is why this chart of the S&P 500 adjusted for CPI – the S&P in real money purchasing power terms – has done no more than reach its highs of 1999/2000. Unmasking the façade that growth has been largely a function of increased money supply (QE) as opposed to real economic gains of which we are certain there are some but not as much as generally appreciated.

S&P 500 discounted for CPI

Figure 1 – S&P500 in Real $ (discounted for CPI)

What therefore will cause this illusion to break?

Quite simply a reversal of the Feds zero interest rate policy … a fate the Fed Funds futures (try saying that 3 times fast) are discounting with a 69% probability by October 25th, 2015 and 34% by July 29th 2015 per CME Group FedWatch

CME Fedwatch probability of higher interest rates

Figure 2 – CME Group Fedwatch

 

If short term interest rates rise but long rates don’t follow and/or economic growth slows rapidly, well, markets rarely sit around waiting for the facts but begin discounting them in advance. We shall see shortly whether the Emperor has any clothes!

 Greg Silberman CFA®, CAIA, CA(SA)

Chief Investment Officer

Advisory Services offered through Atlanta Capital Group.

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