Yesterday, we assessed the Fed’s failure to accurately assess the real problems of the economy.
In simple terms, the Fed under the guidance of Alan Greenspan, was terrified of deflation hitting the US. Greenspan hired Ben Bernanke, an alleged expert on deflation and the Great Depression to combat this.
The two Fed Presidents then proceeded to create an epic bubble in nearly all asset classes. By concentrating on deflation they missed the boat and in fact created a highly inflationary environment.
The dreaded deflation briefly appeared from late 2007 to early 2009. The Fed went ballistic fighting this and has since become even looser in its monetary policy, lowering interest rates to zero and printing over $4 trillion.
The end result?
Inflation is once again soaring in the US. Oil is back above $100 per barrel. Stocks have more than tripled from their 2008 lows, and housing is now more expensive relative to incomes than it was in 2007 for some markets.
Inflation is a reality in the economy, but the Fed likes to publicly argue that inflation is too low or virtually non-existent because bond yields remain at historic lows (see below).
However, the Fed is missing the big picture here. The reason bonds continue to fall in yield is because:
1) Wall Street is front-running the Fed’s QE programs (buying bonds from the Treasury and then flipping them to the Fed for a quick profit).
2) Financial institutions, particularly in Europe, remain highly leveraged and so are seeking higher-grade collateral by buying US Treasuries.
3) The Fed has created an artificial floor beneath Treasury demand by soaking up half or more of all US debt issuance each month for the last five years.
Remember, Fed officials cannot and will not openly threaten to change policy. Instead they will first hint and insinuate that a change is coming before finally making a move.
However, the Fed’s moves usually come much too late. The inflation genie is already out of the bottle again in the US. The question is how bad it will get before the markets begin to ignore the Fed’s asset purchases and we begin to see the normalization of interest rates.
Let us conclude this article regarding the US with an illustration of the current problem of asset price inflation versus a weak economy. Below is a chart showing the performance of basic materials stocks (black line) vs. the price of the actual basic materials themselves (blue line).
Materials stocks are closely aligned with Fed policy and money printing. The basic materials themselves are closely aligned with actual economic activity as maintained by supply and demand. Note the massive divergence with stocks being sharply overpriced relative:
You can literally see that the stock bubble (inflation) took off in late 2013/ early 2014. With the Fed now tapering, at some point these two items will reconnect. The question is when.
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Phoenix Capital Research