I’ve got a bad feeling about the economy and the stock market.
I’ve had the bad feeling since April 2011. I have been wrong up until now.
My current uptick in malaise is caused by the rapid increase in long-term interest rates at the end of last week. That reminded me that a primary cause of the low long term rates over the last year has been Fed purchase of long term treasuries in Operation Twist. From The Wall Street Journal, 2/10/12:
As part of Operation Twist, the Fed has, since October, gobbled up $50.3 billion in regular Treasurys maturing in 20 to 30 years, acquiring 91% of the gross new bond supply issued by the U.S. Treasury for the maturity range over that time, according to data compiled by Barclays Capital.
I think the Fed has been encouraging inflation, and also keeping long-term rates low, to support the housing market, to keep both banks and consumers solvent. Now, the housing market was so overbought through 2007 that even inflation and low rates can’t raise housing prices. What can happen, however, is for the price of housing to rise relative to the price of other goods. That will effectively bring the price of housing down without the pain and possible rapid reduction of the money supply that would be caused by a series of mortgage defaults and foreclosures. I believe we are already seeing the inflation manifested in gas and stock prices.
(Parenthetically, who is hurt by this? Owners of housing, many of whom are the banks and individuals who took advantage of the bubble expansion. Maybe the Fed is thinking just desserts.)
But there’s a limit to what the Fed can accomplish by buying up all of the long-term treasuries. That’s because if the markets develop an expectation of inflation, investors will demand higher rates on their long term investments. If the Fed tries to fight that rate rise, that can fuel an inflationary cycle the Fed cannot win. They would be forced at some future time to execute a Volcker arrest of inflation — which would likely cause the defaults and foreclosures they are trying to avoid.
To further the disaster scenario, now that the U.S. debt exceeds GDP, interest rate increases will be crippling for our government’s ability to finance itself.
In the 1980s we faced high inflation and looming large deficits, but we were able to grow our way out of the problems. That was in large part because the government was getting out of the way as we moved through the 1980s. We committed to lower tax rates and our Executive Branch was minimizing regulation. Now we’re in a different spot. The talk is of raising tax rates, and we currently have an Executive Branch that believes business is evil and needs lots of regulation.
Those are growth-stifling microeconomic polices that restrict our ability to grow our way out of the problem.
So were looking at high deficits that we’ll have to repay from essentially our current level of income.
We could try to hyperinflate our way out of the problem. In my opinion, our central bankers are too smart and too conscientious to resort to hyperinflation.
We could default on our debt. That would reverberate around the world and cause catastrophe. It would hasten the commencement of China becoming the World’s dominant economic power.
We can kick the can down the road. If Obama is re-elected (and I believe he will be), I believe that’s the choice we’ll make. But the day of reckoning will come, and in my opinion we’ll have a problem of such proportions on our hands that a candidate like Rand Paul will be elected on a platform of a return to belief in private property and free markets.
Back to business. I think the stock market is a bad place to be right now because of the likelihood of rising interest rates and bad microeconomic policies. I believe that we’re ripe for a crisis tumble. The precipitating cause of the tumble could be anything, but the most likely cause is a revisit of the European debt crisis.
When the crisis was “solved” a few months ago, there was no fix of the underlying problems in Europe. Europe has the bad microeconomic policies of the social welfare state (job market inflexibility and overburdening government spending are the main culprits), which will make it difficult to achieve the growth necessary to repay the debts of the PIIGS, etc. We’ll see a time soon when investors will be asked to take a haircut on European debt. The crisis will be bigger because the debts will be bigger, and that could be the trigger for the U.S. stock market tumble.
I’m thinking below 10,000, and probably below 9000. But I will be ready to buy at that level.
Europe may choose to tax its savers (read inflate its way out of the debt) rather than enforce bond reductions. But Germany will oppose inflation. That battle will be fought between German banks and ordinary Germans.
