Comstock Partners, Inc.June 11, 2014
The Reason for Interest Rate Declines
Bullish Sentiment is a Problem
Last week we published the special report, “Deflation vs. Inflation”. That topic has become the subject of ongoing debates on the financial news about why the bonds and notes, here in the U.S. and Europe, were declining so much this year. As our report was being distributed the European Central Bank (ECB) met and Chairman Mario Draghi released an onslaught of anti-deflationary policies. The ECB hopes these policies will reverse the spreading deflation throughout the Eurozone.
Deflation is caused by onerous debt collapsing on the system, resulting in less credit extension and less spending, followed by a severe recession or depression. This is what took place in the “Great Depression”, Japan starting in 1989, and it looks to us like the Eurozone and U.S. could be headed for the same scenario.
There have been several debates among the financial gurus in the media attempting to explain why interest rates dropped so sharply this year, after rising last year. Some would argue the lower rates are reflecting weaker economies over the next few quarters or years. Clearly, we believe that these lower rates in Europe and the U.S. are reflecting disinflation presently, (that has a good chance of turning into deflation). The U.S. inflation is running about 1.6%, which is about 1% higher than Europe, which is running about .5%. The U.S. money supply rose over 6% during the past year while Europe grew only 0.8%. The U.S. 10 year Treasury is still trading at about 2.6% while the French 10 year bonds are at 1.7%, Italy 2.8%, Spain 2.6%, and Germany 1.4%. The UK is also under the blight of deflation since their average hourly earnings growth has slowed to just 0.8% while their 10 year bonds are trading at 2.7%.
The anti-deflationary policies that Mario Draghi revealed last week were a reduction of 0.1% in its main rate (similar to our Fed Funds rate), and lowering the interest rate on reserves the banks hold with the ECB. Additional steps were taken to provide banks with low cost long term funding to make loans. These ECB headline policies are not as significant as the policies for their banks to loan out Euros to small and medium sized businesses at the same rate they charge to the large companies. Before this policy they were charging small and medium sized companies almost double the rate they were charging their larger corporate clients.
As much as the ECB went with deflationary policies, they did not go as far as our Fed and the Bank of Japan (BOJ) in initiating quantitative easing (QE). We suspect that they could see the corner we painted ourselves into and didn’t want to wind up with the same dilemma we have presently. They could see that it will not be easy to wind down a $4.3 trillion balance sheet that started at $800 billion just 5 years ago.
In fact, in the past, every time we ended a QE program the stock market declined. We will end the purchases of government securities and mortgage backed securities if we stay on the Fed plan this year. We suspect strongly that before we end the QE program, the Fed will see enough weakness in the economy to reverse the “taper” and begin purchasing more bonds (essentially start another QE). However, even if they complete the “taper” they will still have a problem with the stock and bond markets as they attempt to raise rates. And after that, they still have an enormous balance sheet to wind down eventually. Just yesterday the Fed officials stated that they are concerned about having to sell bonds from their balance sheet (since that could crush the U.S. recovery).
The World Bank cut its global growth forecast for this year from 3.2% in January to 2.8% now - amid weaker outlooks for the U.S., Russia, Brazil, India, and China economies. The U.S. forecast was lowered from 2.8% to 2.1%. They also called on emerging markets to strengthen their economies before the Fed raises interest rates.
Another problem the bulls have got to deal with is the fact that “Investors Intelligence” just reported the results of their weekly poll of financial advisors. The percentage of bulls just jumped to 62.2% from 58.3% a week earlier. This marks the 5th straight week this indicator has been above the key 55% level. This current level exceeds last year’s high-water mark of 61.6% at the end of December. Prior highs came in August 1987 (60.8%), October 2007 (62%), and December 2004 (62.9%). All of those peaks occurred after large rallies and prior sizable corrections.