Surprise… Everyone Was Wrong About The End Of QE

Since the beginning of this year, Wall Street economists and analysts have been consistently prognosticating that following the Federal Reserve's latest bond buying campaign, economic growth would gather steam and interest rates would begin to rise. This has consistently been the wrong call as I discussed in April of this year in "Interest Rate Predictions Meet Bob Farrell's Rule #9:"

"An interesting article hit my inbox this morning from WSJ MarketWatch which was titled '100% Of Economists Think Yields Will Rise Within 6 Months' From the article:

'Economists are unwavering in their assessment of where yields are headed in the next half year.

Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury yield to rise in the next six-months.'

This is very striking from the standpoint that a separate poll of economists showed that there were none, zero, nada expecting an economic contraction either.

With literally 100% of all surveyed economists bullish on the economy, it suggests that there is nothing but clear sailing ahead for investors. Of course, it is also important to remember that it was this same group of "economists" that have been predicting the return of economic growth and higher interest rates for the last three years, as well. As we enter into the sixth year of the current economic expansion the unanimous 'bullish bias' is indeed fascinating."

Almost 18-months ago, after interest rates initially spiked from historic lows, I began writing then that the bond "bull" market was not yet over despite the litany of articles and punditry claiming otherwise. Furthermore, I stated that interest rates would be lower in the future as the three primary ingredients needed for higher rates were missing: rising inflation, increased wage growth and economic acceleration.

So, as we pass the 6-month mark for those predictions, let's take a look at where things stand now that the Federal Reserve's latest QE campaign has come to an end.

Interest Rates

As I discussed earlier this week on Fox Business News, the call for lower interest rates has continued to confound and frustrate the majority of mainstream analysts.

Will long-term interest rates eventually rise? Yes. However, as stated above, the ingredients necessary for a sustained rise in borrowing costs are not currently embedded within the economy. Furthermore, as I wrote previously, the current level of interest rates, given global economic conditions, is not unusual. To wit:

"Since then rates have continued to be in a steady decline as real economic strength has remained close to 2% annually, deflationary pressures have risen and monetary velocity has fallen. The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period."

"Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time. There have been two previous periods in history that have had the necessary ingredients to support rising interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. As discussed recently, this is a structural problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance."

Importantly, since 2009, interest rates have only risen during the Federal Reserve's QE campaigns as money was forced out of "safe haven" investments like bonds into "risk" assets in the equity markets. This, of course, was what was intended by the Federal Reserve under the assumption that inflating asset prices would lead to increased consumer confidence levels and higher rates of consumption.

 

 

(Note: As shown above, interest rates peaked during the latest QE program just as the Federal Reserve announced their first step in reducing bond purchases. Equities, at least for the moment, have appeared to peak as the last of the liquidity support was extracted from the financial markets.)

IF the Federal Reserve remains flat on monetary interventions, the current trend of interest rates suggests a retest of 2012 lows as economic growth slows domestically due to global deflationary pressures.

The Dollar & Oil

Like interest rates, the dollar has also been driven by the Fed's monetary injections. Just as with interest rates, the dollar is a "safe haven" investment during times of global weakness and deflationary pressures. As shown below, the dollar has rallied strongly when the Federal Reserve has extracted support from the financial markets which has made "risk" based investments much less attractive.

Since oil is traded in US dollars globally, it is also not surprising to see the effect of the Fed's interventions applied to oil prices.

As shown, oil prices rose sharply during QE programs as the push for "risk" drove money out of "safe haven" investments of the dollar and bonds and into oil contracts. As monetary interventions were extracted, or as during Operation Twist where the Federal Reserve was not actively monetizing debt, oil prices trended lower. The latest plunge in oil prices coincided with the end of the Fed's latest QE program which, as expected, sent oil prices and interest rates lower and the dollar higher.

Another Year Of Bond Bear Disappointment

The recent decline in interest rates should really not be a surprise as there is little evidence that current rates of economic growth are set to increase markedly anytime soon. Consumers are still heavily levered; wage growth remains anemic, and business owners are still operating on an "as needed basis." This "economic reality" continues to constrain the ability of the economy to grow organically at strong enough rates to sustain higher interest rates.

This is a point that seems to be lost on most economists who forget that the Federal Reserve has been pumping in trillions of dollars of liquidity into the economy to pull forward future consumption. With the Fed now extracting that support, it is very likely that economic weakness will resurface since the "engine of growth" was never repaired.

As I stated at the start of this post, while interest rates are indeed low currently, it is not the first time that we have witnessed such levels. Furthermore, interest rates can remain low for a very long time when there is a lack of sufficient economic catalysts to sustain the drag imposed by higher borrowing costs.

For now, literally "everyone" remains piled onto the same side of the interest rate argument even after 18-months of being wrong. That alone is enough to keep me bullish on bonds and other interest-sensitive sectors of the economy for now.