ARE HIGHER INTEREST RATES PRICING IN USA DEFAULT FEARS?

Back in late August, with interest rates at all-time lows I explained what would need to occur for interest rates to rise substantially:

“Inflation will likely occur during a recovery.? And by then all of this chatter of default and USD collapse will be long gone.? It might get the hyperinflationists hyperventilating again, but these same people fail to understand what hyperinflation actually is – it is the death of the currency that generally occurs due to a lack of faith in that currency.? And that my friends will not occur if we experience a booming recovery and a surge in loan growth.? The two simply do not go hand in hand.”

Since then, interest rates have moved higher (though still very low in historical terms).? This rise in rates happened to occur during the latest round of QE which has provided new fodder for the hyperinflation/default argument from the same pundits who have gotten that story wrong for as long as anyone can remember.? Of course, they’ve been claiming for years now that QE1 & now QE2 would result in hyperinflation and eventually some form of default.? But there is a a disconnect in their argument.? Uncle Sam’s prognosis has not deteriorated in recent months – it has in fact improved dramatically.? So what exactly is occurring here and do the higher interest rates spell impending doom for America?

When QE2 was initiated the Fed’s goal was to lower interest rates by purchasing government debt.? Some commentators said this would crash the dollar and cause runaway inflation.? It was described as “money printing” despite Ben Bernanke’s repeated efforts to explain why he was not increasing the money supply.?? But a funny thing has happened since this new policy was initiated – rates have surged.? This is a remarkable event.? Can you imagine if the Fed announced a target rate on the Fed Funds Rate and rates move in the opposite direction?? That would be a market shattering event, but in the context of QE it is overlooked largely because most people still fail to understand exactly what QE is.? As I’ve previously explained, however, the Fed can’t control the long end of the curve under the current strategy.? They’ve essentially put an unloaded bazooka on the table and the market knows it.? In order to truly control the long end of the curve the Fed would have to specify a target rate and be a willing buyer at any size.? This inherent flaw in QE proves that it was destined to fail before it ever began.? But that hasn’t stopped the hyperinflationists and defaultistas from trying to scare everyone into believing that the USA is about to sink into the same black hole that now consumes Greece and Ireland.

With rates rising they have latched onto the argument that higher rates mean we are being exposed as the insolvent nation they have long argued we are.? Of course, that’s nonsense for anyone who understands how the modern monetary system works.? In a recent article Michael Pento of Euro Pacific (Peter Schiff’s firm) writes:

“By 2015, our publicly traded debt is projected to be at least $15 trillion. Even if interest rates simply revert to their average level – not a stretch, given surging commodity prices and endless Fed money printing – the debt service expense could easily reach over $1 trillion, or about 50% of all federal revenue collected today. Just imagine what would happen if rates were to rise to the level of Greece, nearly 12% on a 10-year note, as opposed to our current 10-year yield of just 3.5%. I bet Athens, Georgia wouldn’t look much better than its namesake. Don’t forget: as interest rates rise, GDP growth slows, sending the debt-to-GDP ratio even higher.

Earlier this year, it wasn’t the nominal level of debt that suddenly sent euroland into insolvency, but rather a spike in debt service payments. Right now, the US national debt is the biggest subprime ARM of all time. Much like homeowners who thought they could afford a mortgage that was 10 times their annual incomes, Messrs. Krugman and Wesbury are blinded by deceptively low current rates of interest. These ostriches won’t poke their heads up to see the writing on the wall: low rates and quantitative easing cannot coexist for long. As rates continue to rise, the reality of US insolvency will be revealed.”

This isn’t the first time Mr. Pento or Mr. Schiff argued that the US dollar was doomed and that interest rates were going to surge and expose the USA as being insolvent.? In fact, they’ve been making this argument for well over a decade and interest rates have continued to decline and the US dollar has remained remarkably stable over the same period.? Inflation, has been remarkably low.? But what about the most recent surge in yields?? Are the gentleman at Euro Pacific finally going to be right??? The evidence says no.

Since the rally in yields began in September we’ve actually seen the hyperinflation story deteriorate further.? The surge in yields are not a sign that Uncle Sam is becoming Greece.? To the contrary, the rise in yields are a sign that Uncle Sam is recovering.? Productivity is increasing, the much feared double dip appears to be a thing of the past and yields are accurately reflecting this higher level of economic output.? Yields are rising because the economic outlook has improved – not because the US government is on the verge of imminent insolvency.? Rising economic activity will almost certainly be accompanied by higher inflation, but let’s not confuse hyperinflation (death of the currency) with healthy rates of inflation.

The hyperinflation story can be debunked easily by looking at the data itself.? As the equity markets rally on hopes of a sustained economic recovery we have seen a coinciding rally in the US dollar and a decline in 5 year US credit default swaps.? This is not even remotely close to what might happen if the government bond market were in fact pricing in default or hyperinflation.? One need look no further than the recent action in Greece for evidence.? As yields in Greek debt surged throughout 2010 their equity markets have collapsed and their credit default swaps have surged to all-time highs.? If it were not for the flawed single currency system in Europe you could guarantee that the Drachma would be absolutely collapsing right now (although the Euro has declined significantly).? The situation in the USA is EXACTLY the opposite.? Rising yields are occurring during a period when 5 year CDS are flat or falling (see chart below), equities are surging and the US dollar strengthens.? That is in no way consistent with an environment in which default or hyperinflation are likely to ensue.

So you can see that this is hardly an environment comparable to the one confronted by Greece, Ireland, Zimbabwe or Weimar.? This is not to imply that the US economy is without troubles (the still very low historical rates show that the USA has severe structural issues), but the most recent rise in yields should not be misconstrued as something that poses a risk of US default, dollar collapse or hyperinflation.? To imply as much is pure fear mongering and nothing more.? The rise in yields merely reflects a marginally higher rate of economic activity when compared to the severely depressed expectations of a few months ago.

In sum, the USA is not insolvent or on the verge of suffering a hyperinflationary collapse.? Anyone who argues as much simply does not understand how the modern monetary system actually functions in the USA.? Furthermore, the latest round of QE has been proven to be a failure as rates surge in the face of a Fed that has vowed to purchase $600B in government bonds, but failed to set a target rate on these purchases.? Make no mistake – this rise in yields is not a sign that Uncle Sam’s balance sheet is weakening.? It is a clear sign that Uncle Sam is recovering from a truly nightmarish economic situation.? Higher rates in the USA are not a sign that we are becoming Greece.? Rather, it is a sign that we are NOT becoming Japan (hopefully).? Let’s hope the recent trends truly do become sustained.? I still believe the USA faces extreme headwinds, but hyperinflation and default are not amongst them.

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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Market Meets New Wall of Worry Or More Likely Just Brief Profit-Taking On Way To Higher Highs

Stocks pulled back after a big advance and that can be good for bull markets

Most of the bricks in the previous wall of worry have been removed.?Economic reports have continued to improve over recent weeks; in manufacturing, the service sector, retail sales, durable goods orders, and even in the employment picture, where 151,000 new jobs were created in October, more than double the 70,000 that economists expected.

The uncertainty over the Federal Reserve’s QE2 decision has been resolved with the Fed adding to the stimulating atmosphere, providing another round of quantitative easing in spite of the already improving economy.

The major U.S. market indexes, including the Dow, S&P 500, and Nasdaq rallied back to, and then above the potential resistance at their April peaks, before pulling back some this week.

Investors have become even more bullish and optimistic. This week’s poll of its members by the American Association of Individual Investors showed 57.6% bullish, the highest level in almost four years.

The good news apparently also reached Main Street. On Friday morning it was reported that the Thomson Reuters/University of Michigan’s Consumer Sentiment Index improved to 69.3 in early November (its highest level in five months) from 67.7 in October.

So what has been wrong with global markets this week?

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The U.S. market closed down roughly 2.5% for the week. Emerging markets, which many analysts projected would benefit the most from inflows of additional liquidity provided by the Fed’s decision, were down the most. Brazil, India, South Korea, closed down two to three percent for the week, while China closed down a big 5.5%. Meanwhile, Japan, a large developed country, which was not supposed to fare as well as emerging country markets, closed up 1.0% for the week.

A bet against emerging markets via the ProShares UltraShort Emerging Markets ETF, symbol EEV (designed to move up when emerging markets move down, and leveraged two to one) closed up almost 9.0% for the week.

Was it just that markets had become short-term overbought and ran into a brief bout of profit-taking, particularly since this was the week before the month’s options expirations week, and the week before tends to be negative?

If so, markets are likely to be back up next week since the decline this week took care of the short-term overbought condition, and next week is the week of the expirations, which tend to be positive.

Or was the decline the beginning of something more serious?

The market does seem to have a new wall of worry just a week after concerns about the economic recovery, and whether the Fed would or would not provide additional quantitative easing, faded away.

The bricks in the new wall of worry include:

• Concerns that the Fed’s additional stimulus may cause new problems rather than help the economy by encouraging home purchases or providing new jobs.
• Worries that commodity prices had spiked up into bubbles which may burst, a worry that struck Friday with the big $40 an ounce (3%) plunge in the price of gold, and equally large declines in the price of oil and other important commodities.
• Apprehensions about the activities of the Chinese government, including talk that it might hike interest rates to dramatically slow its globally important economy and ward off threatening excessive inflation in China.
• Anxiety about a potential currency or trade war if the decline in the U.S. dollar continues.

Via technical analysis there is also the U.S. market’s intermediate-term overbought condition above 20-week moving averages, and the high level of investor bullishness (which is at levels of complacency often seen at market tops).

The uncertainties have even extended to U.S. Treasury bonds, which investors have piled into as a perceived safe haven over the last two years. The safe haven over the last two months has actually been a bet against U.S. Treasury bonds. For instance, the ‘inverse’ ProShares Short 20-year bond etf, symbol TBF, designed to move up when bonds move down, has gained 11% since early September, while bonds have declined 11%.

There’s no doubt about it. We are still in a very fluid economic and investing period, not a time for investors to become so complacent as the investor sentiment readings seem to indicate, that they fall asleep at the switch.

(In the interest of full disclosure, we have positions in the U.S. market, the Japanese market, gold, and the ‘inverse’ bond ETF TBF, in our portfolio, at least at the moment).

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Market Meets New Wall of Worry Or More Likely Just Brief Profit-Taking On Way To Higher Highs

Stocks pulled back after a big advance and that can be good for bull markets

Most of the bricks in the previous wall of worry have been removed.?Economic reports have continued to improve over recent weeks; in manufacturing, the service sector, retail sales, durable goods orders, and even in the employment picture, where 151,000 new jobs were created in October, more than double the 70,000 that economists expected.

The uncertainty over the Federal Reserve’s QE2 decision has been resolved with the Fed adding to the stimulating atmosphere, providing another round of quantitative easing in spite of the already improving economy.

The major U.S. market indexes, including the Dow, S&P 500, and Nasdaq rallied back to, and then above the potential resistance at their April peaks, before pulling back some this week.

Investors have become even more bullish and optimistic. This week’s poll of its members by the American Association of Individual Investors showed 57.6% bullish, the highest level in almost four years.

The good news apparently also reached Main Street. On Friday morning it was reported that the Thomson Reuters/University of Michigan’s Consumer Sentiment Index improved to 69.3 in early November (its highest level in five months) from 67.7 in October.

So what has been wrong with global markets this week?

Special Offer: Jim Oberweis bought Baidu at $7.90, earning readers huge profits.? Click here for more recommended stocks in the?Oberweis Report.

The U.S. market closed down roughly 2.5% for the week. Emerging markets, which many analysts projected would benefit the most from inflows of additional liquidity provided by the Fed’s decision, were down the most. Brazil, India, South Korea, closed down two to three percent for the week, while China closed down a big 5.5%. Meanwhile, Japan, a large developed country, which was not supposed to fare as well as emerging country markets, closed up 1.0% for the week.

A bet against emerging markets via the ProShares UltraShort Emerging Markets ETF, symbol EEV (designed to move up when emerging markets move down, and leveraged two to one) closed up almost 9.0% for the week.

Was it just that markets had become short-term overbought and ran into a brief bout of profit-taking, particularly since this was the week before the month’s options expirations week, and the week before tends to be negative?

If so, markets are likely to be back up next week since the decline this week took care of the short-term overbought condition, and next week is the week of the expirations, which tend to be positive.

Or was the decline the beginning of something more serious?

The market does seem to have a new wall of worry just a week after concerns about the economic recovery, and whether the Fed would or would not provide additional quantitative easing, faded away.

The bricks in the new wall of worry include:

• Concerns that the Fed’s additional stimulus may cause new problems rather than help the economy by encouraging home purchases or providing new jobs.
• Worries that commodity prices had spiked up into bubbles which may burst, a worry that struck Friday with the big $40 an ounce (3%) plunge in the price of gold, and equally large declines in the price of oil and other important commodities.
• Apprehensions about the activities of the Chinese government, including talk that it might hike interest rates to dramatically slow its globally important economy and ward off threatening excessive inflation in China.
• Anxiety about a potential currency or trade war if the decline in the U.S. dollar continues.

Via technical analysis there is also the U.S. market’s intermediate-term overbought condition above 20-week moving averages, and the high level of investor bullishness (which is at levels of complacency often seen at market tops).

The uncertainties have even extended to U.S. Treasury bonds, which investors have piled into as a perceived safe haven over the last two years. The safe haven over the last two months has actually been a bet against U.S. Treasury bonds. For instance, the ‘inverse’ ProShares Short 20-year bond etf, symbol TBF, designed to move up when bonds move down, has gained 11% since early September, while bonds have declined 11%.

There’s no doubt about it. We are still in a very fluid economic and investing period, not a time for investors to become so complacent as the investor sentiment readings seem to indicate, that they fall asleep at the switch.

(In the interest of full disclosure, we have positions in the U.S. market, the Japanese market, gold, and the ‘inverse’ bond ETF TBF, in our portfolio, at least at the moment).

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DID QE CAUSE EQUITIES TO MOVE HIGHER IN JAPAN?

3 November 2010 by TPC 16 Comments

There appears to be some confusion over the response of equity markets to quantitative easing.? Of course, the Fed is hoping that they can ignite a “wealth effect” by driving stocks higher.? But as we saw in Japan this failed to materialize.? In fact, anyone buying in front of the QE announcement in Japan ultimately got crushed in the ensuing few months and years.? When the BOJ initially announced the program in March 2001 the equity market rallied ~16%.

But the euphoria over the program didn’t last long.? In fact, within 6 weeks of the announcement the Nikkei began to crater almost 30% over the course of several months. ? In the ensuing two years the Japanese stock market fell a staggering 43%!? It wasn’t until the global economic recovery in 2003 that Japanese equities finally bottomed and went on a tear.? Ultimately, the BOJ ended the program in March 2006 and deemed it a failure.

(Nikkei 225 1999-Present)

(Nikkei 225 After BOJ Announcement)

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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GOLDMAN SACHS: QE2 WILL NOT DRIVE STOCK PRICES HIGHER

Goldman Sachs is not convinced that QE2 will have a significant impact on the equity markets from current levels.? In a recent strategy note (via Zero Hedge) they cited the primary reason why QE2 was likely already fully priced in and unlikely to impact the real economy heading into 2011:

We believe QE2 is unlikely to change our sales or margin forecasts, so return prospects become a valuation debate. Our targets imply less upside, given 13.5x P/E is consistent with prior 1-2% real rate regimes.

The bullish argument for equities goes as follows: (1) The Fed buys longdated Treasuries to reduce term premium and lower interest rates across the maturity spectrum; (2) The low yields penalize individuals and corporations who hold cash; (3) individuals and institutional investors re-allocate their savings into higher risk instruments such as equities, high yield bonds, emerging market debt and equity, and commodities; (4) firms pursue new capital spending initiatives and boost employment; (5) asset price inflation has a wealth effect and spurs retail spending; (6) a consequence of lower US interest rates is a weaker US Dollar which benefits US exporters and also stimulates some incremental domestic job growth.

Our year-end 2010 price target for the S&P 500 remains 1200 or 1% above the current level of 1183. We expect the S&P 500 will trade sideways during 1Q before rising during the subsequent six months. Our 12-month forecast of 1275 reflects a price return of 8% and a total return including dividends of 10%. For details, see our report US Equity Views: Updating our price targets as investors focus on 2011 (October 15, 2010).

Three topics drive our view of the trajectory of the US equity market. (1) Sales; (2) profit margins; and (3) money flow. Below we briefly outline how each of these items will be affected by the pending QE2.

1. QE2 is unlikely to change our sales forecasts. Goldman Sachs Economics 2011 US GDP growth forecast already incorporates at least $1 trillion of Treasury purchases by the Fed. Despite the hefty forecast of Fed purchases, our 1.8% GDP growth forecast remains below the consensus expectation of 2.5%. The buy-side seems to be in the 2.0%-2 ?% range. Our current index and sector-level sales forecasts incorporate our GDP growth assumptions and therefore already capture QE2. Capacity utilization hovers at 74%, up from the March 2009 low of 68% but below the 81% long-term average, so firms are not compelled to fast-track new projects despite the availability of cheap financing. The US has a demand, not a supply, problem. The US Dollar has weakened in the 12 weeks since QE2 entered public debate and it will benefit revenues of US companies, although by less than many investors believe. S&P 500 generates just 30% of sales outside the US.

2. QE2 is unlikely to change our margin forecasts. Our index and sector level net margin estimates incorporate our US and world GDP, interest rate, inflation, oil and US Dollar forecasts and the firm’s macroeconomic view assumes $1 trillion of QE2. If the Fed successfully spurs higher inflation than we currently assume (1.1% in 2011), it will have a negative impact on profit margins because rising input costs will not be fully-passed through to the? consumer. Passing inflation along to the end customer will be particularly difficult in an environment with nearly 10% unemployment. Our 8.4% net margin forecast stands below bottom-up consensus of 9.0%. The Fed’s desire to re-inflate the economy tilts margin risk lower rather than higher. Firms reporting negative margin surprises in 3Q span the value chain from raw (X, AKS, NUE, MEE) to intermediate (GENZ, LLTC, BMS) to end-demand (AN, AVP, KMB, SLB, EFX, AVY, T) to cite just a few examples.

3. Therefore, QE2’s potential impact on the US equity market reduces to a debate over valuation. Bulls argue stocks are dramatically undervalued relative to bonds. It is true that using Treasuries, BBB corporate bonds, or TIPs in the Fed model leads to a conclusion the S&P 500 is 20% undervalued. Bulls similarly argue that QE2 will drive both yields and risk lower,? reduce the cost of equity, and support a DDM valuation above our 12-month target. Bulls implicitly argue stocks should trade at a higher P/E multiple. Our more modest return projection incorporates a current starting point valuation that shows stocks trade at a 13.5x NTM P/E multiple consistent with past real interest rate regimes of 1-2%. However, the current P/E multiple is calculated when margins stand at all-time highs. A P/E assuming normalized margins would be 14.6x closer to the long-term average. We believe the forward path of stocks will be determined by potential asset allocation shifts by owners of 70% of the US equity market. Individuals own in aggregate 53% and pension funds own 17%. Shares will trade sustainably higher if these investor groups decide to re-risk from bonds to stocks. Any shifts most likely will be gradual.

A lot of that probably sounds familiar to regular readers.

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The content on this site is provided as general information only and should not be taken as investment advice. All site content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The opinions of all guest authors or contributors can and will differ from those of Mr. Roche. These opinions do not necessarily represent the opinions or investment decisions of Mr. Roche. The author(s) may or may not have a position in any security referenced herein and may or may not seek to do business with one another or companies mentioned via this website. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

A brief note on comments – The increase in users in recent months has resulted in an increase in unproductive comments. Any user who engages in the use of racial epithets or uses the comment section as a place to insult other users will be banned from the site. The comment section is welcome to all readers who are interested in asking pertinent questions and/or engaging in thoughtful, intelligent, and productive debate. In short, just be nice. Thanks.

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