While higher stock prices are often cited as the biggest beneficiary of the Fed’s several rounds of quantitative easing (QE), a lesser cited beneficiary has been overall market volatility and the credit markets. With each round of QE and/or “Operation Twist” we’ve seen measures of financial stress in the credit markets (like the Ted Spread or BBB corporate bond yields to 10yr UST yield spreads) contract as seen below. Similarly, whenever we’ve seen the cessation of QE we are treated to a spike in financial market stress and with the ending of the Fed’s recent QE program in October of 2014 we are already seeing the first signs of stress in the corporate bond market as BBB spreads to 10yr UST yields rise. In fact, they have risen so much that they have retraced all of the improvement seen since QE3 began.

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Late last year, with the U.S. economy experiencing falling unemployment and seemingly low inflation, observers were extremely confident that the Federal Reserve would move judiciously in 2015 to restore ‘normal’ interest rates sooner rather than later. However, in light of the recent fall in both stocks and oil, that conviction has softened considerably.

Many, such as the very influential Bill Gross, now believe that our current Zero Interest Rate Policy (ZIRP), which has been in place for six years, will remain in place throughout the year. While this likelihood is a disappointment to many, who would have preferred to see the economy move along without Fed-supplied training wheels, few really understand the pernicious effects these policies are inflicting on the economy the longer they are held in place. In short, ZIRP is slowly transforming the world economy into a dysfunctional basket case.

Historically, it has been estimated that a ‘normal’ fair rate of return on short to medium-term high quality debt is between 2 and 2.5 percent, net of inflation. Recently, the Fed published year-on-year U.S. CPI inflation for mid November 2014 at 1.3 percent. This would suggest normal short-term rates at around 3.5 percent at present.

However, using the government’s methodology that was in place prior to 1990, John Williams’ Shadow Government Statistics (SGS) newsletter calculates inflation to be currently some 5 percent. Using methods in place prior to 1980, it is a staggering 9 percent. At that level, current interest rates should be somewhere around 11.0%. Even if we estimate that real inflation is currently 3%, then our “normal” rate of interest should be around 5%. This is some 50 times the rate paid currently on most bank deposits. This gap is distorting the economy in untold ways.

In early December 2014, the U.S. Congress approved further Government spending of some $1.1 trillion. This came just as the U.S. Treasury’s debt broke through a total of $18 trillion. It wasn’t that many months ago that the $17 trillion barrier was first breached.

Currently, the U.S. Treasury can borrow for 10 years at around a rate of 2 percent. But if long term rates rose to 5 percent, which would be in line with the historic range of “normal,” the 3 percent difference would cost the Treasury an additional $540 billion in annual interest payments (based on the current $18 trillion in debt). This would considerably undermine the government’s fiscal position, and necessitate an upheaval in federal budgeting.

The financial repercussions of a tripling or quadrupling of interest rates truly are horrific. They lead to a sense of foreboding that the Fed, aware acutely that the U.S. Treasury simply cannot afford a return to normal interest rates, will not restore normal rates unless forced to do so by international bond or currency markets. It appears, therefore, likely that ZIRP will continue for years to come. This feeling is underpinned by a view that low interest rates are simply a benign stimulant that fails to appreciate the actual harm they impose, particularly in the fixed income markets.

Savings are the prime source of real long-term investment. Today, savers are being crushed by the Fed’s manipulation of interest rates to below a real return. To find even small real returns, investors have had to scour the financial landscape for sources of yield. In doing so, they have ventured into risky territory and have, for instance, flooded into the high yield market, pushing junk yields to record low territory. The repercussions of providing excess capital to risky businesses have yet to be experienced, but the energy industry should provide us with a hint of things to come. Over the last few years small and midsized energy firms were able to borrow cheaply and lavishly to fund drilling projects, thereby greatly increasing production. But in retrospect, these efforts look like they helped create an oversupply of energy that has depressed the price of crude and has exposed the energy sector to long-term financial stress. Bankruptcies and creditor losses may be inevitable.

Another concern of the Fed is that despite an unprecedented increase in liquidity and part-time employment, real job creation is still sluggish at best. Furthermore, the Manhattan Institute’s Power & Growth Initiative Report of February 2014 notes that the U.S. oil and gas boom has created some one million jobs with a further ten million in associated occupations. The oil boom has improved net employment and kept the economy out of recession. But oil prices have fallen dramatically, threatening these economic bonuses and high-yield bond defaults. It’s hard to see what other distortions and hidden pitfalls have been created by negative real rates. The traps often become visible only after they have been sprung.

But with major economies such as the European Union, Japan and Russia flirting with recession (and China slowing down considerably), there is growing fear that normal interest rates would be dangerous at present. This fear likely will encourage the maintenance of ZIRP, possibly for years, with financial markets disconnected increasingly from the real economy.

Therefore, investors may continue to benefit for some time from the consistent boosting of financial markets by central banks. However, the longer a major correction or even a crash takes to develop, the more sudden, deep and devastating it may be.

John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

Call this the market that simply will not die. As mentioned in some previous posts, just about the time one thinks that this market is finally ready to turn lower marking the onset of the end of the ultra-low long term interest rates and the inception of the new trend towards higher rates, back up it goes and down go the rates.

Between US investors seeking safe havens due to slowing growth and falling crude oil prices, and foreign investors looking for higher yielding alternatives to their own government bonds, ( which pay next to nothing not to mention the currency risk that they are exposed to thanks to the soaring US Dollar), bond bears haven’t a chance in here.

Here is a look at the Daily chart. Notice the ADX/DMI in particular. It generated a solid sell signal the last week of December along with the same in the MACD only to have the signal negated within a week.

Larger Chart

Prior to today, bonds have been attracting selling on forays into the 146 zone. Not any more. Today, the buying just kept coming throughout the session. Every time it looked as if they had had enough and were ready to pull back, down went the equities further and up went the bonds.

The close was impressive as it not only punched through the resistance zone noted near 146, but the close was the highest in a long, long time, May of 2013 to be exact! Based on what we got today, there is a good chance these things will try to test the next resistance zone near 148. I still marvel that they are up here at these levels and yet here they are!

So let’s see what we have technically – buy signals on the MACD, the ADX/DMI ( and some other indicators not shown). Price having pushed through the median line of the Bollinger Bands last week and continuing on to hit the top band. Band width is now widening out again after having constricted for the last half of December.

All things considered, the chart is now firmly bullish. Personally I cannot bring myself to buy these things up here but someone sure is eager to own them. That forebodes some very terrible economic news is expected in spite of the rather upbeat expectations for the next US payrolls report. It seems as if the story remains one of SLOW GLOBAL GROWTH ( if any in some places) in combination with no inflation fears whatsoever and geopolitical concerns arising due to Greece and the Eurozone in general.

I for one cannot imaging trying to institute a risk management program for exposure to interest rate risk given the refusal of this market to back down for any length of time. Just about the time we get strong US Data and hawkish talk coming out of the Fed, and everyone begins to sell bonds ahead of the expected hike in short term rates, the rest of the news globally becomes one of deflation and sluggish growth prospects and up they go, taking out all the new shorts who just moved in ( me included).

At some point these things will finally end the multi decade bull market but as to when that will occur, I have no idea anymore. For now the bond bulls rule.

The BUBBLE for 2015,75 should be the bond market – not stocks. The capital flows should move into the typical flight to quality mode and drive rates even lower. This will set the stage for BIG BANG. To accomplish that, we should see the stock markets tread water, but not necessarily drive off the cliff.

We can see the 30 year bonds from a yearly perspective we recreated back to the late 1700s not only elected THREE YEARLY BULLISH REVERSALS for the close of 2014, but the oscillator also turned up. This is reflecting the sectorial capital flow shift. Of course, the dollar haters are out in force claiming our capital flow models are wrong because the stock markets are dropping. This is typical myopic perspective that will prevent them from ever really profiting from what lies ahead. They refuse to comprehend (1) you have capital flows among nations that drives the currencies for example, and (2) you then have sector driven capital flows.

It is the sector flows that we see as bubbles. To create a bubble in anything, we need capital CONCENTRATION. This is where confidence comes into play. People display their herd-instinct buy running into a sector because that is what everyone else is doing. People are convinced by price movement.

Each 8.6 year peak in the ECM produces a bubble in something. The 1989.95 was the end of Communism and the peak in the Japanese Bubble. The 1985 was the peak in deflation (dollar high) and 1994.25 was the peak in South East Asia with the low in US stock market. The 1998 target was the peak in the Russian boom and the collapse of Long-term Capital Management, The 2000 target was the Tech Bubble, followed by the low in 2002, and then came the securitzation bubble in real estate for 2007.15. The 2011 bottom was the peak in oil and gold and the start of the breakout in stocks.

These are the next three main waves until we reach the end of this 51.6 year wave with the culmination in 2032. Thereafter, China will surpass the USA and Asia will rise to the financial capital of the world. That is set in motion by the corruption in New York in place now that will deter capital in the long-run from the USA because we have no rule of law.

This 2015.75 turn should be the start of BIG BANG and this should be market with the low in interest rates that ferments the peak in the bond bubble. Each 8.6 year wave produces a bubble, yet in a different sector. It is never the same thing twice.

So for those desperate to try to prove me wrong, enjoy yourself. Count you money while you still have something to play with for unless you grasp how the world functions, chances are you will ge sucked into one bubble or another, This is not about being personally right or wrong. This is trying to figure out what make the world tick.

also from Martin: 

Can The Dow Correct for up to 5 Months?

Cybersecurity – Is Anything Safe?

Goodbye Inflation – Hello Deflation

Commodity Contagion

In the sound-money community there is universal skepticism about the Fed’s plan to stop monetizing the world’s debt. Hardly anyone thinks they’ll go through with it and absolutely no one thinks they’ll succeed if they do.

But the Fed is acting like it’s serious. Take a look at the monetary base, which is the amount of new currency that’s been created and pumped into the banking system. The trajectory since the 2008 crash tells you all you need to know about the “recovery,” which turned out to be just the Fed printing money and a few mostly rich people spending some of it. But check out the far right edge where the line turns negative. Not wildly negative, but still, the Fed does appear to have stopped adding and started subtracting. The money supply is falling.

This kind of tightening would normally coincide with — or cause — rising interest rates. But that’s not yet part of the plan, so even in the face of manifestly tighter money, interest rates have been allowed (or forced) to decline.

But the pressure of tighter money has to be released somewhere, and in this case it’s been the foreign exchange market. The euro, for instance, has tanked since mid-year.

Every other major currency is down as well, which is the same thing as saying that the dollar is up big. And a rising currency is functionally the same thing as higher interest rates. Consider: If you borrow money you have to pay back the principal plus interest. A higher interest rate obviously makes the loan harder to repay. But so does a rising currency because in order to pay dollars to a creditor you have to get those dollars, and if they’ve become more valuable in the meantime you have to pay up.

So the US is experiencing two of the three symptoms of tighter money: a falling money supply and rising currency. Will we eventually get the third, rising interest rates? That would be interesting to say the least. To understand why, let’s revisit the monetary base chart, with the addition of arrows showing what the stock market did during the previous two attempts at tapering. It tanked — or at least started to tank — and the government relented.

Note that during those other two taper attempts the monetary base didn’t fall much if at all, and the dollar didn’t rise to anything like its current level. In other words, the Fed didn’t actually tighten, it just stopped loosening. This latest iteration is already more serious than the two that came before.

So either another stock market scare is coming, and soon, or the economy has finally achieved the fabled escape velocity in which it can grow under its own power without help from performance-enhancing monetary drugs. We should know the answer soon.

Spoiler alert: The sound-money crowd is right. This ends very badly.