The S&P500 melted up another 1.3% last week, on the heels of one of the worst jobs reports this year. Volume was light, when you remove the non-recurring volume we saw when the government unloaded a big chunk of its Citibank shares. The VIX index dipped very slightly to its lowest levels since April.
The economy appears to be improving, but only because the federal government is still–almost three years after the Great Recession started–keeping it on life support. Just about all of the so-called recovery over the last year has occurred only because of the government’s massive fiscal and monetary stimulus. Last week–more of the same. Consumer credit was reported to have risen slightly; but that’s only because the government’s student loan funding soared by $32 billion. Without that huge spike in loans to students (who never in history have been burdened by more student debt), consumer credit would have plunged by almost $29 billion. Initial jobless claims came in at a still dreary 421,000 level. Consumer sentiment was slightly better than expected, but even this reading is far below those printed during normal recoveries.
Technically, the stock market is melting up, to form a possible long-term double top, where the first top formed in late April. Volumes are still not confirming the price rise–volumes after late April on the way down were much higher than those on the way up this fall. Momentum indicators and oscillators are still diverging bearishly. Breadth is also diverging; it was much stronger in April’s peak than it is now, meaning a fewer number of stocks are participating in this rise than earlier this year.
Something very interesting started happening in the capital markets a few weeks ago, but not in the stock market. Bond prices started to fall. And not just in one corner of the bond market, but virtually across the board–in the US and internationally.
At home, municipal bonds fell hard, for several reasons: lots of supply, the upcoming end of the Build America Bond program, and worries over deteriorating state and municipal fiscal conditions.
At the same time, the US Treasury market started eroding, gradually at first, and then almost crashing last week. Yields on the 10 year note are up almost one full percentage point from the one year lows set only a couple of months ago.
Investment grade corporate bonds are also plummeting. The large bond ETF with the ticker symbol LQD has dropped almost 5% in four weeks, erasing about half a year’s worth of gains. In bond land, this is a huge drop.
Overseas, emerging market sovereign debt is also falling hard. PCY, also an ETF, has lost over 5% of value in less than a month.
As a result, in the bond markets across the globe, hundreds of billions of dollars have been lost in only a few short weeks. In the US, the Fed has declared that lower Treasury yields are one of the key goals of monetary policy and specifically quantitative easing, both the first and second editions.
The Fed knows that with lower rates, the price of housing and all other risk assets will be supported. If rates rise, the support goes away. This would crush the fragile economy.
So here’s what’s scary: the Fed is losing control of interest rates. And not only will the economy suffer, but the US government would be more vulnerable to a fiscal funding crisis if rates shot up to high (higher rates on the ballooning federal debt load would mean that more and more of the annual budget would need to be shifted to interest payments).
What does this mean? If the rates keep going up, the Fed will be faced with a stark choice. Like the little Dutch boy plugging the dyke with his finger, the Fed has been doing the same with the bond market–suppressing the interest rates to boost the economic growth and the government’s finances. But unlike the Dutch boy, the Fed has also been plugging another dyke at the same time–the stock market.
What happens if the Fed can’t keep both dykes intact? Which dyke will the Fed sacrifice if it had to let one fall apart?
Arguably the Fed would be forced to defend the Treasury market and direct all its fire power to keeping rates low, otherwise the Treasury’s financial situation could blow up.
That means that the Fed might have to let the stock market go. By doing so, the rush of hot money out of stocks would flood into the deepest and most liquid market in the world: the US Treasury market. This scared money would bid up Treasury prices and drop yields–possibly–to new secular lows (with the 10 year dropping below 2.0%).
The Fed may never announce that it’s doing this (ie. taking back its support of stock prices and other risk assets, support declared by Ben Bernanke in a recent Washington Post Op-Ed). No, the trigger would ostensibly be exogenous–a Eurozone default, a North Korean conflict, etc.
But this would be the perfect excuse to get interest rates back under control and buy the federal government more time, to get its fiscal house in order.
Oh and by the way, the same bond market declines that we’re seeing today happened not too long ago…..in the spring and summer of 2008, several months before the stock markets around the world crashed.