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Fed: Out of Powder

With the central banks meeting, it is important to understand just exactly what they are meeting about.

There is an old market adage that says when the stock market increases in value, bonds decrease in value.  This implies that when stocks increase in price, interest rates decrease in percentage terms.  If you look at the 10 year government yield versus the S&P 500, this seems to be the case:


Stocks move with interest rates

In the post internet bubble years, it seemed that stock prices moved nearly in lockstep with the yield on the S&P 500.  This is not exactly true, because you will notice the downward sloping line on interest rates over the last decade.  In fact, this phenomena of declining interest rates is even more apparent when you go back to 1991:

Generation of declining rates

In reality, the declining 10 year is mostly an artifact of declining short term interest rates provided by the Federal Reserve.  This has generally been considered Alan Greenspan’s contribution to modern finance – providing the punch bowl until the party really gets going (Internet Bubble), and then taking the punch bowl away (increasing short term interest rates) when it gets out of hand (when inflation starts creeping in or housing bubbles are created).


When in doubt, cut the Fed Fund's rate to spur economic growth

The Federal Reserve has run out of potential actions, that is why we are seeing the use of “quantitative easing” and other measures of effectively printing money without stating it.  With a short term interest rate of zero percent, it is very difficult for the Fed to move further and *explicitly* charge investors for the privilege of storing money at banks.  The Fed can create inflation and a ripe environment for borrowing and investing in its monetary policy, but it cannot create jobs.

The question that plagues the financial markets is: “Now what?”

The reality is starting to set in that short term interest rates are at 0%, the economy is sputtering, the Eurozone is imploding, and the US federal government is burdened with debt.  The Federal Reserve can either try to hyper-inflate its way out of this mess (taxing anyone with stored wealth in dollars) or we can spend the next decade slowly paying off our past crimes.  I hope for the latter.

Posted in Economics, Markets, Politics.

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