As always, it is important to understand what is going on behind the scenes as opposed to just looking at the headline numbers, and why things are going the way they are. So let's take a deeper look. In the midst of the worst financial crisis since the Great Depression (dubbed the Great Recession), the Federal Reserve enacted extraordinary measures to save the economy from collapse. It worked. The economy eventually found a bottom and things started to improve. However, they didn't improve enough, as job growth was weak, the unemployment rate didn't come down fast enough and the housing market remained mired in a slump. They then decided to enact even more extraordinary measures. With the Federal Funds rate (the rate at which banks borrow from each other, and the rate which is the basis for all other interest rates in the economy) at basically zero, the Fed couldn't cut rates any lower to drive down other interest rates. So they decided to actually become a buyer of fixed income securities to bring interest rates even lower. To do this, they have been buying trillions of dollars worth of Treasury bonds and mortgage-backed securities (MBS) over the last few years. This is called quantitative easing, basically, printing money.
This has had the desired effect of bringing interest rates down to ridiculous levels. Most notably, a 30-year mortgage rate is now at just 3.5%, give or take, which has led to a resurgence in the housing market. As such, home prices have jumped recently, giving current homeowners more financial security since their biggest asset is now worth more. Unfortunately, many homeowners are still reluctant to sell because they are still underwater on their mortgage and need prices to go even higher to break even. This has severely restricted housing supply. Thus, a mix of rising demand due to low interest rates, along with very tight supply due to seller reluctance, has pushed up home prices. The question on the minds of many buyers, and sellers, not to mention anyone involved in the housing industry, is how long will this last? Is this a sustainable recovery? Well, if prices keep going up, eventually more homeowners will put their homes on the market. If there isn't enough demand to absorb that increase in supply, home price growth will likely slow, and prices may actually turn downward again. It is important to keep in mind that there are still millions of homeowners underwater. Thus, even though "listed" supply is very tight right now, the "shadow" supply is very large. So just beware that if prices continue to rise, eventually supply will catch up. Nobody knows what the magic number is, at what price point more homes will come on the market, and that is the tricky part of the whole equation. Of course, the housing rally could stall if prices get so high that buyers are priced out of the market, which could happen even before prices get high enough for underwater sellers to list their homes.
The other major factor in determining the sustainability of the housing rebound is interest rates. As previously mentioned, low interest rates, along with stronger job growth, are helping to propel the housing market, and via the feedback loop the stronger housing market is helping to create housing-related jobs, which comprise a significant share of jobs in the economy. The biggest question is how long will rates remain this low? In addition, what will be the impact if interest rates start to rise, either driven by the Fed or the market? With interest rates at record lows, have home buyers become complacent, thinking that this is the new normal? Will the market be able to handle a 5% or 6% mortgage rate? Of course, it depends on the state of the economy when interest rates begin to rise. If interest rates rise because the economy is getting stronger, the housing market, and the overall economy, should remain in decent shape. However, if interest rates start to rise for other reasons besides improving economic growth, we could have a problem.
So what are those other reasons that interest rates could rise besides strong economic growth? There are a few. First, if inflation starts to creep higher, the Fed may have to raise interest rates. They have stated that their target on inflation is about 2.0%. In other words, they will not raise interest rates until inflation rises above this number. Inflation could rise even if the economy remains stagnant, which is known in economic parlance as stagflation. A major driver of stagflation is often rising commodity prices. As we all know, with a more globalized economy, commodity prices have become much more volatile in recent years, and can rise, sometimes significantly, even though the U.S. economy is weak. Commodity prices are now more vulnerable to supply shocks from bad weather, natural disasters, geopolitical turmoil and other factors than ever before since there is so much more demand for them.
Second, generally speaking, if a country's currency weakens too much, the central bank will usually take measures to increase interest rates in an effort to lure more investors with a higher yield. However, this is not necessarily the case in the U.S. Since the U.S. dollar is the world's reserve currency, investor demand is generally maintained even if the dollar weakens. If the dollar were to fall significantly, however, interest rates could rise noticeably. The other point with the dollar is that a weaker dollar helps U.S. exports as well as overseas profits of U.S. firms. Therefore, over the last few years, we have seen a stronger correlation between a weak dollar and a strong stock market, as more and more companies are doing business overseas. In normal times, when stocks rise, bonds fall, causing interest rates to rise. But, as everyone knows, we are not in normal times. At present, equity prices are at a record high...but so are bond prices! Very abnormal indeed!
That brings me to the third reason why interest rates might rise despite a weak economy. That is, the Fed's balance sheet conundrum. Through all the Fed's bond buying over the last few years, its balance sheet has ballooned to over $3 trillion. With the Fed holding such huge amounts of fixed income securities, they are also holding a lot of risk. When interest rates rise, bond prices fall. Therefore, if interest rates rise, the Fed will take losses, possibly substantial, on their holdings of all the securities they have recently purchased. Because of this, rather than selling their holdings in order to push up interest rates, as was previously thought to be the Fed's exit strategy from its massive quantitative easing program, the thought now is that they will just hold those securities until maturity, in which case they will not take any losses. Unfortunately, by continuing to hold these securities, that leaves less room to buy more securities should the need arise. They are currently buying $85 billion per month in Treasuries and mortgage-backed securities (MBS), but this simply cannot go on forever. There has to be a point at which the central bank simply says "we can't do this anymore."
How big will the Fed's balance sheet get? $5 trillion? $10 trillion? Most of the money the Fed is printing is not making it into the broader economy right now because it is sitting in electronic bank accounts at the Fed. Basically, the Fed is printing money, using it to buy Treasuries and MBS from banks, and the banks are turning it around and sticking it right back into holding accounts at the Fed, called excess reserves. That is why there is so little inflation, at least as reported by the government, despite all this money printing. Until that money gets unleashed into the broader economy in the form of bank loans, we will not see much of an increase in inflation. Still, if the economy eventually gets to a stronger footing and the risk of default diminishes and lending becomes more profitable, banks will start to lend that money out. The rate at which that money seeps into the economy will determine how fast inflation will rise. Think of it like a dam. The more water there is behind the dam, the greater potential for a flood should the dam break. Similarly, the more money there is stored up in excess reserves, the greater potential there is for a flood of money to flow into the economy, which would push up inflation. How much greater is the potential for crippling inflation if there is $10 trillion in excess reserves down the road versus around $2 trillion today?
If that flood scenario does occur, that just means the Fed will have to raise interest rates much faster. The usual way they do this is via open market operations, buying and selling Treasuries and other securities to influence the money supply and, thereby, interest rates. But what happens if the Fed wants to sell fixed income securities in an effort to pull money out of the system to raise interest rates to cool inflation, but nobody (i.e. the banks) wants to buy those securities because prices are falling rapidly, which would happen in a rising rate environment? That would mean prices for those securities would have to come down even further, which would drive up interest rates even further. Thus, there is the potential for a double whammy if excess reserves start to leak out via bank loans: inflation ramps up, and the Fed can't stop it like they normally could without a massive and very quick increase in interest rates. That would almost certainly lead to another recession. Again, it all depends on if, and when, and how fast those excess reserves enter the broader economy. The bottom line is that the more excess reserves that are built up, the greater potential there is for a catastrophe. Thus, at some point, the Fed will need to stop buying bonds. (If the effort to lower interest rates involves printing money and buying Treasuries from banks, one would think in order to raise interest rates they could just reverse the process, and have the banks buy the Treasuries back from the Fed. But in a rising rate environment, banks will have no interest in buying those Treasuries back, especially considering they have record low coupons. They may not even want to buy them at much reduced prices, choosing instead to buy newly issued bonds with higher coupons. It depends if the bank is looking for income (buy higher coupon bonds) or growth (buy the lower coupon bonds at reduced prices from the Fed). At any rate, the Fed would either take heavy losses on their holdings, or they would be handcuffed and unable to raise interest rates to slow down inflation. That is a very scary thought! And what happens if the Fed takes losses? Do the taxpayers have to bail out the Fed?)
So what happens when the Fed finally stops buying bonds? It is abundantly clear that the recent stock market rally has been largely driven by the Fed's actions. As the Fed has pushed interest rates to record lows, fixed income investors (especially retired folks) are getting killed. Thus, investors are "reaching for yield" by investing in stocks and high yield corporate bonds, whose yields are also near record lows. This is happening despite only 2% or so GDP growth over the last couple years. Thus, although the economy has improved since the depths of the Great Recession, it is nowhere near strong enough to justify a doubling of the stock market from the March 2009 lows. It is primarily being driven by the Fed's desire to push investors into riskier assets in order to drive up the value of said assets, thereby making people feel wealthier and more willing to spend (the wealth effect). This is all working like a charm, so far. Heck, it's working so well that we have recently been seeing utterly preposterous headlines, such as "Stock market jumps despite weaker-than-expected economic data as investors are hopeful that the Fed will continue its bond buying program." We are seeing these headlines quite often now. As a matter of fact, some experts are even saying that investors don't even want a strong economy, they just want the Fed's sugar pill of more stimulus, more stimulus and more stimulus. It's like a drug addict, the more of a high he gets, the more of the drug he wants. Eventually, he either crashes from the high, or dies. Unfortunately, that is exactly what is happening in the stock market today. It's all a phantom high, driven by the Fed, primarily because, quite frankly, it doesn't appear that they know what else to do. We are in uncharted waters, and they simply are not sure what else to do to stoke stronger economic growth and job creation. So when the Fed finally stops buying bonds, look out. We could see a violent reaction in the stock market. Indeed, we have seen triple digit losses on the Dow a few times recently, and those have come on days when investors have become more concerned that the Fed will end its bond buying program. And those are just concerns. What happens when it finally does end its program? Especially if the economy is still weak? Look out below!!!!!
In summary, the economy is on a sugar high of record low interest rates right now, and this is not sustainable. Eventually, the economy will have to find an equilibrium that is not induced by the Fed. The longer this sham continues, the bigger will be the fall. Be careful out there.