Illusions

Jim Puplava
Financial markets are part fiction/part reality with public perception acting as the driver. What drives markets over shorter periods of time is the belief system held by its active participants. This is no more evident than today’s widely held beliefs of a strong U.S. economic recovery with accompanying low inflation rates. While it is acknowledged that inflation rates may head up in an environment where financial markets are concerned over deflation, a slight up-tick in inflation is now welcome. In fact it is now viewed as a positive.

The U.S. economy is growing at its fastest rate since the mid-90’s. Yet these growth rates have failed to ignite the financial markets or create real jobs this year. Since January all of the major indexes have given up their gains and have now turned negative. An element of uncertainty has been injected into the stock market. The Fed is in the process of changing monetary policy and will embark on a series of interest rate hikes that will raise borrowing costs in an economy that runs on credit. While speculators rest uneasily on pins and needles as to when the Fed will pull the trigger, the markets have already begun to react. As shown in the two charts below, interest rates on the 10-year note and the 30-year bond have risen by almost 100 basis points.

Wall Street believes the Fed will embark on a rate renormalization program that will take the fed funds rate from its current 1% to a more neutral rate of 3%. This is an illusion. In an economy that has $35 trillion in debt, of which $15 trillion has been added in the last six years, a tripling of the federal funds rate would become disastrous. The financial sector has doubled its debt from $5,532 billion in 1997 to $11,402 billion in 2003.[1] The economy and the financial markets have become so leveraged that even slight increases in interest rates could bring the markets and economic activity to a screeching halt. In fact, it may end up collapsing both the financial markets and the economy.

What makes an aggressive change in Fed policy unlikely at this time is that the strength of the U.S. economic recovery is based on asset bubbles fed by debt, which supports consumption. In the last three years consumer mortgage financing doubled from $376.7 billion to $758.1 billion. Total consumer debt increased by $654.4 billion in 2001, $775.7 billion in 2002, and by $879.9 billion in 2003.[2] In addition to consumer and financial debt government, debt has also increased by nearly $1.5 trillion. By September 2003 (the end of the government's fiscal year), total debt stood at $6.8 trillion. Today that debt is $7 trillion and is now climbing rapidly as government deficits exceed $500 billion, ($700 billion if you count money borrowed from social security and other trust funds). It now takes $5.40 of debt to produce $1 of GDP growth.

Rest of the article.