Recommended Reading: Low Interest Rate Addictions

There is a great deal of debate over whether the ending of QE will adversely affect the US economy, and by extension the global economy. The bulls believe that the Fed’s decision to “taper” their securities purchases is a reflection of the fact that stimulus is no longer require due to an improving economic outlook. However, the bears will argue that the US economy is nowhere near reaching “escape velocity” and that an early exit by the Fed will trigger a spike in interest rates and a dramatic slowdown in economic growth together with a sharp reversal in the price of both real estate and stocks.

Michael Pento, President of Pento Portfolio Strategies, sets the scene for the debate, noting that “It is amazing so many investors are oblivious to the fact that the developed world is completely addicted to artificially-produced low interest rates. Perhaps that is why there is still a debate over whether the ending of QE will adversely affect the economy, and if rising rates can occur within the context of a healthy economy.”

He continues, “It isn’t so much about whether or not QE is about to end, or even if growth is now causing interest rates to become unglued. The truth is the end of QE and the normalization of interest rates – for whatever reason – means it will be the end of this anaemic and unsustainable recovery in both Japan and the US economies.”

Pento, who approaches the world of economics and finance from the vantage point of Austrian economics, notes that it’s not possible to separate central banks’ influence on markets from their affect on economies. “The BOJ and Fed have dramatically supported equity and real estate prices by taking interest rates to record lows. Therefore, it is simply illogical to then assume that rates can increase without negative ramifications.”

The Fed and other central banks have engineered a “recovery” by monetizing trillions of dollars in deficits, lowering the value of their currency and by inflating asset prices. By artificially lowering interest rates and punishing savers with negative real interest rates, policymakers have done their level best to re-inflate the consumption bubble. “And, most importantly, record-low interest rates have provided consumers and government with massive debt service relief. Without the aid of rising real estate and equity values (brought about by central bank debt monetization), along with drastically reduced debt payments, the consumer and the economy would be in full deleverage mode.”

Thanks to their massive debt burdens, rising interest rates are now the biggest threat to the Japanese and US economies. At the end of 2007 total debt in the US reached $49 trillion or 353% of GDP, however by the beginning of 2013, total US debt had increased to $54 trillion, which is still around 350% of GDP. Meanwhile over in Japan, total debt to GDP has increased from 170% in 2008 to around 240% today. As Pento points out, “It is clear, once that interest rate “pin” is pulled, the entire house of cards will collapse”.

The recent spike in 10-year bond yields in both the US and Japan gave us the first taste of just how damaging even a small rise in rates can be. A week ago the yield on 10-year US Treasuries spiked to 2.16% (a 13 month high) triggering a 2% drop in the S&P 500. Investors nerves were calmed somewhat after Fed President Eric Rosengren said that the central bank should continue with record stimulus in order to support growth, reduce unemployment and boost inflation.

A similar turn of events earlier in May saw the Japanese 10-year note nearly double in a matter of days from 0.6% to almost 1%, which triggered a major selloff in the Nikkei.

“Central banks have created the illusion of growth that is based upon re-inflating asset prices. And, it is also predicated on their ability to suppress interest rates.”

He concludes that, “record debt levels and central bank inflation targets are a deadly combination. Once those inflation targets are achieved, the bond vigilantes will have the central banks in checkmate. The Fed and BOJ will then have to choose whether they want to aggressively raise interest rate; by not only ceasing bond purchases but also unwinding their massive balance sheets in order to fight inflation. Or, they can sit idly by and gradually let their balance sheets run off; while watching inflation – the bane of the bond market – send bond prices plunging and yields soaring. In either case it will mean the end of the over 30-year bull market in bonds. And it will finally prove beyond a doubt that the combination of interest rate manipulations, massive levels of debt and betting the economy’s future growth on creating ever-increasing inflation is nothing short of a miserable mistake.”

Read the full article here.

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