By raising interest rates later this year, the Federal Reserve may accidently incite a stock market crash, driving investors to safe haven assets like gold. Janet Yellen has repeatedly suggested improving economic conditions would justify a long overdue rate hike, but the Fed may be underestimating the market’s addiction to cheap money.
Historically, low interest rates have effectively reduced the cost of borrowing to zero, a move designed to spur business investment and consumer spending. As a response to the 2008 financial crisis, the central bank started buying toxic assets to ease the balance sheets of troubled banks.
The program continued as a full-blown doctrine of quantitative easing, with U.S. printing presses footing the entire bill. In July 2015, the Federal Reserve’s liabilities stood at $4.5 trillion, up more than 417% from August 2007. (Source: Federal Reserve Board, July 13, 2015.)
Only last year did the central bank scale back the massively expansionary program. However, the Fed continues to buy residential mortgage backed securities, a security that pools many home loans into a single asset for financial institutions to buy and sell.
Why Gold is in a Rout
The indiscriminate money printing by the Federal Reserve has deflected a lot of investment from precious metals. Gold is down over 16% in the last 12 months. Silver dropped even further, even as the NASDAQ gained 14%.
The optimism on equities reflected a muddled sense of logic: investors believed that easy money would incentivize banks to lend. As a result, increased spending by individuals would send demand higher, forcing firms to hire new workers with their access to cheap credit.
But there was one little snag in this neatly laid plan; we’d just emerged from a financial crisis that was driven by debt. Private companies and individuals were looking to deleverage their financial positions, not add to their mountains of debt.
Most market participants chose to ignore the futility of endless monetary stimulus, probably because wilful blindness is an easy option when there’s money on the line. Quantitative easing helped prevent a deeper crisis, but that doesn’t mean it can build real growth out of thin air. Here’s a visual example:
This chart shows a clear relationship between growth in the money supply and advances in the Down Jones Industrial Average. My concern is that markets have fooled themselves into thinking the stock market rally was tied to a real economic recovery.
Waking Up to Reality
While the unemployment rate is widely reported as 5.7%, it does not account for those who are in part-time jobs or working for less than a liveable wage. When you add in that part of the workforce, the unemployment rate jumps to 11.3%. That means that more than one in ten Americans is either out of work or earning less than is necessary to survive. (Source: Bureau of Labor Statistics, last accessed on July 28, 2015.)
The economic situation is improving, but it is far from healed. Take a look at this next chart:
Potential gross domestic product (GDP) is a measure of how much the economy is capable of producing if we used all our available resources; including equipment, factories, and human resources. But we’ve fallen far short of that potential since the start of the financial crisis.
Even now, the economy is operating below 100%, but the Federal Reserve has committed to an interest rate rise. We’ve reached this awkward scenario where the central bank has to unwind monetary stimulus without crashing the economy, simply because financial markets are addicted to its support. But what both the Fed and the market fail to realize is this: the only recovery that took place was on Wall Street.
When markets can’t run on false optimism any longer, they’ll start panicking as they always do. Traditional safe haven assets like gold and silver are going to skyrocket in the tumult that follows an interest rate hike. It’s history repeating itself.