Life, Liberty, and the Avoidance of Pain

It would appear as though the markets have included the avoidance of pain as one of our inalienable rights, as outlined in the Declaration of Independence. The markets have rallied recently, apparently on the expectation of further action by the Federal Reserve. In fact, the equity markets rallied on a horrible jobs report that showed the number of job openings declined the fastest in over seven years. I know the markets are forward thinking, but this logic increasingly strikes me as strained and the equivalent of a driver excitedly accelerating the car because they see a tree ahead that will stop the car.

Maybe the Federal Reserve gives the markets all they want tomorrow. However, I struggle what would satisfy the markets. I suppose QE3 is what the market wants, but will it have an impact? If so, will the impact ultimately cause more harm than good? Sure, investment spending likely benefits from lower interest rates. But, do highly leveraged consumers need more debt? Can the people in need of low cost financing actually get it, despite the lower interest rates? I continue to believe that the Fed is losing its ability to stimulate demand, instead simply stimulating supply growth. This imbalance results in short-term boosts to the economy as businesses spend but eventually loses its steam as demand trends do not justify the increased investment spending. In short, Sagflation.

Potentially more ominous is my belief that the US economy has been built on a low interest rate foundation. What does this mean? It means that debt service has been low relative to the outstanding debt, enabling over-consumption on the demand-side and over-expansion on the supply-side. In essence, we have been painting ourselves into a corner with the only possible outcomes of depression, default or excessive inflation. Since all of these produce some form of pain, albeit in very different forms, our on-going avoidance of pain likely only leads to excessive pain in the future.

I was also amused by comments on CNBC about the housing market. The bullish bias continues as experts believe the industry should outperform the economy. Commentators take that as a bullish sign about the economy. In my view, the housing market likely outperforms only because mortgage rates keep declining, in essence enabling consumers to manage a larger debt balance and therefore pay a higher price for a house. Looking at it in reverse, when the rate on a 30-year fixed mortgage rises to the historically inexpensive 6% from the current level of around 4% the monthly interest payment for any prospective buyers increases 50%. So the Fed's actions can stimulate industries like housing for the short-term but also encourage excessive debt levels and inflates asset prices.

There is a lot of "hope" out there, but I fear this economy is living on borrowed time.