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Warning: Why My Flash Crash Alert Flag Is Flying High

Stock-Markets / Financial Crash May 16, 2013 - 12:58 PM GMT

By: Bill_Bonner


Whoa! Investors are acting as if it were 2007 all over again.

USA Today has the story: Emboldened by soaring stock prices and record-low borrowing costs, stock investors are taking out loans against their portfolios at the fastest pace since before the Great Recession hit.

So-called margin debt hit $379.5 billion in March, the highest level since July 2007 when such debt hit an all-time record of $381.4 billion, according to the most recent data available compiled by the New York Stock Exchange.

The trend signals that investors are more comfortable with stocks and are more willing to use borrowed money to buy more securities in hopes of garnering fatter returns in a hot market that has pushed the Dow Jones industrials up more than 15% in 2013.

Why are investors so bullish? Because the economy is coming back? Because the future is rosy? Because stocks are going to earn even more?

Nah... What do you take us for, dear reader? We know the story. Stocks are going up because the Fed is making them go up. Here's David Rosenberg in Canada's Financial Post:

The US Fed has always been important in influencing trends in the financial markets, even if the economic effects have been far less than dramatic. This influence has actually strengthened in recent times to the extent that the correlation between the Fed's balance sheet and the direction of the stock market, which was barely 15% before all these rounds of quantitative easings began four years ago, is 85% today.

By way of comparison, the timeworn correlation between the market and corporate earnings has remained unchanged at around 70%.

The Fed is trying to bring the overall cost of capital down to a level that would be consistent with a -2.2% Fed funds rate, which is where the rate actually should be based on current inflation and the still-huge amount of excess capacity in the economy.

But the funds rate has been at zero for more than four years. The Fed cannot magically create a negative nominal interest rate, so it is using the powers of its balance sheet to achieve the same result.

This then brings me to my very last point, which is what I think was a critical inflection point when the Fed said in its December post-meeting press release that it will not budge from its 0% policy rate until the US unemployment rate drops to 6.5%. It is currently around 8%.

We have done estimates based on various assumptions and found that achieving this holy grail likely takes us to the opening months of 2018 or another five years of what is otherwise known as financial repression.

No Exit

But wait a minute. If the Fed continues goosing up stock prices for another five years, isn't that going to put stocks in "irrational exuberance" territory?

Won't artificially low interest rates – over such a long period – create the same sort of distortions and bubbles that led to the crisis of 2008-09 in the first place?

Well... yes... of course.

But the Fed is on the case. It says so right there in the paper. The Fed governors "are considering an exit strategy." Exit from what? They are trying to figure out how to get down.

For four years, they have been climbing up and up – offering loans at negative real interest rates – trying to encourage people to borrow and spend. They want people to part with their money, not save it. And they've also significantly boosted the monetary base through QE1, QE2 and now QE3. In the current version of QE alone, they print up an extra $85 billion per month and pump it into the banking system!

That money hasn't done much for the real economy (the unemployment rate has gone down, but only because people have left the workforce), but it's done wonders for stock prices. The Dow has more than doubled since 2009. It's up this year too – hitting record after record.

Ben Bernanke says he wasn't targeting equities with his QE program. But that's what he hit... climbing higher and higher to get a good shot. Now he's sitting on top of a monetary base (the "stock" that is four times as tall as it was in '07).

And now how will he get the Fed down without getting hurt? If stock prices are so closely correlated to Fed money printing, won't stock prices go down if they turn off the presses? And how will the Fed react when it sees stocks go into another major bear market?

Our guess is that as soon as Bernanke hints at cutting off the presses, stocks will begin to slide. Then, when the presses really stop, they'll fall hard. That's when it will get interesting. If the Fed can't cut back now... how will it do so when the markets and economy are even more dependent on it?

Instead, the Fed will panic... and climb even higher.

Bill Bonner
Bill Bonner is a New York Times bestselling author and founder of Agora, one of the largest independent financial publishers in the world. If you would like to read more of Bill’s essays, sign-up for his free daily e-letter at Bill Bonner’s Diary of a Rogue Economist.

    © 2013 Copyright The Daily Reckoning, Bill Bonner - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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