The Federal Reserve’s holding pattern on interest rates should signal one thing to investors: start brushing up on astrophysics if you want to understand why the world’s economy might be approaching a cosmic conclusion.
Like a massive star exploding into a supernova, debt is rising at a blistering pace. There is currently more than $230 trillion in global debt – that’s three times the amount of debt the world held during the credit crisis.
Central bank intervention has fueled this explosion in debt, including historic levels of quantitative easing, zero interest rate policies and the adoption of negative rates. In the U.S. alone, there’s more than $63 trillion in combined public and private debt.
In stark contrast, there are only $3.8 trillion total dollars in circulation, and each of these dollars has been lent and borrowed more than 16 times. The amount of leverage continues to climb.
At the end of every supernova comes a black hole. Black holes have such a strong gravitational effect that nothing can escape their pull. And fundamental laws of physics are distorted at the center of a black hole, also known as the gravitational singularity. We’re seeing a similar phenomenon in the investment world: the crushing weight of all this global debt is distorting some fundamental economic principles.
Buying stocks for yield and buying bonds for returns
With treasury bonds yielding less than 2 percent, many investors are buying dividend-paying stocks for their yield. For 35 years, interest rates experienced a steady decline into negative territory, and today’s bond investors are actually hoping rates will keep moving lower to offer their portfolio some returns. Otherwise, they’re stuck paying the borrower to borrow their money.
Cash might not be the parachute investors hope it will be, either. The interest rate environment has banks and other financial institutions shunning cash. Others are charging depositors just to hold it. This dynamic has a direct effect on banks’ willingness to lend capital into the real economy, distorting the money supply as measured by M2, which includes cash (M1) and short-term cash alternatives like money market funds.
A declining money supply typically indicates deflation because there is less money to be spent, which causes prices to fall. But despite all of the quantitative easing, money printing and deficit spending, the velocity of money has been declining steadily since the credit crisis.
The gravitational pull is truly strong if the U.S. Federal Reserve is printing money at record levels and yet the velocity of money is declining.
Does the stock market reflect the economy?
The stock market is making all-time highs. But where is the celebration? Where are the Dow 18,000 hats on CNBC? The stock market used to reflect the health and strength of the economy, but this may also be distorted by an impending investment black hole.
Stocks are going up at a record pace, earning investors more than 17 percent per year since the credit crisis, well above the 10 percent historical average. This is largely due to investors buying stocks for their dividend and the lack of other attractive options in the low interest rate environment. With so many investors going all-in on equities, it is no wonder most are a little uneasy with the new highs.
The economic event horizon
A place where the stock market is at all-time highs, bond yields are at record lows and no one is happy? This environment has many investors worried that we’re creeping closer to the event horizon: the edge of the black hole from which there’s no escape. The Fed holding on rates shows that they’re already succumbing to the gravitational pull.
What happens at the center of this economic black hole is anybody’s guess, but there are some signs to look out for. For example, the Federal Reserve has historically lowered interest rates between 400 and 500 bps during a recession.
If they do this in response to the next economic slowdown, that would plunge us deep into negative territory and further contort the natural rules that govern the market. One way to protect a portfolio when you don’t know what rule will be distorted next is to maximize the diversification in your portfolio. Because when even your normal safe haven isn’t safe, all you can do is diversify your risk.