The Tyranny of Forced Correlations
Martin Hutchinson

The Fed’s artificial policies will eventually cause gigantic losses and a major market crash.

The S&P 500 Index pushed above 1700 last week, and is now 10% into record territory above its 2007 high. Meanwhile the second quarter U.S. GDP report showed growth of only 1.7%—and that's after including an extra 3% of intangibles in GDP that weren't previously thought suitable to capitalize. The forced correlations between bond markets, energy prices and the world's stock markets become ever closer and more profitable for leveraged traders—and the real correlation with actual economic activity grows ever weaker.

The notable feature of the GDP numbers was the weakness of the last three quarters, with average growth of less than 1% in spite of $85 billion per month in Fed bond purchases, a program that began in September. There is however one caveat; most of the last three quarters' sluggishness has come from the downsizing of government. Because the GDP statistic is rigged to show growth automatically if government bloats, the genuine if modest downsizing of government in the last three quarters has played merry hell with the GDP numbers; the private sector, in contrast, has grown at a more respectable 2.0% over the period.

Nevertheless, recent growth has been far below historic levels, in which average real growth for the 1929-2002 period was 3.4% annually. That's why this year's strength in the stock market, with the S&P 500 now up over 20% since January 1, is so strange (although predicted here at the beginning of the year).

Economically it is impossible for corporate earnings to increase continually as a percentage of GDP, so a period of very slow GDP growth should be accompanied by a period of lackluster stock prices.

The key to the puzzle of course lies in monetary policy. $85 billion a month is a lot of money. It however doesn't seem to be enough to keep bond yields down at low levels--the 10-year Treasury bond yield has risen over 100 basis points, from around 1.7% to 2.7%, since the Fed bond purchases began last September. However it is sufficient to distort the market very severely indeed.

In this case, it acts as a subsidy to leverage of all kinds, rewarding the rich, who are generally far more able to borrow large amounts than the middle classes. It also rewards hedge funds and private equity funds, who are only able to access returns comparable to those of investing in equities by using their access to cheap leverage. By rewarding certain groups of investors at the expense of the population as a whole (who find their income returns from investments ground down by year after year of cheap money), it forces correlations between asset classes that speculators find profitable.

One such correlation involves a massive effective subsidy to residential mortgage real estate investment trusts (REITs). Short-term interest rates are held down artificially near zero, while long-term interest rates are prevented from rising substantially by Fed quantitative easing (at least mortgage REIT sponsors think so). Thus for the last five years mortgage REITs have been able to leverage themselves in the short-term market and buy government-guaranteed home mortgages, leveraging the spread between the two interest rates. If that spread is 2.5%, and a mortgage REIT is leveraged 10 to 1, it can make a return of 25% on its capital, plus whatever return it gets on the mortgages purchased with its equity.  That in turn allows it to pay dividend yields above 10%, and leads the shares to trade well above their book value—that in turn allows the mortgage REIT to carry out repeated stock issues, growing exponentially by doing so.

Normally this silly game would be defeated by an eventual rise in long-term interest rates, which would cause mortgage bonds to decline in price until the mortgage REITs capital was wiped out (because with a 10:1 leverage ratio, a 10% bond price decline, occurring after a rise in long-term rates of only about 1%, would have this effect.) However with the Fed capping long-term interest rates through bond purchases, the mortgage REITs' silly but profitable game can be carried on ad infinitum, since the Fed is never going to run out of money.

A similar correlation is reviving the homebuilding business. Thanks to Fed bond purchases, mortgage rates are far below the level they should be in a free market, when the probability of default is taken into account (which probability is far higher than it seemed a decade ago). This is forcing up house prices and artificially raising homebuilding as it did in the middle 2000s.

A third correlation resulting from the Fed's artificial policies is the Goldman Sachs game currently being played through warehousing aluminum inventories. Thanks to ultra-cheap money, the costs of holding inventories have dropped to almost zero and traditional rewards for the service of inventory management have become excessive. Now that interest rates are beginning to rise again (at least at the long end) Goldman Sachs is getting out of this business, having caused artificial shortages that appear to have proved economically costly in the aluminum market.

In 2009-10, ultra-low interest rates forced up commodity prices themselves, but since then new sources of supply have been forced onto the market, causing a reversal of the commodities bubble. In energy, fracking techniques caused a collapse of natural gas prices in 2011-12, but it's interesting to note that no such collapse has occurred in the oil market, presumably because the new supply sources are insufficient and have been offset by the artificially increased demand for automobiles in China and India especially. Interestingly, the rise in gold and silver prices caused by cheap money (if cash has a negative real return then gold and silver are ipso facto a good investment) has been suppressed over the last 18 months by the IMF and the world's central banks, seeking to disguise the true effect of their monetary policies, but this effect may be wearing off.

Finally, negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to U.S. GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere.

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play. Thus in Brazil, for example, interest rates are actually rising because the profligate government has destabilized the domestic economy. However Japan, still the world's third largest economy, is following the same policies as the Bernanke Fed only to an even greater extent (a similar volume of bond purchases on an economy one-third the size). The effect is very healthy for the Japanese housing market (which has not seen a decent boom since the 1980s) and is also forcing up stock prices even more rapidly than in the U.S., albeit from a much less over-inflated base.

Eventually, the global economy as a whole will suffer the fate of the hedge fund Long Term Capital Management, bailed out in 1998 with the loss of 90% of the partners' equity. It will be remembered that LTCM, staffed with the best and brightest from the former Salomon Brothers, obtained by one means and another sufficient leverage to carry $3-4 trillion nominal amount of positions, betting on converging correlations such as that between emerging market debt costs and prime debt costs. This all worked beautifully, making the partners spectacular rates of return, until it didn't. Between May and August 1998, LTCM's correlations all went into reverse, and the house of cards tumbled to the ground, to be rescued into an orderly liquidation by a group of banks prodded by Alan Greenspan's Fed.

The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. However the new correlations are—like LTCM's correlations in 1996-8—entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As for LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash.

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out—an altogether more perilous state.

S&P 500: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

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