Sunday, July 22 , 2018, 9:45 pm | Fair 73º


Craig Allen: Renewed Speculation on Further Stimulus Drives Stock Gains

Despite rally, long-term consequences of financial injections remain perilous for global economy

Renewed speculation over the possibility of further stimulus drives stock market performance last week
The Dow Jones Industrial Average’s impressive move back above 13,000 on Friday capped off a strong week for stock performance, with a three-day advance that drove weekly gains of about 2 percent for the Dow, 1.1 percent for the NASDAQ and 1.7 percent for the Standard & Poor’s 500.

While the 13,000 level is psychologically important, a move above 1,400 on the S&P 500 would be much more meaningful from a technical perspective. The S&P 500 ended last week at 1,386, so it’s only about 14 points away from the 1,400 threshold. More important, the relative weakness in performance of the tech-heavy NASDAQ is concerning, since tech stocks typically drive overall stock market performance during bull-market rallies.

Friday’s gains were driven primarily by word from both the Federal Reserve here in the United States and the European Central Bank that further economic stimulus could be just around the corner. There were also reports that the Bundesbank president and ECB chief may be in discussions on new measures to ease the euro-zone’s continuing debt crisis, which has plagued world markets for months.

Bloomberg reported Friday midsession that Deutsche Bundesbank president Jens Weidmann is in talks with ECB president Mario Draghi with Draghi possibly proposing rate cuts, bond purchases and new Long-Term Refinancing Operations (LTRO). On Thursday, Draghi vowed to do “whatever it takes” to save the euro, which helped spark a global rally Thursday that carried through to Friday’s trading as well.

These recent comments by Draghi are unusual, and could be a sign of desperation, since he may be finding it easier to comment on the markets rather than to take specific actions to address the glaring problems faced by the European Union and the euro.

My concern, which I have voiced repeatedly, is the probable negative long-term consequences of these continuing injections of liquidity into the worldwide financial system. Stimulus is certainly a commonly used tool by central banks in times of economic strife. However, we have never experienced so many central banks simultaneously using these measures — and never in the magnitude we are seeing them used today. The added liquidity, at some point, will need to be removed from the system. Taking liquidity out isn’t always an easy task.

To inject liquidity, the typical method involves buying long-term securities, including treasuries and mortgage-backed securities from banks. The purpose and outcome of these operations has been to drive the prices of these assets up and their yields down. Lower long-term interest rates is the end result that central banks are after when conducting stimulus operations. To unwind these trades, at some point in the (near) future, they must sell these securities, thus driving prices down and long-term interest rates back up. If inflation threatens, forcing a rapid unwinding of these stimulus operations, rates could skyrocket, crushing any economic growth we have achieved.

Those who lived through the late 1970s and early 1980s will certainly remember double-digit interest rates and the horrible recession (double-dip) of 1980 through 1982 — probably the worst recession since the Great Depression. Many economists are already calling for another recession in early 2013. These predictions are not a result of expectations for the unwinding of stimulus; they are in spite of the predicted additional stimulus that is yet to come!

Higher long-term rates are not just frightening because of the potential for recession. Mounting U.S. and global sovereign debt levels — $15 trillion in the United States alone — are currently being financed at historically low interest rates. Since we cannot balance our budget, we are spending more than we bring in each year in government revenues. As rates rise, the cost of financing this massive debt will increase dramatically — the higher rates go, the more expensive it will become to finance our debt. Since, again, we are spending more than we bring in each year, we have to borrow all of the interest that is accumulating on our debt. This is essentially like taking a cash advance on a credit card to make your minimum credit-card payments each month (except with a lot more zeros at the end). This means we have to sell increasingly more bonds to finance that interest. The more bonds we sell, the more downward pressure on bond prices, and the more interest we will owe, especially with rates rising.

This is an ugly scenario, but the most likely one, I’m afraid. It is easy to ignore this impending financial crisis, but someday very soon, we will no longer be able to ignore it. Unfortunately, by that time, it may be too late to deal with it without draconian measures that will severely and negatively affect the lives of everyone on the planet.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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