Why This Equity Rally Is About To End Badly

The deafening cacophony on Wall Street for the past six years has been since interest rates are at zero percent that there is no place else to put your money except stocks. For most, it just doesn’t matter that the ratio of Total Market Cap to GDP is 125 percent, which is 15 percent points higher than in 2007 and the highest at any time outside of the tech bubble at the turn of the century. Sovereign bond yields are at record lows across the globe and the strategy for most investors is to ignore anemic economic growth rates and just continue to plow more money into the market simply because, “there’s no place else to put your money.”

But the epicenter for this market’s upcoming earthquake will be in the FX market. The US dollar has soared since May due to the overwhelming consensus that while the Fed will be out of the QE business in October and raising rates in 2015, Japan and the Eurozone are headed in the exact opposite direction. The BOJ is already going full throttle with QE and the ECB announced last week that its own asset back security purchase program would begin in October. The Greenback is already up over 5 percent on the DXY in the past four months and a continued increase in the dollar’s values will start to significantly impair the reported earnings on US based multinational corporations. This deflationary force is one reason why stock prices could correct very soon.

But what is even more likely to occur is a sharp and massive reversal of the dollar’s fortunes. As stated before, nearly everyone on Wall Street is convinced the Fed will be hiking rates next year. And now that the BOJ and ECB have committed to go all-in on QE, how much more can they really do to cause their currencies to depreciate further? With the Ten-year notes in Germany and Japan yielding just .93 and .50 percent respectively, can these central banks really make the case that borrowing costs are still too high to support GDP growth?

If robust U.S. GDP growth does not materialize this year as anticipated, just as it has failed to do each year since the Great Recession ended, the dollar will come under pressure. In fact, real GDP growth has not grown north of 2.5% since 2006. With the Fed ending its massive bond purchases and the rest of the developed world flirting with recession, it’s hard to make a case why this year’s growth rate would be the exception—U.S. GDP growth for the first six months of this year is running at just 1 percent.

If the market perceives that Fed won’t be able to hike rates next year and may be forced back into the QE business due to a stalling U.S. economy, a reversal in the yen carry trade will occur. Financial institutions have been borrowing yen at near zero percent and investing into our bond and stock markets. Since yields are higher in the U.S. and the direction of the yen was virtually guaranteed to be headed lower due to the continued intervention from the BOJ, the trade has been a double-win. However, if the dollar reverses course it will cause a stampede of dollar sellers out through a small and narrowing door to sell overvalued stocks and bonds in order to purchase back a rising yen.

Massive currency volatility is just one of the incredibly-destructive effects resulting from this unprecedented manipulation of interest rates on the part of global central bankers. The unwinding of the yen carry trade is one factor that could bury the notion that stock prices can’t fall while the Fed is at the zero bound range.

Of course, the selloff in stocks would merely be a tremor that forebodes a much greater earthquake—one that would be devastating for both stocks and bonds. The real quake I’m speaking of is the inevitable synchronized collapse of global sovereign debt prices.

This is because the free market works a lot like plate tectonics. Continental drift causes friction in the earth's lithosphere. The slippage of these plates causes the earth to quake and is really nature’s way of relieving pent-up pressures. Smaller earthquakes tend to preclude larger ones from occurring by gradually relieving that stress.  Likewise, recessions and depressions relieve the imbalances of debt and asset bubbles that build up in the economy. Trying to prevent minor earthquakes and recessions from occurring can only lead to a complete catastrophe.

Central banks tried to avert a healing recession in 2008 by completely commandeering the global sovereign debt market. And now, yields in Europe, Japan, and the United States have never been lower in history. Record-low sovereign bond yields should be the result of plummeting debt to GDP ratios and central bank balance sheets that have shrunk down significantly to ensure inflation will be quiescent.

However, the exact opposite is the case. For example, U.S. National debt has increased by $8.6 trillion since 2008 and the debt to GDP ratio has increased from 64 percent, to 105 percent during that same time frame. In addition, the Fed’s balance sheet has jumped from $800 billion to $4.4 trillion in those same years. Therefore, the credit quality has vastly decreased while the danger of inflation has dramatically increased due to the growth in the monetary base. Unless the economy is flirting with a deflationary depression, interest rates would be much higher than they are today.

Central bankers should eventually achieve success in creating inflation above the 2 percent target. But these money printers can’t pick an arbitrary inflation goal and stick the landing perfectly. It is likely that inflation will overshoot the stated goals. The difficult choice would then be to either allow inflation to run out of control or force bond sales. This means central banks would swing from being a huge buyer of sovereign debt, to selling massive quantities of bonds. In this scenario interest rates would not only mean revert very quickly but most likely eclipse that level by a large degree.

In the case of Japan, the 10-year note averaged 3 percent from 1984 until 2014. A spike in yields from .50 percent to over, 3.0 percent would cause interest expenses on sovereign debt to explode to the point where the economy would be devastated. Much the same scenario holds true for the Eurozone and the United States.

In contrast, if these central banks are unsuccessful in creating growth and inflation, then the resulting economic malaise will cause bond investors to lose faith in the government’s ability to ensure debt service payments don’t outstrip the tax bases of these countries. This is exactly what occurred in Europe during the recent debt crisis of 2010-2012. Once a market becomes convinced that a nation can’t pay back its debt in real terms the value of that debt plummets.

Ultimately, this is the real crisis that awaits us on the other side of this massive and unprecedented distortion in global bond yields. And is why this equity market rally will end sadly in a massive quake that will make 2008 seem like a mild tremor.

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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

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