'The Fed is the market'

There’s little doubt now that artificially low interest rates are at least a part of the reason for the dramatic stock market rise of the past year. Money has flowed out of the bond market—with its low yields—into stocks, driving stock prices up. Low interest rates have increased margin buying and corporate buy-backs, further driving up stock prices.

Financial writer and venture capitalist Bill Frezza puts it succinctly: “The Fed is the market.” If you don’t believe that, consider this: In May, Fed Chairman Ben Bernanke said he was open to trimming the Fed’s bond-buying program—if the economy continued to improve. That put the bond markets on a minute-by-minute alert for how new economic data would affect Bernanke’s brain. That exercise, in turn, caused U.S. bond markets, usually harbors of tranquility in even rough economic seas, to pitch. The 10-year Treasury bond yield rose 50 basis points in May alone, to 2.1 percent. The 30-year bond was over 3 percent. And on May 31, the day after a bond auction where the yield spiked, the Dow Jones Industrial Average fell 200 points.

Because everyone in the markets is (so far) making money, and the data are conflicting, it’s been hard to make criticism of Fed policies stick. But we’re beginning to see cracks in the orthodoxy. Stocks and bond yields are not the only things going up. Housing prices are up, too. The Case Shiller/S&P Index released in late May indicates home prices are up 10.9 percent from a year ago, while the rate of home ownership hasn’t changed. Mark Vitner, chief economist at Wells Fargo, worries that the rise in home prices might be the result of investor speculation. He says it’s “troubling” that home prices are going up so much and so fast just four years after one of the biggest crashes in home prices in U.S. history.

The question is: Are these rises in the cost of assets and the uptick in bond yield a return to historic norms, or ominous signs of a bubble, inflation, or both? Frezza thinks the markets “have become a casino.” He said historically markets “aggregated knowledge.” Lots of participants competing with one another would bring out the best ideas and reward them with financial success. Now, though, “the wisdom of the market is overwhelmed by the Fed’s role. The market is no longer a good place to get information.” He said when the banking industry in Cyprus crashed earlier this year, he exited both the stock and bond markets. “I know I’ll miss the peak,” he said. “But I can sleep at night.”

Jared Pincin, assistant professor of economics at The King’s College, is less worried: “I don’t see inflation being a problem.” He said the increase in bond yield is because “risk-appetite is increasing and the demand for bonds is falling, so yields are rising.” He said his greatest concern is that “we’re in a slow growth environment.” This slow growth has created a stubbornly high unemployment rate of 7.5 percent. Add in the underemployed and discouraged workers, and what some call the “true unemployment rate” likely tops 12 percent. The more than 20 million Americans in these categories didn’t participate in the Fed-induced bull market. Neither will the millions of Americans who lost their homes when the housing bubble burst be able to participate in the rise in home prices.

Mark Twain said history does not repeat itself, but it does echo. So will we see an echo of the crash we saw in 2008 and 2009? Frezza says yes. “They’ll keep this charade up through the mid-term election,” he said. “Then this asset bubble will bust.” Others are less sure. But virtually everyone agrees that the housing, stock, and bond markets are being priced by factors other than the underlying value of the assets, especially by the Fed’s policy of increasing the availability of money. And one echo that reverberates throughout economic history is this: The price and value lines can’t stay apart for long without coming back together, sometimes dramatically.