Keith Weiner: “The Fed Poisons The Stock Market” – Forbes

Posted on :Mar 01, 2014

By: Keith Weiner

Forbes

February 29, 2014

The Fed has pumped trillions of dollars into the financial system since 2008. The unintended consequences of this bank bailout have spilled over into the markets. Fed money injections go directly into bonds, tending to push up their prices. Since interest rates move inversely to bond prices, the effect is to cut interest. After the 2008 crisis, the Fed pushed the ten-year Treasury yield down from 4 to 1.5 percent, though it’s bounced a bit from there.

An artificially low interest rate is bad enough, as it hurts savers and retirees on a fixed income. However, a falling rate is deadly poison to business. This toxin operates by two different mechanisms.

Businesses constantly face a trade off between labor and capital equipment. Suppose Acme Corp. is considering buying an expensive new widget-making machine. Acme holds off because the monthly payment is too high. When the interest rate falls, then the payment fits its budget. Buying the tool and laying off workers increases the company’s profits. The first mechanism of falling rate toxin is layoffs across the economy.

Normally, replacing tedious and backbreaking work with machines is a good thing. It frees people for jobs that produce more and stress their bodies less. However, our Fed-distorted interest rate isn’t normal. Few new jobs are being created, and people aren’t freed for anything except unemployment. The destruction of labor is a human tragedy that deserves its own story.

High unemployment means weak consumer demand, and therefore soft prices, for the products made by Acme and other companies.

The Fed’s rate suppression has a second path of attack. Successful companies constantly look for opportunities with a return on investment (ROI) greater than their cost of capital—i.e. the interest rate. Lower interest rates perversely encourage them to chase smaller margins. Suppose the prevailing ROI is 5 percent but the interest rate is pushed down to 2.5 percent. Acme and many other companies are happy to borrow at 2.5 to expand, because they hope to make 5.

Normally, growing a business is a good thing because it offers new goods to consumers, and creates wealth for investors. However, when the Fed pushes down the rate of interest, the rate of profit tends to follow, with a variable lag.  The end result is not wealth creation, but profit margin compression.

Shrinking margins are bad enough for new borrowers, who get less bang for their cheaper buck, but they’re deadly to old borrowers. The rate of profit can be pushed below the old borrowers’ original rate of interest. Then, a new competitor may drive them out of business.

Consider a restaurant, Sleepy Steak & Potatoes. Sleepy borrowed at 5 percent to build a nice store. What if their competitor, Hip Hotpot Fusion can borrow at 2.5 percent? Hip Hotpot builds a bigger place with taller ceilings and high-end finishes.  Former Sleepy customers switch to Hip. This is churn—one business simply supplants another, creating little or no wealth.

Labor destruction, margin compression, and churn are the result of corporate decisions. Business executives are not stupid. The problem is that they must live or die in a Fed-distorted market. They have little choice. If they don’t seize an opportunity, then a competitor can. They’re forced to be like Olympic ski jumpers. If one skier is unwilling to risk life and limb and push it to the limit, he gets beat by the next athlete who is.

It’s pretty obvious that lower interest rates encourage more borrowing, and we’ve looked at two ways that each downtick incentivizes businesses to load up on more debt.

The effect on the stock market is not simple. Rising profits tend to push stocks up, but that’s not the whole story. Higher debt makes companies more dependent on credit market conditions, and lower profit margins make them more sensitive to consumer spending. Companies and their stock market valuations become brittle, vulnerable to small changes. Stocks can crash if credit stops flowing, like it did in 2008.

When the next heart attack strikes, the Fed deserves the full blame.

Gold Goliath is not your typical gold dealer.

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