This Vicious Catch-22 Could Doom the Stock Market

As you're probably well aware, the stock market has been absolutely on fire since bottoming out a bit over four years ago. The broad-based S&P 500 (SNPINDEX: ^GSPC  ) and Dow Jones Industrial Average (DJINDICES: ^DJI  ) have both hit all-time highs this year, eclipsing levels that many would have laughed at in 2009 if you would have told them we'd reach these heights. Even the Nasdaq Composite (NASDAQINDEX: ^IXIC  ) , a tech-heavy index still well off its all-time highs, delivered a recent streak during which it hit an intraday 12-and-and-a-half-year high for 18 straight days!

A combination of an accommodative monetary policy from the Federal Reserve, which has targeted record low interest rates to spur lending, combined with a monthly $85 billion bond-buying program comprising long-term Treasuries and mortgage-backed securities, has boosted housing, lightened the load on our nation's largest banks, and sent the markets soaring. However, the same recipe that pulled the markets out of their doldrums looks like it could send them right back.

Let me preface this by saying that bull and bear markets are the normal evolution of the economic cycle. No matter what we or policymakers do, there will always be economic downswings, just as there will always be times when the economy is booming. Unfortunately, at the moment, it appears as if the Fed's accommodative monetary stance has set us up for a downturn, perhaps even a recession, regardless of what actions it and Fed Chairman Ben Bernanke take. It's what you might call the ultimate in Catch-22s.


Ben Bernanke. Source: Medill DC on Flickr. 

What happens if we stay the course
It might seem counterintuitive to think that continuing on the current course of having a record low federal funds target rate and buying $85 billion in bonds each month -- known affably as QE3 -- would be bad. Housing prices have found a bottom, and millions of homeowners have been able to refinance at remarkably good rates. But there's another side to the do-nothing strategy, and it isn't pretty.

For one, staying the course is a crushing blow to the few Americans who are good savers. Yes, it does entice investors to throw their money into the stock market, where the prospect of returns is greater than, say, bonds or CDs over the long run. But if you're a risk-averse investor or are anywhere near retirement, these record-low rates are crushing your returns, and taking on greater risk by investing in the market probably isn't prudent in many cases.

Also, QE3 has stopped having much of an impact on businesses, and I'd venture to say it's having no effect on the unemployment rate. I'll gladly admit it's nice to see the unemployment rate at a five-year low, but also consider that countless people have retired or simply given up on finding work and therefore are no longer counted among the labor force. That drop, as well as job creation, has made the unemployment figure a bit rosier than I suspect it actually is.

Then there's the effect on businesses, which has been good but not great. As with many individuals, low lending rates allowed many businesses to refinance hefty debt loads to much lower rates. Unfortunately, businesses haven't exactly been using these loans to expand their operations and grow their sales. In fact, more than half of the S&P 500 in the second quarter missed Wall Street's revenue estimates, yet about two-thirds beat on earnings. To me it's pretty clear evidence that enterprises are trimming the fat rather than expanding for the future. Simply put, no amount of extended rate cuts or bond-buying will fix that.

Staying the course is also hampering the profitability of the nation's largest banks. I'm sure most consumers aren't going to shed a tear over the fact that net interest margins -- the difference between the interest rate a bank pays to borrow money and the rate at which it lends -- for most banks are shrinking. Until QE3 ends and the Fed funds target begins to rise, chances are bleak that banks will see any meaningful bottom-line boost outside of cost-cutting and merger-and-acquisition activity.

What happens when the Fed stops easing
If staying the course isn't the right answer, then you might be compelled to think that raising the Fed funds target rate and ending QE3 might be the answer. Here again, we're in for a world of potential problems.

The housing sector would be expected to take a pretty big hit if interest rates begin to rise in any meaningful way. With lending rates remaining at record lows for such an extended period, we've been spoiled. The expectation here would be that as soon as we see even the slightest bump higher in rates, refinancing and mortgage activity would slow to a crawl.

Similarly, while banks would rejoice in being able to earn more on deposits, they'd have almost zero chance of attracting loans from consumers and businesses alike that have locked in record low lending rates for the next five, 10, or even 30 years!

The end of QE3 could also be the beginning of a strengthening U.S. dollar. With less money being printed for Treasury bonds and MBS purchases, it would only make sense that the U.S. dollar would gain in value. Though this sounds good on paper -- and you'll certainly be able to get more bang for your buck overseas -- it makes U.S. products less competitive in international markets and would only further hurt global businesses that are relying on this overseas growth to drive any meaningful growth at the moment.

The ultimate catch-22
In short, the Fed's ultra-accommodative monetary policy, which did help pull the economy out of a recession, is now a concrete block that's sure to weigh down the recovery process. If the Fed stands pat on its lending target rates and on QE3, then banks and risk-averse investors will suffer and businesses would probably turn to cost-cutting and share repurchases to drive bottom-line profit growth. Yet if the Fed pares back on QE3 and its accommodative lending rates, then the housing sector and global business could suffer. This appears to be a no-win situation and all the more reason to be very untrusting of the stock market with most indexes near all-time or multiyear highs.

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