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Pentonomics

Will Trump Bring Morning or Mourning in America?

On election night, as political analysts were coming to terms with the possibility of a Trump presidency, the Dow Jones futures plummeted over 800 points, and Japan's benchmark Nikkei 225 plunged more than 6.1%.

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Will Trump Bring Morning or Mourning in America?
November 21st, 2016

On election night, as political analysts were coming to terms with the possibility of a Trump presidency, the Dow Jones futures plummeted over 800 points, and Japan's benchmark Nikkei 225 plunged more than 6.1%. Investors across the country went to sleep with nightmares of protectionism (Smoot-Hawley Trade Tariffs 2.0) and the fiscal train wreck that a Trump presidency might bring.

But by the start of trading on November 9th, Dow futures had recouped most of their losses, and it didn't take long for the erstwhile despondent equity markets to turn sharply positive.

America reached a sudden epiphany that it perhaps had elected a pro-growth champion in the White House with an obsequious Republican Congress. Therefore, for those on Wall Street it became once again "Morning in America."

However, I would warn that before you pile your life savings into an S&P 500 ETF and fall into a complacent slumber, it's important to explain why the markets have gotten ahead of themselves and where things can go very wrong from here.

The earnings rebound for equities had been predicated on a falling USD and an oil price rebound. Most importantly, markets had relied upon the Fed's provision of artificially-low interest rates as far as the eye can see. However, oil prices have fallen from over $51 a barrel a month ago to $45 today. The dollar index has risen from 98.61 before the election to over 101, which is a fourteen-year high, and long-term interest rates are now spiking.

According to Reuter's, interest rates on the 30-year fixed mortgage averaged 3.95%, up from 3.77% the prior week, the highest level since January of this year. Rates on the 15-year Fixed-rate and Five-year adjustable-rate mortgage rose to their highest levels since March. This has already started to take its toll on mortgage refinancing, as the MBA's weekly measure of application activity for refi's fell 10.9% last week. This is soon to be exacerbated when the Fed resumes its rate hiking mode in December.

But it's not just interest rates in the U.S. that are rising; rates are spiking all around the globe. For example, the Italian Ten-year yield has jumped an incredible 45% in the past few trading sessions.

But the perma-bulls on Wall Street, who first warned that a Trump presidency would be a disaster, now believe that a drastic rise in rates around the world will be ameliorated by a bit more growth here in the United States sometime in the future. But the President's protectionist trade policies and massive deficits will be an offset to much of his growth measures.

And while relief on taxes and regulations is something to celebrate, as of now, not one dollar of taxes has been cut, not one regulation has been reduced, and not one shovel for a "shovel ready job" has been purchased. The point is that rising rates could send the anemic U.S. economy into a recession before any of Trump's plans come to fruition.

And certainly, U.S. economic growth will not get any help from Emerging Markets (EM). As the significant correction in EM shares immediately following the election is foreboding tough times are ahead for these nations that are strapped with huge amounts of dollar denominated debt.

But perhaps the most important point to remember is that during the Regan Revolution, which started back in the early 1980's, morning in America didn't come overnight. It took time for those harmful Keynesian fiscal and monetary policies to work themselves through the system. It took almost two years for that imbalance to rectify, and for dawn to break for both the economy and equities. But today's imbalances are far greater than what was extent in 1980.

In November of 1980, the S&P 500 was 140; and it was at the same level in November of 1982. It wasn't until 1983 that the S&P 500 saw significant moves higher. Furthermore, the U.S. economy experienced two major recessions during that timeframe, as then Fed Chair Paul Volker squeezed the harmful monetary policies of the 1970's out of the economy. The first recession occurring between January and July 1980 and the other from July 1981 to November of 1982.

Ronald Regan reduced the top rate income tax bracket from 70% to 50%. According to CNN Money, the amalgamated plan proposed by Trump and the House could lower the top bracket to 33%. However, the top tax rate currently sits at 39.6%. Therefore, tax reductions, although good news, will not have the same effect as it did in the 80's. This is because marginal rates will only fall a few percentage points on those job creators, rather than the 20 percentage points enjoyed under Regan.

Furthermore, debt levels as a percentage of GDP back during the Regan Revolution pale in comparison to those of today. A rapid increase in interest rates will make the cost to service debt extremely onerous. Add to this the massive amount of infrastructure spending that Trump has proposed and we are likely to see much larger deficits and eventually much weaker GDP growth.

Finally, as seen in the chart below, stocks began the decade of the 80's with a very modest price to earnings multiples and therefore had a lot of room to run. It's less likely that Trump's "Morning in America" will be as favorable for stocks give today's lofty PE's.

The stock market is a forward-looking indicator. And while it is uplifting to see it anticipate better news for the economy, investors should understand that a massive bubble in the bond market isn't going to unwind with impunity—especially in light of the already overvalued stock market and the huge increase in leverage ratios that exist today. That truth extends to most asset classes and the global economy. Trump may end up turning Mourning in America to Morning…but a surging interest rates may bring Midnight first.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Trump's Mandate to Yellen: Print More Money or You're Fired!
November 11th, 2016

What kind of President will Donald Trump be? Will he restore America to its former position of greatness, or end up being feckless like a long list of his predecessors? That is yet to be determined.

However, what is clear now is if Donald Trump wants to avoid starting his tenure with an economic crisis similar to that of Mr. Obama he will need to put a lid on long-term interest rates rather quickly. And in order to do that he will have to convince a supposedly politically-agnostic Fed Chair, Janet Yellen, to not only refrain from further interest rates hikes but also to launch another round of long-term Treasury debt purchases known as Quantitative Easing (QE).

The move higher in Treasury yields since the election of Trump has been nothing short of violent, but borrowing costs were already on the rise prior to November 8th. The Ten-year Note Yield began its ascent after it bottomed at 1.36% back in July. This is because central bankers arrived at a new conclusion: that a steepening yield curve would be best for the banking system and economic growth, rather than to just continually push long rates lower. The Ten-year yield climbed up to 1.83% on the day prior to the vote, then spiked to over 2.30% several days after America made its choice for president.

But why is the election of President Trump so bad for bond prices? The answer is twofold. First, Trump's pro-growth policies of lower corporate and personal taxes, in addition to reduced regulations, are causing investors to sell fixed income products and to place funds in equities. Growth stocks simply offer the potential for better returns than the current historically-low yields found in bonds. Second, and most importantly, a Trump presidency is highly inflationary because his massive $1 trillion infrastructure refurbishment plan, along with his proposal to rebuild the military, will—at least in the short-term—significantly increase annual deficits. In fact, deficits are already soaring; the fiscal 2016 budget hole jumped to $587 billion, up from $438 in the prior year, for a huge 34% increase.

Enormously growing deficits, which will add to the intractable National debt, tends to force a central bank into an ultra-loose monetary policy. But it's not just the $20 trillion public debt that will put pressure on the Fed to keep printing money. Total Non-financial Debt has soared from $33.1 trillion at the end of 2007, to a record $45.6 trillion in Q1 2016. That means debt as a percentage of GDP has climbed from where it was prior to the Great Recession (226%), all the way up to 250% of the economy.

A central bank that vastly increases the money supply, one that far transcends the legitimate pool of savings, is the tool used by governments to keep interest rates from skyrocketing. This has been the recipe for runaway inflation since the beginning of economics.

In addition to this, Trump's protectionist trade policies would implement either a 35% tariff on certain imports or would require these goods to be produced inside the United States at much higher prices. For example, the increase in labor costs from goods made in China would be 190% when compared to the federally mandated minimum wage earner in the United States. Hence, inflation is on the way.

The incredible nearly 50 basis point surge in the Benchmark Treasury yield in the immediate wake of the election is proof of Trump's fiscal profligacy and his inflationary impact on the nation.

The end of the 35-year-old bond bull market is upon us. Trump's trade policies, along with his avowed love of debt, is putting significant upward pressure on borrowing costs. The Donald will now try to convince Janet Yellen to reverse her incipient tightening policy and bring rates back to zero—and eventually even to launch QE IV.

If rates continue to rise it won't just be bond prices that will collapse. It will be every asset that has been priced off that so called "risk free rate of return" offered by sovereign debt. The painful lesson will then be learned that having a virtual zero interest rate policy for the past 90 months wasn't at all risk free. All of the asset prices negative interest rates have so massively distorted including; corporate debt, municipal bonds, REITs, CLOs, equities, commodities, luxury cars, art, all fixed income assets and their proxies, and everything in between, will fall concurrently along with the global economy.

For the record, a normalization of bond yields would be very healthy for the economy in the long-run, as it is necessary to reconcile the massive economic imbalances now in existence. However, President Trump will want no part of the depression that would run concomitantly with collapsing real estate, equity and bond prices.

But the problem is he will be asking Ms. Yellen to do the exact thing he accused her of doing during the campaign. Namely, being a political puppet of the President. If the Fed is truly apolitical, she will politely refuse. Nevertheless, what Yellen and Trump don't understand is that our nation is both debt-disabled and asset-bubble addicted, which requires interest rates to be near zero percent or the whole ersatz economy will implode. The devastating bond bubble's collapse will bring Trump to that reality very soon. And if Ms. Yellen doesn't agree to pick up the speed on the printing presses she may hear the words "Your Fired", even before her tenure is up in February 2018.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Q3 GDP Growth was Hogwash
November 7th, 2016

Since most everyone is focused on the upcoming U.S. elections, many investors may not have had the time to peel back the onion on the third quarter U.S. GDP report. So, if you just glanced at the headline GDP number of a 2.9% annualized growth rate, you may have concluded that the U.S. economy was finally on its way to sustainable growth.

That 2.9% read was the biggest in the last two years and it also beat the median forecast of 2.6%. However, to put that number in perspective, average GDP growth over the past four quarters was only 1.5%, and the average for first three-quarters of 2016 is just 1.7%.

So before you get out your party hats and declare this economic malaise over, there were a few notable concerns in that Q3 GDP report.

First off, consumer spending, which accounts for more than two-thirds of U.S. economic activity and just under 70% of GDP growth, fell significantly during the quarter to an annualized rate of 2.1%. That 2.1% is a little bit over half the level of spending posted in the previous quarter. Also, spending on durable goods fell three-fold from Q2 levels.

Third-quarter growth was also flattered by a buildup in business inventories, as re-stocking shelves added 0.61 percentage points to GDP.

And after flatlining in the second quarter, trade contributed an impressive 0.83 percentage points to GDP, as exports surged at a 10% rate.

Was the surge in exports a sign of a U.S. manufacturing renaissance? No. A surge in soybean shipments dispatched to meet the insatiable appetites of Chinese hogs helped to shrink the trade deficit this quarter, as bad weather destroyed crops in Argentina and Brazil (the world's largest exporters) leaving U.S. soybean producers to fill the gap.

Taking out Communist China's dictum to increase the hog herds, and that inventory build-up for a consumer who won't show up due to soaring Obamacare premiums and the incipient recession, GDP growth would have been just 1.4%. Thus, confirming that the languishing growth rates we have grown accustomed to since the Great Recession are taking a further move down.

But if you believe the pundits that think GDP growth is about to accelerate on a worldwide basis, think again. The most import reason why global growth is about to turn even lower is borrowing costs have started to spike worldwide on that enormous mountain of record debt. This is because global central banks have come to a brief—but surely temporary--period of sanity, in their epiphany that there are negative ramifications to endless counterfeiting.

For the past three years, the Bank of Japan has embarked on an unprecedented bond-buying scheme to boost inflation towards 2%. The BOJ now owns more than half of all ETFs and 40% of all outstanding Japanese government bonds. But despite all that manipulation of markets, Japan's central bank has now admitted it will not be able to reach its inflation target until the spring of 2019. The BOJ had originally thought it could achieve 2% inflation during 2015. Most importantly, Japan's central bank has shifted its focus from achieving its inflation target, to just steepening the yield curve. The BOJ is now seeking to boost long-term borrowing costs rather than simply try to push the entire yield curve lower.

Koichi Hamada, an economic adviser to Japan's Prime Minister Shinzo Abe, went on record saying that the BOJ is "at the end of the road." Thus, admitting the BOJ has reached its monetary limit for now and that achieving 2% inflation was no longer its immediate mandate.

Likewise, the head of the European Central Bank, Mario Draghi, has admitted achieving 2% inflation will take several more years—conveying the ECB will also be patient in reaching its target.

And of course, the Federal Reserve ended QE in October of 2014 and is now threatening to raise interest rates for the second time in the last ten years come December 14th.

This change in central bank monetary strategy means that although global bond yields have yet to soar, it is also clear they are no longer falling. And perpetually falling interest rates has been the corner stone to this phony economic recovery.

Debt loving governments and inflation enamored central bankers have ironically been able to push yields to zero percent and under, so they were already as low as they can go. And now bankrupt sovereign governments--and the debt that they issue--are running smack into the next recession, which the money printers have nothing to offer other than to implement more QE. That is the road to economic chaos rather than viable GDP growth.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Earnings Fairytale Has an Unhappy Ending
October 31st, 2016

The air underneath stock prices is indeed getting very thin at these altitudes. According to none other than Goldman Sachs, median stock prices are positioned at the 97th percentile of historic valuations. Other metrics such as Median PE ratios, Market Price to Sales and Total Market Cap relative to GDP all validate the extremely overvalued condition of U.S. stocks.

In order to justify these near-record valuations, analysts are once again predicting a J-curve in earnings growth for next year. S&P 500 earnings are projected to rebound from the trailing twelve months earnings per share (EPS) of $111, to about $130 for the forward 12 months EPS.

The S&P 500 has produced five consecutive quarters of negative earnings growth. According to FactSet, earnings growth for the index so far in the third quarter of 2016 has a blended increase of just 1.6%. And even if earnings manage to produce a small single digit rise in year-over-year earnings growth for the first time in the past one and one half years, it would hardly support near record market valuations.

Since 2010, economic growth in the United States has been slightly above 2%, and for the first three quarters of this year GDP growth has averaged just 1.7%. Yet despite this anemic economic growth and shaky earnings backdrop, perma-bulls are still betting on a huge earnings surge next year of 16% in order to reach that illusory target of $130 EPS.

But the news coming out of multinational conglomerates so far this quarter proves EPS won't even come close to that Wall Street earnings fantasy.

Right out of the earnings gate light weigh metals giant Alcoa blamed, "near-term challenges in some markets" for missing its earnings estimate, as its revenue declined 6% year-over-year.

General Electric lowered its revenue growth and narrowed its profit forecast for the year. The multi-national industrial giant noted its revenue rose less than expected, to just 1 percent in the quarter. The company also trimmed its full-year revenue forecast, now expecting revenue to be flat to 2 percent growth.

Honeywell cut its full-year EPS guidance for 2016, noting that its core organic sales are now expected to be down 1-2% for the year.

Manufacturer Dover (DOV) cut its full-year sales and profit forecasts, citing a weak global economy. On their conference call they noted, "The primary factors driving this revision are generally weaker capital spending across several industrial end-markets…"

PPG Industries, who makes paints and coatings for the construction and other markets, said it was, "disappointed with this quarter's EPS growth rate as we continue to operate in a sluggish economic environment with no clear near-term catalyst for improving global GDP growth."

Global construction and mining equipment maker Caterpillar reported an astounding 18% decline in its global retail sales for the three months ended Sep 2016. The company cited listless demand for heavy machinery in its core markets due to a slowdown in construction and mining activity. For the past few quarters Caterpillar has suffered from a weak mining industry, low oil prices, stronger U.S. dollar and China's economic woes. In addition to all this, its third-quarter profit was cut in half due to the global economic slowdown that the company expects to extend into next year.

3M sited challenges in its Electronics and Energy Sales Division for the reduction in profits for 2016, which saw a decrease of $1.3 billion, or down 7.5 percent in those key segments.

And finally, if you needed more proof, YRC Worldwide Inc., a leading provider of transportation and global logistics services, saw its profit drop 9.5% YOY, blaming a "soft industrial backdrop".

There are many more examples of earnings shortfalls, and to be sure, not all companies reported bad numbers. Nevertheless, these earnings and revenue warnings regarding current and future global economic weakness from multinational industrial giants should not be ignored.

But it is not just multinational industrial conglomerates that point to a lack of earnings growth. There are numerous examples of weakening revenue and earnings--along with projections of further weakness—across various enterprise sectors. For example; Fast Food chain Sonic dropped 17%, Home appliance maker Whirlpool fell 11% and Sports Apparel provider Under Armour plunged 13%, all on the same day they reported earnings.

It may have been acceptable for investors to maintain hope for a huge earnings rebound as long as the epic bond bubble was still inflating (yields falling), the dollar stopped rising, oil prices were well on their way back toward triple digits and the Fed had your back. However, this is no longer the case.

Long-term interest rates have been rising sharply across the globe due to the new central bank strategy of steepening their respective yield curves. The Trade-weighted Dollar Index has jumped 4% since August of this year and is up 20% since the summer of 2014 in anticipation of a resumption in the Fed's tightening cycle. The price of WTI Crude Oil seems to be stuck below the $50 per barrel range, despite numerous attempts by OPEC to construct a deal to freeze production at all-time highs. And, as mentioned, the weakening multinational earnings picture has not yet dissuaded the Fed from recommencing its rate rising campaign come December 14th. Indeed, the Fed's median dot plot projects short-term borrowing costs will rise close to 1¼ percent by the end of 2017.

When near record-high market valuations slam into slowing global growth, rising interest rates on both the long and short end of the yield curve and the epiphany reached by investors that there will be no robust or sustainable earnings rebound, it will lead to the end of this equity bubble. A prudent investor should listen to the message of markets not the perpetually-inane optimism of Wall Street analysts. Therefore, expect a 7-10% correction in the major averages between now and the end of this year.

This selloff in stocks should continue until our inflation-loving central bank returns to the printing press with the futile hope that a rising CPI will bail out the economy. And even though stock prices may then catch a bid, expect the chances of viable economic growth and a strengthening middle class to fall further down the cesspool.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Government Stimulus is an Oxymoron
October 25th, 2016

The accumulation of Debt, at its very essence, is simply borrowing consumption from the future. And this is true on any level of debt, be it either public or private. Just as savings is deferred consumption, the exact opposite is true for debt. Therefore, it can only be beneficial in the long-term if it leads to an expansion of productivity in the present. If the funds borrowed do not improve output per unit of labor it is much more difficult to pay back that debt and any perceived benefit ends up being nothing more than an ephemeral illusion.

This is the reason why public debt is the most pernicious variety. The problem with government spending is that it mostly amounts to little more than hole-digging and filling. Borrowing money to pay people to empty the ocean onto the beach may temporarily increase employment and demand in the economy. But since this is merely state directed busy work, it does not grow the economy and expand productivity. Thus, the result is a rise in the debt to GDP ratio.

The 2008 financial crisis led to the passage of the Troubled Asset Relief Program, referred to as TARP, the American Recovery and Reinvestment Act and a rapid increase in government transfer payments, which produced multiple years of record deficits. The accumulation of those deficits sent the U.S. National debt to GDP ratio leaping from 64% in 2007, to over 104% today.

Likewise, the nominal level of government debt soared from below $10 trillion, to over $20 trillion in just a handful of years. The Keynesians promised us that all this debt would eventually lead to robust and sustainable growth. However, what predictably occurred was the first recovery since World War II where yearly GDP growth hasn't gone over 3%.

According to the Congressional Budget Office, the U.S. budget deficit for the fiscal year 2016 ending in September will be $588 billion, or one-third greater than last year. This was a result of spending that rose by $168 billion to $3.9 trillion. However, real GDP for the third quarter of 2016, as modeled by the Atlanta Fed, is set to come in at just 2.0%. This is historically a very sub-par growth rate. With the second quarter of 2016 GDP coming in at 1.4% and the first quarter print a measly 0.8%, it appears years' worth of government "investment spending" has yielded GDP growth that is slowly faltering.

And while fiscal spending was unable to provide viable economic growth, Central bankers have also failed in the same endeavor. This, despite global central bank balance sheet growth of $15 trillion since 2007, 96 months of virtual zero interest rate policy in the U.S. and even negative interest rate policy (NIRP) around the world. Since their monetary plans have failed, central bankers now want to hand off the responsibility of growth back on the fiscal authorities… as if this was somehow a brilliant new idea.

Deficit spending is not a new concept in Washington DC or around the world and it hasn't moved the needle on growth. For example, thanks to numerous infrastructure bubbles fueled by government and State Owned Enterprises in China, total debt quadrupled to nearly $30 trillion, from $7 trillion in 2007. And total debt has recently ballooned 465% over the past decade to nearly 300% of GDP in 2016, from just 160% in 2005.

And then we have Japan, the island nation has spent the past 25 years deploying one government stimulus program after another to no avail. With a Government Debt to GDP ratio nearing 230%, it's hard to imagine that increased deficit spending now is going to break new ground, or turn this scary trend around.

And it's the same thing in Europe:

And in the United States

If government debt, a.k.a. "investment" led to viable economic growth the debt to GDP ratio around the globe would be falling. The truth is Government debt amounts to nothing more than a gigantic misallocation of capital that brings along with it future anemic GDP growth, higher interest rates, and greater inflation. Perhaps this is the real reason behind the persistent lowering of global GDP growth rates.

Nevertheless, this hasn't stopped the Keynesian manipulators such as the Fed's Vice Chair Stanley Fischer from claiming, "Some combination of…improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.".

And both presidential candidates have lofty spending plans: Clinton proposes an increase of $35 billion dollars a year to refinance college loans, allocates $27.5 billion for child care, $16.6 billion for IDEA (Individuals with Disabilities Education Act) and another $9 billion for alternative energy investing. In addition to all this Hillary would like to spend $275 billion over five years on a variety of projects, including airport modernization and Wi-Fi accessibility in rural areas. Trump doesn't bother to go into much details; but just proposes a nice round $500 billion figure for infrastructure spending.

In this carousel, or ping pong match, between monetary and fiscal stimulus it looks like the ball has now landed on the fiscal side of the court. But we shouldn't pretend that government stimulus hasn't already been tried in a big way and with negative results, or that the results will be different this time. The endgame will be the unholy marriage between fiscal and monetary stimulus in the form of direct monetization of massive government debt. This too has been tried before…and the pernicious result has always been intractable inflation and economic chaos.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Equity Bubble Has Run Out of Excuses and Time
October 17th, 2016

It is finally going to be a make or break earnings season for stocks. This is because the justification for record high stock prices that have been perched atop extremely stretched valuation metrics has been the following false assumptions: the hope that the Federal Reserve will not resume its interest rate hiking cycle, the U.S. dollar stops rising, the price of oil enters a sustainable bull market and long-term interest rates continue to fall.

If all those conditions were in place investors could continue to believe a turnaround in the anemic 2% GDP growth rate endured since 2010 was imminent. And, most importantly, that a reversal in the 5 straight quarters of negative earnings on the S&P 500 was just around the corner. But even if they were perpetually disappointed in growth and earnings that didn't materialize, they could always afford to wait until the next quarterly earnings report because there just wasn't any alternative to owning stocks.

However, if earnings come in weak for the current quarter—which would be the 6th quarter in a row—that disappointment would occur in the context of a rising U.S. dollar, falling commodity prices, spiking long-term interest rates and a Federal Reserve that will most likely resume its hiking cycle in December. In other words, it would be game over for the equity bubble.

After all, market pundits have placed nearly all of the blame for the negative earnings string on a crashing oil price and a spiking U.S. dollar. However, during the 3rd quarter the WTI Crude price and the dollar were both very stable. And the price of crude was trading in the mid $40 a barrel range for both Q3 2015 and 2016. Therefore, if earnings don't bounce back now how can they be expected to improve in Q4 and beyond, especially while the Fed re-commences its hiking cycle, which should cause the dollar to rise and commodity prices to fall once again?

So how does the earnings season look so far? Industrial and Metals giants such as Honywell, Dover Corporation, PPG Industries, Alcoa and United Technologies have all missed and/or warned on earnings for the third quarter. In the case of worldwide lightweight metals producer Alcoa, (down 11.4% on its earnings report) not only missed bottom line expectations but revenue fell by 6% year over year, which indicates the lack of global growth and demand for industrial metals. Multinational industrial giant Honeywell's CEO Dave Cote said last week that Jet engine service orders, scanners, and logistic and shipping services simply failed to materialize in September. His warning and comments sent the shares down 7.5% last Friday. The company further sited worsening growth in the Middle East, Russia and China.

The free pass on overhyped stock valuations is now over. And with the S&P 500 trading at 25x reported earnings, this market needs a huge revenue and earnings rebound in Q3 or the gravitational forces of rising interest rates will send stock prices significantly lower.

The low on Treasury yields is most likely behind us. In fact, the Ten-year Note yield has risen from 1.36% in July, to 1.8% recently. Indeed, interest rates are rising across the globe as central bankers now believe higher long-term rates and a steeper yield curve are necessary for a healthy banking system. And the Fed has similarly duped itself into believing asset prices are not in a bubble and that borrowing costs can normalize without hurting equity prices and economic growth. However, both assumptions are extremely far removed from reality.

The truth is this protracted economic and earnings malaise—that shows no sign of turning around--coupled with record high stock prices and the reversal of a nearly decade-long zero interest policy on the part of the Fed is clear: a collapse in equity, bond and commodity prices concurrently. The reversal of the central bank's trickle down wealth effect should cause a recession to hit the economy hard by the middle of 2017.

But this next bear market and recession may once again lead to a change in monetary policy on the part of the Fed. Collapsing equity prices and rising bond yields should cause the monetary megalomaniacs on the FOMC to follow up on Ms. Yellen's recent threat to use fiat credit to purchase corporate securities in an attempt to reflate the bubble once again. That is when Pento Portfolio Strategies will close out our current short hedges, aggressively repurchase precious metals and use our substantial amount of spare capital to pick up internationally diversified high-dividend yielding stocks at a steep discount from today's unreasonable prices.

Last December, the Fed's liftoff from ZIRP sent stock prices tumbling over 10%--for their worst start of a year in its history. Investors still have time avoid a similar outcome. But since that correction in equity and bond prices should be enough to tilt this anemic economy into a recession, the cumulative collapse could end up being much worse.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Bubble Blind Central Bankers
October 10th, 2016

Fed Head Janet Yellen is keeping alive the tradition of her predecessors, Messrs. Greenspan and Bernanke, by showing she is equally as blind-sighted to the bubbles central banks are blowing in the bond and equity markets. During her September press conference, Ms. Yellen stubbornly clung to the misconception that it is only possible to tell if a bubble exists after it bursts. And because of this delusion, in Yellen's eyes ninety-six months of a virtual Zero Interest Rate Policy (ZIRP) is merely, and I quote, "a modest degree of accommodation." Her blinders are so opaque that she claims to see, "no signs of leverage building up." And her feckless ability to spot market imbalances even resulted in this doozy of a Yellen quote: "In general, I would not say that asset valuations are out of line with historical norms."

Can it really be the case that the women who holds a dictatorship on the cost of money, which is the most important price signal in an economy, is unaware that the stock market is at a level that is virtually the most overvalued in history? The Median PE, Price to sales and Total market cap to GDP ratios all show that the equity bubble is about as far detached from economic reality than at any other time in history. For example, the market cap of equities in relation to the size of the economy is over 70 percent points higher than the level experienced from 1975-1990.

We have indeed climbed up to the very thin air historically speaking on the 25 times trailing earnings on the S&P 500. And the air here is especially rare given the fact that earnings have fallen six quarters in a row. According to Fact Set, earnings will drop by 2.3% year over year; and that is despite the dollar falling 4% and crude oil rising 20% so far in 2016.

Furthermore, Yellen's reckless money printing has led to a humongous rise in corporate debt. And to see this bubble all she has to do is view the Fed's own data.

And this corporate debt bubble isn't limited to the United States, according to the UN Conference on Trade Development, corporate debt in Emerging Markets (EM) has swelled to $25 trillion. This is 104% of EM GDP, up from 57% at the end of 2008.

Household debt is also surging in the U.S., up to a record $14.3 trillion. And this impulse to take on debt at record low interest rates has spread across the globe. According to Institute for International Finance (IFF); China, Saudi Arabia, Thailand, and Korea led the way with the largest build-up in household debt per adult since 2010.

Indeed according to Deal logic, global debt issuance is up 5.02 trillion dollars so far in the first three-quarters of 2016; this would put it on course to rival the all-time high of $6.6 trillion hit in 2006. Central bank largess has caused government, household and corporate debt to surge across the globe; but according to Ms. Yellen there is nothing to see here.

However, Ms. Yellen need not pour through the staid analysis prepared by the IFF or the UN Conference to see if central bankers have caused a debt pile with trillions of dollars' worth of free money. She only needs to muse the over-indebtedness of our over-leveraged Federal Government to see the bubble in bonds she has helped spawn.

And if none of those points convince her, perhaps the former MIT and Yale Fellow should find it troublesome that close to $13 trillion of global sovereign and corporate debt trades at negative yields. Thirteen trillion in negative yields screams bubble! Its time Yellen took off her blinders and her senses.

For the first time in the history of economics, corporations and governments are getting paid to lend money. This is the direct result of the 96 months of nearly free money from the Fed and the combined $15 trillion increase in central bank balance sheets since 2007. And this rate of central bank money printing is still growing at a rate of $200 billion each month.

The consequences of these actions has produced, for the first time ever, record bond, stock and home prices that all exist concurrently. Therefore, one has to conclude Ms. Yellen is either bubble blind, or deliberately trying to cover up the massive distortions in asset prices that central banks have created. Perhaps this is because she is viscerally aware that there is no escaping these bubbles without destroying the phony economic recovery, which has been predicated on the Fed's wealth effect. Incredibly, she recently has gone so far as intimating that the direct purchase of corporate equity and debt could be an appropriate course of action for the Fed to take during the next downturn.

But for now, Ms. Yellen appears ready to resume the aborted rate hike cycle it began last December. However, any such increase in interest rates will expedite the flattening of the yield curve and usher in the next brutal recession, along with the third 50% haircut in equity prices since 2000. And then our perpetually bubble-blind Fed will get that opportunity to purchase a humongous amount of securities in order to reflate the bubble once again—which the Fed still won't admit its culpability, let alone be able to recognize.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

The Free Market Always Prevails
September 27th, 2016

The global market for securities got a surprise recently when U.S. core consumer price inflation crept up to 2.3% year over year in the month of August. This closely followed core measure, which strips out the more volatile food and energy costs, increased 0.3%; this was the biggest rise in core CPI since February.

According to the government, while the costs associated with food and energy decreased, price increases came primarily from medical care commodities and medical care services. According to the Bureau of Labor Statistics (BLS), the prices for medicine, doctor appointments, and health insurance rose the most since 1984.

Unfortunately, it doesn't appear that consumers will have any relief from the rising cost of health care. According to Freedom Partners the average state increase for health insurance premiums under the Affordable Care Act was 15.1% from 2015, as the promised premium reductions from Obamacare circles the drain.

The rise in health care costs stands as another glaring example of the negative consequence of supplanting free-markets with government control. Demonstrating once again how flawed Keynesian economic policies inevitably lead to stagflation.

Unprecedented debt levels, massive money printing and intractable asset bubbles have failed to produce viable growth. And with the "stag" firmly in tow, it's only a matter of time before the "flation" kicks into full gear.

Once inflation targets are finally achieved, central banks will be forced to either rapidly raise interest rates or sit back and watch the free market do it for them.

In our current low growth and incipient inflation environment, central banks have embraced the role as master to the subservient financial markets. And for the past eight years, equity prices and bond yields have moved in Pavlovian fashion to every dovish or hawkish utterance out of a central bankers' mouths.

But let's not forget, at the height of the 2008 financial crisis these same markets were nobody's lackey. The stock market dropped over 50% despite the fact that the Fed was busy slicing interest rates from 5.25%, down to 0%. The truth is that governments and central banks only have the ability to control markets for a relatively brief period of time and eventually market forces always prevail.

Therefore, ultimately inflation will supersede central banks in their ability to control the yield curve. This will be especially shocking to people like Haruhiko Kuroda, the Head of the Bank of Japan (BOJ), who recently had the audacity to proclaim he can peg long-term rates at 0%, despite having an inflation target that will now be allowed to rise above 2%.

Recently, we received a small taste of how this may play out when a handful of individuals on the FOMC a.k.a. (the Federal Open Mouth Committee) and the President of the European Central Bank, Mario Draghi, forced markets to consider there may someday be limits to their monetary policies. This caused the Dow to shed nearly 400 points in one day and pushed long-maturity Treasury yields much higher.

Bond yields in developed markets also rose in tandem. In Japan, yields rose from -0.28%, to 0% and in Germany yields jumped from minus 0.19%, to 0.01%.

But more importantly, commodities, bonds and stocks all dropped together--for a few volatile days markets gave investors nowhere to hide. This is a small preview of what lies in store for financial markets once the thin veil is removed on this artificial and tenuous global economy.

For example, just imagine the shock to bond prices once Mr. Kuroda is successful in creating his newly espoused "overshoot" on the 2% inflation target in Japan; especially after pegging the 10-year at 0%. Yields will spike aggressively in an attempt to price in rising inflation, an insolvent government and the mandatory removal of the BOJ's bid. That means yields will surge 100's of basis points in a relatively short period of time. And since the bond market is global in nature; the end of the Japanese bond bubble will send yields soaring worldwide.

Manipulated markets can't last forever and never end well. Currently, every market on the planet is extensively mispriced because every asset's value is a function of sovereign debt yields that are now under the control of world central bankers. However, such an ability to dominate markets is temporary. And once yields normalize the entire economic charade, which has been based on a global artificial wealth effect, comes crashing down.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Bond Bubble has Finally Reached its Apogee
September 19th, 2016

Boston Fed President Eric Rosengren recently rattled markets when he warned that low-interest rates were increasing the temperature of the U.S. economy, which now runs the risk of overheating. That sunny opinion was echoed by several other Federal Reserve officials who are trying to portray an economy that is on a solid footing. And thus, prepare investors and consumers for an imminent rise in rates. But perhaps someone should check the temperatures of those at the Federal Reserve, the idea that this tepid economy is starting to sizzle could not be further from the truth.

In fact, recent data demonstrates that U.S. economic growth for the past three quarters has trickled in at a rate of just 0.9%, 0.8%, and 1.1% respectively. In addition, tax revenue is down year on year, S&P 500 earnings fell 6 quarters in a row and productivity has dropped for the last 3 quarters. And even though growth for the second half of 2016 is anticipated with the typical foolish optimism, recent data displays an economy that isn't doing anything other than stumbling towards recession.

The Institute for Supply Management Purchasing Manager's index for the manufacturing sector during August fell into contraction at 49.4, while the service sector fell to 51.4 compared to 55.5 in July, which was the lowest reading since February 2010 and the biggest monthly drop in eight years. And the recent jobs report was also full of disappointment too, with just 151,000 jobs created in August and a decline in the average work week and aggregate hours worked.

But our Federal Reserve is not the only central bank making statements troubling to stock and bond prices. The President of the European Central Bank (ECB), Mario Draghi, threw all the major averages into a tailspin at a recent press conference by failing to indulge markets with a grander scheme to destroy the euro. When asked if the ECB had talked about extending Quantitative Easing (QE) at its meeting, Draghi had the gall to make the egregiously hawkish announcement that they "did not discuss" anything in that regard. This mere absence of a discussion regarding extending or expanding QE caused the Dow to shed nearly 400 points on Friday and spiked the U.S. Ten-year from 1.52% to 1.68%. Indeed, stock and bond prices plunged across the globe.

It appears that nothing is ever enough to satisfy global stock and bond markets that are completely addicted to central bank stimulus. Mr. Draghi has managed to drive rates so low that they are now in effect paying European companies to borrow--yet markets want even more.

That's correct, it's no longer just sovereign debt that offers a negative yield. According to Bloomberg, French drug maker Sanofi just became the first nonfinancial private firm to issue debt at yields less than zero. Also, shorter-term notes of some junk-rated companies, including Peugeot and Heidelberg Cement, are yielding about zero percent.

Christopher Whittall of The Wall Street Journal reports that as of September 5th, €706 billion worth of investment-grade European corporate debt was trading at negative yields. This figure represents over 30% of the entire market, according to the trading platform Tradeweb. You can attribute this to the fact that global central bank balance sheets have increased to $21 trillion from $6 trillion in 2007, as central banks continue to flood the markets with $200 billion worth of QE every month.

The bond bubble has now reached epic proportions and its membrane has been stretched so thin that it has finally started to burst. As mentioned, not only did U.S. yields spike on the Draghi disappointment but the Japanese Ten-year leaped close to positive territory from the all-time low of -0.3% in late July. And the German Ten-year actually bounced back into positive territory for the first time since July 22nd.

What did Mario Draghi say that was so unsettling to the Global bond market and caused speculators that have been front-running the central bank's bid for the last eight years to panic? He didn't avow to sell assets; he didn't even promise to reduce the 80 billion euros worth of bond buying each month. All he did was fail to offer a guarantee that the pace of the current bond buying scheme would be increased or extended beyond March 2017. That alone was enough to cause yields around the globe to spike and stock markets to plunge.

This is merely the prelude of what is to come once the ECB and Bank of Japan reverse their monetary stimuli; or when the Fed actually begins its rate normalization campaign. Just for the record, the Fed's first hike in ten years, which occurred last December, does not count as a tightening cycle.

The bond bubble has grown so immense that if, or when, central banks ever begin to reverse monetary policy it will cause yields to spike across the globe. But as recent trading volatility has proved, it won't just be bond prices that collapse; it will be every asset that is priced off that so called "risk free rate of return" offered by sovereign debt. The painful lesson will then be learned that negative yielding sovereign debt wasn't at all risk free. All of the asset prices negative interest rates have so massively distorted including; corporate debt, municipal bonds, REITs, CLOs, equities, commodities, luxury cars, art, all fixed income assets and their proxies, and everything in between will fall concurrently along with the global economy.

Perhaps after this next economic collapse central banks will deploy even more creative ways to increase their hegemony and destroy wealth; such as banning physical currency and spreading electronic helicopter money around the world. In the interim, having a portfolio that hedges against extreme cycles of both inflation and deflation is essential for preserving your wealth.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Why the Greater Recession will be Dollar Bearish
September 12th, 2016

The Great Recession of 2008 provided markets with an interesting irony: As the US economy was collapsing under the weight of crumbling home prices, investors curiously flocked to the US dollar under the guise of "The Safety Trade."

But the truth is that investors weren't running into the dollar for safety, what they were actually doing was unwinding a carry trade. In a carry trade an investor borrows a depreciating currency that offers a relatively low interest rate and uses those funds to purchase an appreciating currency that offers the potential for higher returns on its sovereign debt and stock market. The trade's objective is to capture the difference between rates, while also benefitting from the currency that is rising in value against the borrowed (shorted) funds.

In the years leading up to the 2008 crisis, a popular trade was to short the US dollar and invest in higher yielding emerging markets (EM's) such as Brazil, Russia, India, and China referred to as the "BRIC'S". The Federal Reserve's manipulation of interest rates following the attacks of September 11, 2001, sent the market on a desperate search for yield. Investors found the return they were seeking in the EM's and remained there for years as the Fed was merely playing catch-up with rates. The Fed Funds rate went from 1 percent in 2004, to 5.25 percent in 2006, while the value of the dollar reduced during that timeframe.

As you can see from 2002 to 2008, EM stocks rose and the dollar fell as investors took advantage of the relative yield differential between the US and EM's.

But by the second half of 2008 the market's focus shifted away from yield differentials and FX advantages to a massive concern over tumbling US growth spilling over to the EM's due to collapsing real estate prices and insolvent banks. The short dollar/long EM carry trade reversed as investors panicked to cash out of booming BRIC markets and bought back dollar loans to close out the trade. This sent the dollar soaring and EM stocks crashing, which provided the peculiar narrative that investors were moving into the dollar for safety even as the US economy and financial system was in freefall.

What's happening now?

Today we actually have the reverse scenario: the dollar index is rising as the yen and euro currencies are falling. The carry trade is to borrow (short) the yen and euro and buy higher-yielding dollar-denominated assets. Therefore, the next economic collapse will reverse this carry trade.

Dollar Index:

Yen:

Euro:

This explains the real reason why the Japanese yen spikes at the slightest whiff of market turmoil. Market analysts again like to describe this phenomenon as a flight to safety. But why would any investor seek protection in Japan when its enormous debt to GDP ratio proves the nation is insolvent and its central bank is hell-bent on creating inflation by all means necessary?

Investors need to prepare their portfolios for the next recession, which will be worse than 2008 due to the massive increase in global debt and central banks that have no room left to reduce borrowing costs. Therefore, expect the yen and euro will be the beneficiaries of the next carry trade reversal and a much weaker response on the part of the greenback during the next crisis.

But as mentioned, perhaps the biggest worry for investors is what happens to the global economy when there is no room for central banks to save us? After all, they are already pushing the limits of their money printing and Zero Interest Rate Policies schemes. And the 90+ months of unprecedented and unorthodox monetary expansion has made asset bubbles and debt levels much greater than at any other time in history. The dollar will also come under pressure as the Fed's current divergent monetary policy joins the ECB and BOJ in a commitment to perpetual QE and ZIRP.

The next recession will be much different than the crisis of 2008 in its intensity, duration and effect on the US dollar. Of course, the only caveat would be a crisis that is precipitate by an aggressive Fed rate hike cycle. Otherwise, wise investors will anticipate this differential and have a plan to increase their allocation to precious metals at the onset of the next crisis.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

King of Debt vs. Queen of Deficits
August 30th, 2016

The Congressional Budget Office (CBO) estimates the total deficit for fiscal 2016 will be $590 billion. This is $152 billion (34%) greater than the shortfall posted in fiscal year 2015. And by 2026 the deficit would be considerably larger as a share of the nation's output (GDP) than its average over the past 50 years.

In addition to this, debt held by the public would rise significantly from its already high level, reaching 86% of GDP by 2026.

These accumulating budget deficits add to the Gross Federal debt that is now over $19.4 trillion dollars (105% of GDP). Most importantly, the debt and deficit estimates from the CBO assumes a growth rate in nominal and real GDP that is markedly higher than any other enjoyed in recent history; and also do not include any recessions over the next decade.

But the nation's growing debt and deficits don't appear to be weighing on anyone's mind. After all, Americans are burdened on a daily basis by more pressing issues such as an Olympic swimmer's drunken exploits and the ongoing search for Pokémon. Unfortunately, while the hypnotism of America intensifies, our debt burden grows unabated.

But with the election year upon us, one would have hoped this topic was at least superficially broached. That the two candidates would have at the very least made a glib proposal as to how they would avert our impending debt crisis.

Instead, both Clinton and Trump appear hell-bent on outspending each other at every campaign stop.

Hillary says if you are with "her" you'll get free college tuition! Her $350 billion proposal covers millions of voters set to pay for college, as well as interest rate relief for those saddled with student loans. Clinton has gotten applause when she suggests she will stick the rich with the bill. But this no growth economy isn't churning out enough Beyoncé's, to pick up the cost of college for the other ninety-nine-point-nine-nine percent. And a transfer of the cost of college education from the individual to the state will explode future federal deficits.

Ivanka Trump described her father as "a tough-talking deal-maker who also worries about family leave, equal pay for women and the cost of child care." But this softer side of Trump that Ivanka reveals is certain to make America broke again. Trump is promising working moms free child care. It's unclear how much this will cost since the proposal keeps changing but unless he can get Mexico to pay for it, it will add a lot to the deficit. In fact, the self-proclaimed lover and king of debt even goes so far to claim, "I would borrow, knowing that if the economy crashed, you could make a deal."

But the proposed spending doesn't just stop at child care and college. Both candidates promise infrastructure programs to rebuild America's roads, bridges, and airports.

Clinton's plan, which is estimated to cost $275 billion over five years, calls for setting up a national infrastructure bank to help fund large-scale projects. For the record, an infrastructure bank is a euphemism for off balance sheet government borrowing. And if Hillary's spending plan is big, Trump's, as you can imagine, is "Yuge" – his program is set to be double that of Clintons…not including the wall.

Both candidates will significantly add to the amount of red ink. The Committee for a Responsible Federal Budget estimates that Donald Trump's plan would add $2.55 trillion to the deficit over the next decade. And a study by the American Action Forum says Clinton's plan will increase the deficit by $2.2 trillion.

But the scary truth is that even if current laws remain in place, the pressures from rising deficits will catapult debt held by the public three decades from now to constitute 155% of GDP, a far larger percentage than any recorded in the nation's history.

The last recession saw an increase in the 2009 annual deficit of $1.2 trillion; bringing it to $1.4 trillion. Since annual deficits are already rising quickly--and are set to increase dramatically regardless of who is president--we can anticipate an unmitigated disaster if interest payments begin to rise towards more normal levels.

The major take away is this: Deficits will quickly explode over $2 trillion once the next recession hits, which is already overdue, and will go significantly higher if debt service payments are rising. This massive debt burden is only made manageable by eight years of near-zero percent interest rates and the global $200 billion worth of monthly QE. This incendiary cocktail will explode in a deflationary implosion if QE were to ever stop; or will soon result in a pernicious outbreak of global inflation if central banks keep printing money at this torrid and unprecedented pace. Therefore, a dynamic investment strategy that can profit from either of these scenarios has now become mandatory.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Proof the Economic Recovery Has Ended
August 22nd, 2016

The primary data point that the perennial bulls on Wall Street claim as evidence for an improving economy is the monthly jobs number. The Non-farm Payroll Report claimed that 255,000 jobs were added in July on a seasonally adjusted bases. This number was well above the 12-month average of 190,000. And according to the Bureau of Labor Statistics (BLS), at total of 1.66 million additional people have been employed thus far in fiscal 2016, making this the one bright spot in the economy.

And with 1.66 million additional paychecks flooding the economy, one would assume the U.S. Treasury was flush with new tax receipts, which would assist in reducing the budget deficit. However, according to the Treasury Department, the deficit came in at $112.8 billion in July, the highest since February's $192.6 billion. For the first ten months of the fiscal year, which ends Oct. 1, the budget deficit was $513.7 billion, up from $465.5 billion a year earlier.

Obviously, the government runs a deficit when it spends more than it collects in taxes and other revenue, as is almost always the case. But this year the Congressional Budget Office (CBO) is predicting the 2016 deficit will total $590 billion, up more than 34% from last year's budget shortfall. Most importantly, this growing gap comes primarily because of lower-than-expected receipts to the Treasury.

A closer look at tax receipts over the past few years reveals that the growing number of employed has not had the effect on cash flows to the Treasury that you would expect. Receipts from the Federal Unemployment Tax Act (FUTA) have been falling steadily since 2012, according to the Office of Management and Budget, moving counter to the growing number of people employed. The FUTA tax is levied at 6% on the first $7,000 of an employee's wage.

In 2012 receipts totaled $66.6 billion, in 2013 those receipts fell to $56.8b, in 2014 they were down to $54.9b, and in 2015 they dropped to $51.8b.

The decrease in the FUTA rate in July of 2011 from 6.2%, to 6.0% may explain some of the shortfalls, but FUTA has continued its decline since 2012 despite the steady rise in employed persons.

In the past fiscal year of 2015, FUTA also fell short of the US Treasury's own estimate of $56.35 billion coming in at just $51.8 billion, creating an 8% shortfall.

In the fiscal year 2015, Social insurance and retirement receipts also came up short at $1,065.3 billion, $5.1 billion lower than the Mid-Session Review estimate.

This begs the salient question: If the employment condition is booming why are payroll taxes falling?

There are a couple of answers to that question and neither is favorable. The BLS numbers are either wrong or the quality of new jobs created must be very poor. The latter response seems the most credible; a combination of an increase in the proportion of part-time workers and full-time jobs that provide lower compensation. This would also explain the economy's falling rate of productivity. After all, it's hard to increase the output per hour of barmaids and waiters.

The true employment condition, as well as the quality of those jobs, can be found in the tax receipt story, which is more comprehensive than the BLS's estimate. But it's not just payroll taxes that have declined; corporate tax receipts have fallen 12.8% year-to-date, while individual taxes are down 0.4%.

Again, the only consistent outlier amongst all of the weak data is the monthly Non-Farm Payroll Report. But if the quality of those net new jobs created is extremely poor, then the headline BLS number can be easily reconciled with the economic data points that point towards recession.

The bottom line is that our standard of living cannot be improving when Productivity has been negative for 3 quarters in a row. The economy isn't getting better while earnings on S&P 500 companies have been negative 5 quarters in a row, and are projected to come in negative for the 6th time. There can be no real growth when tax policy remains unchanged and receipts are falling. And finally, it's hard to be upbeat regarding growth when nominal GDP is up just 2.4% year-over-year. The government's own measurement claims Core Consumer Inflation is up 2.2% YoY. This means real economic growth is just 0.2%. But even that paltry growth rate quickly vanishes if you believe inflation is higher than what the Bureau of Labor Statistics reports.

The truth is the economy is most likely already in a recession and there never was a viable economic recovery. Just an anemic, ersatz and transitory bounce in GDP derived from artificial, record-low interest rates and asset bubbles. Investors need to keep their eyes open as equity prices march further into all-time high territory. And, most importantly, have a strategy to protect their portfolios once sanity returns to the market.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Sacrificed to the Inflation gods
August 15th, 2016

Our Federal Reserve is composed of labor market economists who place their faith in the theory that inflation is spawned from too many people working. They believe there is a trade-off between employment and prices, where price stability and full employment cannot exist peacefully together the same time.

Given this view, the Fed's maximum employment and stable inflation mandates are played as a zero-sum game--the lower the unemployment rate the higher the rate of inflation. Therefore, they set about to fulfill this task of low inflation as though it were a sort of Ancient Mayan sacrificial system: ceremonially counting how many job seekers need to be sacrificed on the altar of labor slack to placate the inflation gods.

And so began the FOMC's countdown to the inflation blastoff since the end of the great recession. Our economy started with an unemployment rate as high as 10% in 2009 and negative Consumer Price Inflation (CPI). The Fed first warned us that an inexorable rise of inflation would start once the unemployment rate fell below 6.5%. However, the unemployment rate has dropped to 4.9% and the Fed is left starring at the heavens wondering why its 2% inflation target has yet to be reached.

Now, from some truth about inflation. Inflation occurs when the market loses faith in the purchasing power of a currency, not from too many individuals becoming productive. In reality, there is no evidence that full employment is inflationary. In fact, the 1970's stagflation struggles proved that unemployment and inflation could rise rapidly in tandem. And during the sub 4% unemployment rate during the turn of the century proved that an unprecedented amount of productive people could exist in a world of below 3% CPI.

Despite overwhelming data to the contrary, the 255,000 increase in July jobs created is putting pressure on the FOMC to finally raise rates for the first time this year. But even a cursory look at the relationship between high CPI and a low unemployment rate since 1971 shows that none exists.

Consumer Price Inflation CPI:

The Unemployment rate:

But Yellen and company need look no further than Japan to see there is no correlation. Throughout the nation's multiple lost decades marked by disinflation, Japan has always had an extremely low unemployment rate; averaging 2.73% since 1953, and hitting a high of just 5.6% in July of 2009.

In June of this year, Japan's jobless rate dipped to a twenty-year low of 3.1 percent. The number of employed increased by 720,000 year on year, to 64.97 million for the 19th straight rise. The number of unemployed dropped 140,000 on year to 2.1 million, for the 73rd consecutive fall.

If Fed dogma were correct, these newly employed spenders would at the very give the Japanese inflation rate the jolt it needed to reach its long awaited 2% target. But Consumer prices in Japan dropped by 0.4 percent year-on-year in June of 2016, the 4th straight month of declines. And core consumer prices fell 0.5 percent from a year earlier in June, the steepest drop since March 2013. Household spending fell 2.2 percent in June from a year earlier, while industrial output slipped 1.9 percent on an annual basis.

If full employment is the progenitor of inflation, why isn't Japan breaking into hyperinflation?

The truth is the inflation evident in today's economy is not coming from a low unemployment rate, it originates from the record size of central bank balance sheets and the staggering increase in government debt that is being monetized. And that inflation is disproportionately being funneled into the bond and stock market, driving bond yields into negative territory and stock prices to all-time highs. In fact, the size of global central bank balance sheets has now risen to an astonishing 17.2 trillion dollars.

But the Fed still feels compelled to worship its labor market dashboard; believing the inflation gods will be angered by the low unemployment rate. Therefore, the chances are increasing by the day that the yield curve will invert. This is because while Ms. Yellen is slowly and painfully hiking short-term rates (albeit for the wrong reason) just as the long end is being suppressed by the nearly $200 billion per month of QE from the developed world's central bankers.

Flattening of the yield curve:

Why is an inverted yield curve so important? An inverted yield curve cuts off bank lending and has precipitated the last 7 recessions 100% of the time. Only this go around, the yield curve will invert somewhere in the one percent area instead of the mid-single digits—so there isn't much room at all for the Fed to widen spreads. Unfortunately, this is just one of the landmines placed by global central bankers that will explode with unprecedented ramifications.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Greenspan Gets One Right: Here Comes stagflation
August 8th, 2016

In a recent interview, former U.S. Federal Reserve Chairman Alan Greenspan (the "Maestro") warned that the economy was experiencing, "the early signs of stagflation." This is a very rare occasion where Mr. Greenspan and I are actually in agreement. I also warned of this in my "Time to Invest for Stagflation" commentary published several months ago.

In fact, the U.S. economy—and indeed the entire developed world—is in the beginning stages of an unprecedented breakout of stagflation. The number one reason for this can be summed up in a single word…debt. Debt not only steers an economy towards low growth but it also mires the nation with inflation.

Public and private debt as a percentage of the economy had been 150% for decades prior to going off the gold standard in 1971--a standard of money that Greenspan himself advocated before becoming Fed chairman. That ratio of total debt to Gross Domestic Product shot up 350% before the great recession of 2007-9 and it remains near that level today. And now, the annual level of red ink has started to rise sharply. The fiscal 2016 deficit is projected to rise to $600 billion, up more than 35% since fiscal 2015.

In fact, global debt as a whole has increased to $230 trillion, up $60 trillion since 2007, nearly three times the size of the entire global economy. All this debt engenders the stag part of stagflation because it is difficult to invest for growth in an economy under such high debt burdens. The baneful part of this worldwide debt buildup is that it didn't lead to the accumulation of capital goods for the purpose of expanding productivity. Instead, it was spawned for the fruitless Keynesian ruse of what amounts to not much more than hole digging and filling.

While it is true that debt service payments are currently at historic lows, it is also true that debt levels are at a record high both in nominal terms and as a percentage of the economy. Therefore, low-interest payments are the direct result of an unprecedented bubble in the bond market. Individuals are intuitively aware of this unstable rate environment and must prepare their balance sheets for rising carry costs.

Most importantly, a debt saturated economy can't function properly because it is marred by capital imbalances and asset bubbles that must be unwound for the credit and savings channel to work efficiently. But our economic leaders seem intent on obduracy.

A perfect example of this condition is Japan. The nation is now set to take its 26th trip down this deficit spending road to nowhere since its property, and equity bubble crashed back in 1990. And despite multiple recessions and lost decades, the government is still clinging to the deluded fantasy that a debt to GDP ratio greater than 240% is needed to jump start the economy.

But, the effects of this unproductive debt pile aren't just evident in Japan. U.S. GDP averaged just 2.1 percent since 2010. And that anemic growth rate is headed even lower; up just 1.2 percent over the past year and only 1 percent for the first half of 2016.

Indeed, the International Monetary Fund (IMF) recently lowered its 2016 forecast for the entire global economy to just 3.1 percent.

So where does the inflation part of stagflation come from?

If there is one thing that all central bankers foolishly agree on it's that a 2 percent inflation goal is now mandatory for growth. According to Haver Analytics, the balance sheets of the Fed, European Central Bank, Bank of England, Bank of Japan and People's Bank of China have soared to $17.2 trillion, from $6.5 trillion over the past eight years.

In pursuit of this fatuous task, ECB and BOJ balance sheets are ascending at the blistering pace of a combined $180 billion per month of newly created fiat credit. And now the Bank of England just stepped up its asset purchase scheme to a total of $570 billion. But unlike what most Keynesians will tell you, inflation doesn't come from a low unemployment rate but rather from too much money chasing too few goods.

Therefore, it would be silly to assume that central banks can achieve their 2 percent inflation targets with precision. Reckless deficit spending, surging debt to GDP ratios and an unmanageable increase in central banks' balance sheets will eventually erode the confidence of central bankers to maintain the purchasing power of fiat money. Therefore, inflation won't just magically stop at 2 percent; it will eclipse that level and continue to rise.

This return of inflation will cause a mass exodus from the bond market, just as short sellers begin to pile on top. The bond market will respond in violent fashion—taking yields up 100's of basis points rather quickly—as bond bids from yield-agnostic central bankers are supplanted by a genuine market that will justifiably demand higher rates. And of course, the inevitable surging debt service payments will subsequently render debt-saturated governments completely insolvent.

An unprecedented accumulation of unproductive government debt that is fueled by a massive increase in the global base money supply is a perfect recipe for worldwide stagflation. But the truth is that stagflation isn't something on the horizon, it has already arrived.

The hallmark of a healthy economy is to have its real growth rate to be double the pace of inflation. Today, this sign of prosperity has been turned completely upside down. The core Consumer Price Index is up 2.3 percent year over year while real GDP has grown just 1.2 percent. Inflation is now running at twice the rate of real economic growth!

Stagflation is not an economic peril we only need to fear in the future; but rather it is something consumers are forced to deal with right now. The former "Maestro" is perhaps getting better with age. Investors should prepare their portfolios for a protracted period of rising prices and slowing growth.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

4 Stages of Monetary Madness
August 1st, 2016

There are four stages of fiat money printing that have been used by central banks throughout their horrific history of usurping the market-based value of money and borrowing costs. It is a destructive path that began with going off the gold standard and historically ends in hyperinflation and economic chaos.

Stage one is the most benign of the four, but it sets the stage for the baneful effects of the remaining three. The first level of monetary credit creation uses the central banks' artificial savings to set short-term interest rates through the buying and selling of short-duration government debt. This stage appears innocuous to most at first but is insidiously destructive because it prevents the market from determining the cost of money. This is crucially important because all assets are priced off of the so called "risk-free" rate of return. A gold standard keeps the monetary base from rising more than a few percentage points per annum and thus restrains bank lending. However, having a fiat currency also means a nation has a fiat monetary base. This leads to unfettered bank lending and the creation of asset bubbles.

The second stage of monetary madness has been around for decades but is now commonly known as Quantitative Easing (QE). After several cycles of lower and lower short-term interest rates that are intended to bring the economy out of successive recessions, the central bank (CB) ends up pegging rates at zero percent or below. Once CBs run out of room on the downside of short-term rates they go out along the yield curve and begin to artificially push down borrowing costs for long-term debt. It is important to note that at this stage CBs only purchase assets on private banks' balance sheets and at least pretend they will someday liquidate these holdings.

The third level of monetary madness is now being threatened to be imposed upon the population by central banks across the globe. This stage is called "Helicopter Money" and is the brainchild of noted economist Milton Friedman. But in reality, versions of it have been used many times prior to Mr. Friedman's appellation of central bank money drops. Friedman argued the use of Helicopter Money to combat deflation, but it has been traditionally used to help an insolvent government service its debt.

At its core, Helicopter Money is defined to be the issuance of non-maturing government debt or the direct issuance of credit to the public that is financed by the central bank. Both forms of money drops operate most efficiently by circumventing the private banking system. This is because CBs and governments don't have to worry about private banks deciding to forgo buying more government debt if favor of holding the fiat credit as excess reserves. Helicopter Money allows citizens the direct access to new credit without the threat of having it unwound from the CB. The main difference between non-maturing debt issuance and direct public credit is the former allows the government to direct who gets the new money, and the latter gives the CB that discretion. But in either case, Helicopter Money amounts to a direct increase in the broad money supply and inflation.

As I mentioned in last week's commentary, The Bank of Japan and perhaps even The European Central Bank are seriously contemplating saying "get to the chopper" very soon. Alas, once you get to level 3 there will be an inexorable march towards the next level. This is because there is no calling in the helicopters without causing a devastating plunge in asset prices and a bond market collapse, which results in massive economic chaos.

This brings us to the final stage of central bank intervention, which is the interminable and direct purchase of sovereign debt by a central bank for the sole purpose of keeping interest rates from spiraling out of control. Hence, the 4th stage of Monetary Madness occurs once inflation becomes fully entrenched in the economy.

It would be pure folly to assume that central banks can achieve their 2% inflation targets with impeccable precision. Years' worth of deficit spending, surging debt to GDP ratios and a gargantuan increase in central banks' balance sheets will eventually lead to a significant erosion in the confidence of central bankers to maintain the purchasing power of fiat money. Therefore, inflation won't just magically stop at 2%; it will eclipse that level and continue to rise.

But that's only half of the issue. Sovereign bond yields have been slammed so far down by CBs that nearly 30% of the entire supply of government-issued debt now trades below zero percent. The return of inflation must surely cause a mass exodus of longs from the bond market, just as short sellers begin to pile on top. The bond market will also respond in violent fashion—taking yields up 100's of basis points rather quickly—due to the anticipation of waning bond bids from central bankers.

Of course, surging debt service payments will render debt-saturated governments completely insolvent, which forces central banks into stage 4. Sadly, this is the conclusion that lies ahead for the developed world. Investors should not become complacent with the current innocuous state of global bond yields. In reality, they have become incendiary bombs that will inevitably explode with baneful implications for those that are not fully prepared.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Japan's Lemming Syndrome
July 25th, 2016

The financial world is buzzing about former Fed chairman Ben Bernanke's recent trip to Japan, where he advised Japan's central bank chief Haruhiko Kuroda on how to manage his nation out of multi-decades of stagnant growth. Channeling economist Milton Friedman, Bernanke warned that Japan was vulnerable to perpetual deflation and stagnate growth and that helicopter money--where the government issues non-marketable bonds with no maturity date and the Central Bank buys them with counterfeited credit--was the most useful tool in overcoming this condition.

Bernanke encouraged Japan to carry on with the Abenomics policies that have failed to date by supplementing monetary policy with even more fiscal stimulus—as if Japan's 230% debt to GDP ratio wasn't enough. And he assured Abe and his staff that the Bank of Japan (BOJ) has instruments to ease monetary policy yet further.

And in case this village needed another idiot, Nobel laureate Paul Krugman, also chimed in. Arguing that Japan should raise its inflation target to 4 percent and embark on a significant but temporary fiscal stimulus to boost prices in the economy. Speaking at a conference on Thursday in Singapore, Krugman called for "a big burst of government spending and maybe also cash donations."

But the truth is that despite pumping trillions of yen into the financial system, Japanese money printing has had little or no effect in restoring growth. In fact, Japan has already undertaken the largest quantitative easing program--much larger in relative terms than the U.S. Federal Reserve and the European Central Bank.

Despite this, lawmakers in Japan are drinking the Keynesian Kool-Aid and have bought into the notion that inflation is the progenitor of growth. They are calling for a government debt package of about 10 trillion yen ($94 billion) financed by the BOJ.

The BOJ is currently purchasing nearly 110-120 trillion yen of bonds a year to satisfy a pledge to expand the balance of its holdings. And demand for Japanese Government Bonds (JGB's) is pushing those yields into negative levels that only a central banker could love. There is no private investors in JGBs any longer. The only buyers left are the price-agnostic BOJ and speculators trading bonds like stocks; hoping to grab enough principal appreciation to make up for the negative coupon, and then flip it to the next foolish gambler, or directly back to Japan's central bank as part of its latest bond-buying program.

But the BOJ's spending spree is not limited to JGB's; the Bank of Japan owns more than half of the nation's exchange-traded funds (ETF's). As you can imagine, all these asset purchases have exploded the BOJ's balance sheet to a record 432.8 trillion yen.

But the question for Messer's Abe and Kuroda is: if money printing is the solution, what is the actual problem?

In 2015 Japan stood as the fourth-largest economy in the world. And despite some fits and starts, that the Japanese economy has been stagnant since the early 1990's.

However, a chart of per capita GDP shows that Japan's growth has been on an impressive upward trajectory.

Indeed, Japan is growing on a per capita, or per person basis. Therefore Abe and Kuroda must believe that printing money is going to increase the population. Japan's working-age population peaked in the mid-1990s and has been declining since. And according to government projections the workforce is expected to shrink to 44 million by 2060, which is about half of its peak level.

This endless debt and money printing scheme is in reality a solution in search of a problem. Or, perhaps if central bankers were a more honest bunch, they would tell you the BOJ is using the growth excuse to tackle the real issue: Japan's tax base can no longer service its debt.

Therefore, its fiscal and monetary conditions must be completely taken over by the central bank in the doomed hope that inflation will become the nation's panacea. The outcome to this absurd plan would be a mystery if countries haven't tried this many times before. Like lemmings, the Japanese government and central bank will blindly follow the same path as Weimar Germany, Zimbabwe and Hungary. Perhaps they should read up on the history of hyperinflation.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

Record Bond and Stock Prices Sending the Same Message
July 18th, 2016

The S&P 500 is trading near an all-time record high. But investors should not take this as the all clear signal. According to most indicators, the market is now more overvalued than ever before.

The Cyclically Adjusted Price to Earnings Ratio analyzes the value of the S&P 500 Index with the 10-year average of "real" (inflation-adjusted) earnings as the denominator to determine if the market as a whole is overvalued or undervalued. Today this ratio sits at 26.73, close to the short-term high of 27.2 seen in 2007 and well above its historic average of around 16.

Then we have the Q ratio, developed by James Tobin. This metric takes the total price of the market divided by the replacement cost of all its companies' assets. The average Q ratio is .68, but the latest estimate of the Q ratio .98. This suggests that the S&P 500 is currently dramatically above the mean.

Adding to this, the total market cap of U.S. stocks is now 122.5% of GDP. This is the highest level since mid-2000, which was during the NASDAQ bubble. This measure reached its peak at 142%, before crashing back to the more traditional level of just 70% by 2002.

And last we have the Price to Sales Ratio of the S&P 500. It is a measure of the Index's value compared to its sales. The most recent Price to Sales is estimated at 1.91, in December of 2015 it was 1.81 and in 2007 it was 1.43. This metric shows the market is vastly overvalued compared to firms' revenue.

All these indicators demonstrate that the S&P 500 is sitting in nosebleed territory. However, while the market marches to ten-year highs, the Ten-year Note yield is hitting historic lows. Bonds and stocks historically have an inverse relationship. This is leading investors to question what the bond market knows that equity investors do not and vice versa. But the correct answer to this seeming conundrum is that both stocks and bonds are in a bubble, which is the direct result of unprecedented central bank credit creation.

The condition of record low bond yields should be the result of a record low deficit and debt to GDP ratios, strong economic growth, which would increase the credit quality of the issuers, and historically low central bank balance sheets.

But today, low bond yields are all about central bank manipulation of bond prices. For instance, the last time the 10-year note was anywhere near this neighborhood was when it reached 2.29 percent in April 1954, during the Eisenhower era. As I noted in my book "The Coming Bond Market Collapse", during the 1950's the United States held most of the world's gold and manufacturing base. The National debt was high but was falling precipitously in relation to the economy; meanwhile, household debt was very low. Also, a strong dollar backed by a partial gold standard and robust economy led to a healthy Treasury market. Bond yields were not a result of central banks manipulating currencies in a frenzied search of inflation to perpetuate a growth fallacy.

But the longer Central Banks stay in the game of thwarting market prices the greater the divergence between economic growth, equity markets, and bond yields will become. This game can last a lot longer than most believe. However, reality will eventually take hold and cause a cataclysmic global bond market collapse.

This is because all asset prices are a function of the so-called "risk-free" rate of return on sovereign debt. Record low and even negative, bond yields have forced yield-starved investors far out along the risk curve in search of a positive return. Therefore, the worldwide sovereign bond bubble has infected; Collateralized Loan Obligations, Mortgage Backed Securities, Municipal Bonds, Real Estate Investment Trusts, Junk Bonds, and Equities…just to name a few of the assets warped by this unprecedented phenomenon.

What will be the sign that equity prices will crash back to reality? The answer in one word is inflation. If, or rather when, these maniacal central bankers achieve "success" in forcing inflation upon the masses; whatever is left of the free market will run for the narrow door to exit all of the assets listed above. Thus, exacerbating the global economic meltdown that must follow the faltering of government debt throughout the developed world.

One more warning for equity holders to heed: As we are all aware, the U.S. housing bubble collapsed back in 2008 and caused a global financial crisis. However, unlike what most market pundits will tell you, a fairly localized Real Estate meltdown cannot be worse than having the entire global sovereign debt market collapse. Blindly riding out this bull market without appropriately hedging your investments is extremely dangerous. Indeed, economic savvy and vigilance have never been more important for your financial health.

Michael Pento produces the weekly podcast "The Mid-week Reality Check", is the President and Founder of Pento Portfolio Strategies and Author of the book "The Coming Bond Market Collapse."

 

ECB and BOJ Now Trapped in Endless Counterfeiting
July 11th, 2016

The Fed was able to end its massive $3.7 trillion series of Quantitative Easing campaigns without the stock market and economy falling apart. The end of QE 3, in October of 2014, did cause temporary turmoil in the major averages; but all in all, it did not lead to a protracted market decline, nor did it immediately send the economy into a recession.

The consensus view then became that the Fed’s strategy of unprecedented interest rate and monetary manipulations was a huge success, and it would be able to slowly raise the Fed Funds rate with impunity.

Perhaps it was this assurance that gave Ben Bernanke’s successor, Janet Yellen, the temerity to begin liftoff in December of 2015. However, when the Fed commenced its first rate hike, it led to the worst beginning of a year in stock market history, as the Dow Jones industrial average lost more than 10% of its value between January 1st and Feb. 11th. Therefore, while the markets seem to have become somewhat comfortable with the end of QE (at least for now), they have also reached the consensus that a protracted tightening cycle is a completely untenable position for the Fed to hold.

The U.S. Central Bank’s “success” with QE, coupled with the pervasive condition of economic weakness throughout the world, persuaded the Bank of Japan (BOJ) and the European Central Bank (ECB) to not only follow in the Fed’s QE footsteps, but also to force sovereign debt yields into negative territory. In fact, thanks to the BOJ’s ¥80 trillion ($660 billion) and the ECB’s €960 billion ($1.06 trillion) per annum bond-buying schemes, there is now nearly $12 trillion worth of government debt that trades in sub-zero territory. What’s more, is the ECB’s total QE program now exceeds the entire GDP of Spain and Italy; while the BOJ’s intervention has brought its ownership to over half of all ETFs and over 33% of all its sovereign bonds.

But as arduous as the path to interest rate normalization will be to the Fed, it will be far more chaotic for the BOJ and ECB to even hint at rate hikes. Indeed, it will be virtually impossible for these two central banks to terminate their counterfeiting sprees without causing complete chaos in global markets and economies.

This is because the Fed stopped its QE programs well before inflation hit 2%, and when the Ten-year Note yield was well above zero percent. Year over Year CPI in the U.S. was 1.6% in October 2014 and was headed down towards negative territory by the start of 2015. Also, the 10-year Treasury was 2.3%. Hence, inflation was below the Fed’s target and going lower, while Treasury yields were far from being negative. These two conditions allowed the Fed to stop buying bonds without causing the market to completely revolt.

In sharp contrast, Messer’s Draghi and Kuroda have vowed they would not end QE until the inflation target of 2% is achieved in a sustainable manner. But these gentlemen have been trying, unsuccessfully, to bring inflation to that level for years; what gives them the confidence they can stick the landing on a 2% inflation target? They cannot. Inflation will eventually rise to 2% and keep on moving higher.

Also, 10-year yields in Germany and Japan are negative 20bps and 28bps respectively. This amounts to a tremendous difference in economic conditions that were evident in the U.S. during the end of QE 3 and what we find in Europe and Japan today. By ending QE when disinflation was still prevalent and yields were in positive territory, the Fed was able to cease its intervention in markets without causing its bond bubble to burst.

However, by waiting until inflation is well entrenched in the mindset of investors and after pushing sovereign bond yields well into negative territory; the ECB and BOJ have unwittingly backed their sovereign debt markets into death traps. Therefore, even suggesting that it is time to gradually pull back from bond purchases will cause a colossal stampede out of Japanese Government Bonds and European Sovereign Debt.

Traders that have habitually been front-running the central banks’ bids will try to dump their holdings of negative yielding debt as bond prices plunge in response to a 2%--and rising—inflation rate. Throw in debt to GDP ratios that have absolutely soared since the Great Recession of 2008 and the result will be complete chaos in bond markets.

Even worse, whatever anemic growth rates that have been achieved in Euroland and Japan have come off the back of asset bubbles and persistently falling borrowing costs and debt service payments. Therefore, as bonds begin to reverse decades of falling yields, look for the denominators in the debt to GDP ratios of these countries to plummet. Thus, exacerbating the move higher in rates, which will only expedite the plunge in asset prices and in turn further depress GDP growth.

This is the inevitable result of such massive and unprecedented distortions in market prices. Sadly, the price discovery mechanism has been trampled on for so long that a safe return to free markets has now become absolutely impossible.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Ready or Not the Recession May Have Already Arrived
July 7th, 2016

While investors have been focused on the perennial failed hope for a second half economic recovery, they have been missing the most salient point: the U.S. most likely entered into a recession at the end of last quarter.

That’s right, when adjusting nominal GDP growth for Core Consumer Price Inflation for the average of the past two-quarters the recession is already here. But before we look deeper into this, let’s first look at the following five charts that illustrate the economy has been steadily deteriorating for the past few years and that the pace of decline has recently picked up steam.

There is no better indicator of global growth than copper. Affectionately referred to as “Dr. Copper”, this base metal has traditionally been a great barometer of economic health. Unfortunately, as you can see from the chart below, copper has been in a bear market for the past five years and shows no sign of a recovery from its 55% plunge.

Next, we have the Baltic Dry Index. This index measures the demand to transport dry commodities overseas. An advancement of this index would represent an increase in global growth. But as you can see, this index has been in a down-trend since the end of 2013 and fallen 75% from that point.

Baltic Exchange: Baltic Dry Index (BADI: Exchange)

With both of these vital indicators pointing south, it should come as no surprise that Reuters recently reported that the Organization for Economic Co-operation and Development (OECD) said that global trade would only grow by, “2 percent this year, a level it has fallen to only five times in the past five decades and that coincided with downturns: 1975, 1982-83, 2001 and 2009.”

There is little debate that the worldwide economy is stagnating, and despite what some would like to argue, the United States has not been immune from this slowdown at all.

To prove this we can first look at the spread between the Two and Ten-year Treasury Notes. When this spread is contracting there is increased pressure on banks’ profits, which leads to falling loan growth and less economic activity. The 2-10 Year yield spread has been narrowing since July 2015 and is now the tightest since November 2007.

Then we have Industrial Production that measures the output of factories, mines and utilities in the U.S. economy. According to the Wall Street Journal, industrial production is faltering:

“Overall industrial production peaked in November 2014 but has failed to regain that level amid a mining sector collapse and leveling off at factories. Overall industrial production was down 1.4% in the 12 months through May. Utility output is down 0.8% and mining output has plunged 11.5%.”

And the once crowned jewel of the post-Great Recession economy, the lagging economic indicator known as the Non-farm Payroll Report, is also rolling over fast. Last month’s disappointing 38k net new jobs created was written off by some as an anomaly, but the chart below shows that this was actually part of a declining trend that has been in place since October 2015.

The falling copper price, tumbling global trade, a flattening yield curve, weakening industrial production and the rolling over of monthly job creation all point to an economy headed into contraction.

But as mentioned earlier, to confirm that this recession may have already arrived, we need to look no further than the data published by the Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS).

The official designator of a recession is the BEA, which defines the situation as two consecutive quarters of negative real GDP growth. During Q4 2015 and Q1 2016, real GDP posted 1.4 and 0.8% respectively—so officially we’re not in one yet. However, when deflating nominal GDP by the core rate of Consumer Price Inflation (CPI) published by the BLS, you get real GDP of just 0.3% in Q4, and negative 0.8% during Q1. Therefore, the economy is dangerously close to a contractionary phase; and is already in one when averaging the prior two quarters (at minus 0.25% when adjusted by core inflation).

It took 1.5 years to bring the economy out of the Great Recession that began in December 2007. And it took a $3.7 trillion increase in the Fed’s balance sheet, plus 525 basis points of interest rates cuts to pull us out. The major problem is that stock market is now pricing in a strong recovery from the four quarters in a row that the S&P 500 has posted negative earnings growth. Another year, or more, of falling earnings for equities would result in a devastating bear market.

The Fed already has a bloated balance sheet in relation to GDP and only a few basis points to reduce borrowing costs before short-term rates hit zero percent. Therefore, there just isn’t much the Fed can do this time around. Therefore, this next recession could last even longer than the previous one.

The stock market is pricing in perfection and is ill prepared for a protracted recession that may already be underway. Prudent investors should hedge their portfolios now from such an unwelcomed event.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Insanity Definition on Full Display
June 21st, 2016

Wells Fargo recently announced a new mortgage product they are calling “A game changer in the industry”. According to the bank, this product is purported to facilitate the dream of homeownership to more people by …wait for it... lowering the down payment and out-of-pocket costs associated with a more conventional mortgage products, while also offering more consumer friendly income and credit guidelines.

This new product that those at Wells Fargo have declared “revolutionary” is called yourFirst MortgageSM and one has to imagine it must have been developed by somebody with a severe case of amnesia and who recently suffered from a bad concussion.

Wells Fargo Home Lending contends that the new program, “provides access to credit while maintaining responsible lending practices.” However, according to their press release, the loan program offers a down payment of as little as 3 percent for first-time homebuyers and low-to moderate-income credit history. And Income standards have been loosened to include others who will live in the home, such as family members or renters. Also, the required minimum credit score to qualify for this program was reduced down to just 620.

But for those who may be concerned Wells Fargo is lending like its 2005…have no fear; Well’s has partnered with in their words “credit experts such as Fannie Mae” to develop a loan option that gives homebuyers the best offering in the market.

Their so-called credit expert, Fannie Mae, was the same Fannie Mae that was placed into conservatorship by the United States Federal Housing and Finance Agency on September 7, 2008. The then quasi-government agency ran aground when they failed to properly manage credit risk, leaving them vulnerable to bankruptcy during the 2008 financial crisis.

One safeguard they did keep in place was proper documentation. But, if pesky w-2’s and bank statements are standing between you and the home of your dreams--have no fear--there is a revolutionary new loan product for you too. New York City-based Quontic Bank just rolled out its product called “Lite Doc,” it’s a five-year, adjustable-rate mortgage that requires only two months of employment verification and bank statements.

The sad fact is lending standards are dropping quickly back to the same level that fueled the start of the Great Recession. And as you might imagine, all these newly un-qualified borrowers entering the housing market have boosted home prices.

According to the Census Bureau’s new home sales report: The median sales price of new houses sold in April 2016 was $321,100; the average sales price was $379,800. And the average price in April 2016 was $379,800 and the median price was $321,100. Both of these are above the bubble high.

Furthermore, less than 2% of new homes were sold for less than $150K in April 2016. This is down from 30% in 2002, leading many to speculate that the under $150K starter-home is becoming extinct.

Existing home sales reached an annualized pace5.47 million, growing on a year-over-year basis by 6%. Sales of existing homes have also risen, the median sale price for an existing home in December reached nearly $233,000, up 6.3% year over year, growing faster than income. In fact, the ratio of median home prices to median income is 4.1, well above the historical range of 3.2.

The rise in home values will create equity that an owner can draw from and use for things such as vacations, hot tubs and RVs. This will entice more speculators into the market that will drive up the price of homes further. And the economy will grow on the back of home equity extractions and asset bubbles. This may all sound great if we had not tried this already less than eight years ago and it nearly brought down the entire global economy!

Some may wonder why after the 2008 financial crisis Wall Street and the banks didn’t learn their lesson. The reason: The sad truth is the economy has become a giant Ponzi scheme that has become totally addicted to ever increasing credit issuance and asset bubbles, which need progressively falling interest rates and reduced lending standards to entice new participants into the baneful game.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Fed’s Rate Normalization Will Be Far From Normal
June 6th, 2016

The Fed traditionally embarks on an interest rate tightening cycle when inflation has started to run hot. This decline in the purchasing power of the dollar will nearly always manifest itself in: above trend nominal GDP, rising long-term interest rates and a positively sloping yield curve. These prevailing conditions are all indications of a market that is battling inflation; and thus prompts the Fed to start playing catch up with the inflation curve.

For example, the last time the Fed began a rate tightening cycle was back on June 30, 2004, when the Fed moved the Overnight Funds rate from 1% to 1 ¼%. At the time, the Ten-year Note yield was 4.62%, and the Two-year Note was 2.7%, creating a 1.92% spread between the Two and the Ten-year Note. To illustrate the fact that the long end of the yield curve was pricing in future inflation, the Ten-year yield climbed to 5.14% two years into the Fed’s rate hiking cycle. And perhaps more importantly, real GDP was 3% and rising, while nominal GDP posted an impressive 6.6% in the second quarter of June 2004.

To reiterate, the last time the Fed began to raise rates it did so on the back of higher than normal nominal GDP, rising long-term interest rates and a positively sloping yield curve. With this in mind, let’s take a look at the environment for the current tightening cycle.

The FOMC began its latest rate hiking campaign on December 17, 2015. At that time, the Ten-year note was 2.24%, and two-year Note was just 1%. Hence, the 2-10 year Note spread was 1.24%. And in the fourth quarter of 2015 nominal GDP was 2.3%, while real GDP was a paltry 1.4%.

As the markets sit with bated breath for the threatened second rate hike by the FOMC, the Ten-year Note Yield has actually decreased to 1.72% and the Two-Year Note dropped to 0.8%, creating a yield spread of a meager 92 basis points. This is the tightest yield spread since November of 2007. Making matters worse, nominal GDP during Q1 was 1.4% and Real GDP was 0.8%. Therefore, after just one measly rate hike from the FOMC, the yield curve is already flattening, and the rate of economic growth is shrinking.

This is in sharp contrast to what occurred in 2004. Back then the bond market didn’t immediately succumb to the Fed’s initial raise in rates. The long end of the curve, as well as inflation, pushed onward despite the Fed’s attempts to slow them both down.

However, the yield curve did eventually invert by 2006 when the Fed Funds rate climbed to 5.25%. An inverted yield curve forebodes a recession because the money supply contracts once banks find it unprofitable to make new loans, and this causes asset bubbles to pop.

If this trend of a rising Fed Funds Rate and falling long-term rates continues, the yield curve will invert with just a few more interest rate hikes and over the course of the next few quarters. And this brings us to the most salient point of this commentary: the major problem is the Fed will most likely have around 400 basis points less ammo (room to lower interest rates) during this next economic contraction than it had to pull the economy out of the Great Recession of 2008.

From September 2007 to December 2008, the Fed reduced rates by 525 basis points to 0%. However, during this next recession, the Fed will only be able to take back the handful of 25 basis point increases it managed to push through before the gravitational forces of deflation plunged the economy into its next collapse.

Indeed, the Fed very well may be filled with such hubris to believe its ZIRP and QE’s have healed the economy to the point that it can normalize interest rates with impunity. But that is not the message that the bond market or the economy is telling.

In fact, the FOMC itself will tell you that its desire to raise rates is not to quell an economy on the verge of bubbling over, but it is instead to stockpile interest rate ammunition to fight the next recession. Conversely, it will be these next few hikes that will expedite the economy’s cliff dive that will lead us to a recession worse than 2008.

The sad truth is that it is virtually impossible, after 90 months of ZIRP and the creation of unprecedented asset bubbles and capital imbalances, for the Fed to raise rates at just the right pace to maintain a 2% inflation target. Our central bank will gradually hike rates until the yield curve inverts once again, and a deflationary depression ensues. Such is the unavoidable consequence of choosing to abrogate markets in favor of financial despotism.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Will the Fed be Blind Sided by Stagflation?
May 30th, 2016

Most Central Bank watchers know that our Federal Reserve has a dual mandate of stable prices in the context of maximum employment. But its use of the words “stable and maximum” is somewhat misleading. For instance, one would assume that “stable” inflation would lead the Fed to pursue no change in prices and “maximum” employment would be a rate targeted at 0 percent unemployment; but this is not the case.

For some antithetical economic reason central bankers have unanimously redefined stable prices as adopting a 2 percent inflation target. The Fed has also morphed the term maximum employment rate to mean a 5-6 percent unemployment rate, clinging to the misguided belief that full employment is the progenitor of inflation, despite no supporting economic or historical evidence.

For instance, the 12.2 percent (YOY) rise in the CPI in November 1974 led to the cyclical high of unemployment in May of 1975, which also coincided with the 1973-75 recession. Likewise, in 1979, the YOY high in CPI of 14.6 percent was followed by another cyclical high in unemployment of 10.8 percent in late 1982.

The Misery Index hit a high of 20.76 during 1980. And one now has to wonder what the true Misery Index (the unemployment rate plus the inflation rate) would be if both inflation and unemployment were calculated properly.

What the Fed doesn’t understand is that full employment can exist in perfect harmony with stable prices. That’s because having more people producing goods and services can never by itself lead to an environment of rising aggregate prices. And, most important, an increasing rate of inflation increases the rate of unemployment.

This condition plagued the United States during the majority of the 1970’s and early 1980’s and was “affectionately” referred to as stagflation: rising inflation that is coupled with a high unemployment rate and low to negative economic growth.

But Janet Yellen isn’t going to have to dust off her eight track of KC and the Sunshine Band to evoke the 1970’s; she is creating 70’s style stagflation with her monetary policies.

For the past few weeks the Fed has been circling the wagons trying to convince markets it can raise the Fed funds rate slow enough to boost GDP growth higher than the 0.5 percent rate in the first quarter; while also raising it quickly enough to prevent inflation from getting out of control.

But, as evidenced in the following two charts below, you can plainly see that since July of 2015 economic growth has been languishing, while CPI has been rising during a relatively similar time span.

In fact, the most recent month over month increase in the CPI of 0.4 percent was the highest since February 2013.

Meanwhile, the unemployment rate, which conveniently excludes discouraged workers, appears benign at just 5 percent. But we are starting to see chinks in the armor of employment.

Most recently, the 4-week moving average for unemployment claims was 275,750, an increase of 7,500 from the previous week's unrevised average of 268,250. And according to the BLS, the economy added just 160,000 new jobs in April. Wall Street had expected a 203,000 gain. This left many to wonder if hiring has begun to taper off along with a broader economic slowdown.

According to Market Watch, the pace of hiring was the lowest since September 2015 and job creation has slowed to an average of 200,000 net new jobs created for the past three months. This slowdown in the pace of hiring is coming off a five-year high of 282,000 a month in the fourth quarter of last year.

As stated before the Fed is seeking robust growth in the context of low inflation. But what is becoming manifest is the exact opposite. The Fed is missing its targets on both fronts--inflation is rising while at the same time growth is slowing.

What will Janet Yellen do if faced with a recession that comes along with inflation? Both the Fed and Wall Street are totally unprepared for this risk.

The government’s effort to engender viable growth through debt and inflation is virtually guaranteed to fail. It has tried to repair an asset bubble and debt saturated economy by increasing both conditions. But, the real medicine the economy needs is to allow the free market to set interest rates much higher, which would deleverage the economy and allow the normalization of asset prices to income ratios.

This is why a collapse worse than 2008 is inevitable.

After 90 months of ZIRP and the creation of unprecedented asset bubbles—especially in the fixed income area—a neutral level on the Fed Funds Rate does not exist. Bubbles never pop with impunity no matter how much the FOMC would like investors to believe that this time is different.

The Fed will either be slowly raising interest rates into an economic meltdown or will remain behind the inflation curve until inflation runs intractable. Therefore, the most salient question for investors to answer is: Will the economy suffer through a 70’s-style stagflation before the markets and economy fall into a steep and unprecedented contraction, or will it simply implode into the inevitable deflationary collapse straight away. My guess is that it will be the latter and next week’s commentary will explain why.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Real Estate Bubble Part II
May 23rd, 2016

It shouldn’t be hard to understand that nearly 90 months of ZIRP has regenerated the equity and real estate bubbles that first pushed the global economy off a cliff back in 2007. In fact, the Fed’s unprecedented foray with interest rate manipulation has caused these assets to become far more detached from underlying fundamentals than they were prior to the start of the Great Recession.

The prima facie evidence for the stock market bubble can be found in the near record valuation of the S&P 500 in relation to GDP and in its median PE multiple. But perhaps the best metric to illustrate this overvaluation of equities is the current 1.8 Price to Sales ratio of the S&P. This is the highest ratio exhibited outside of the Tech Bubble and is especially absurd given 5 quarters in a row of falling revenue.

Accretive to the prior two bubbles is the creation of the most dangerous distortion of fixed income values in economic history. Evidence for the global bond bubble is clearly manifest in the simple fact that $9 trillion worth of sovereign bonds now offer investors a negative yield. When 30% of the developed world’s insolvent debt trades with a minus sign you know that fixed income has entered the twilight zone and that bond vigilantes have fallen into a deep coma. In fact, according to the Bank of America Global Broad Bond Market Index, yields have now fallen to a record low 1.25%. Not only are global bond yields at record lows but the duration on these fixed income holdings has reached a record high. This isn’t a problem for creditors; but the holders of long-duration debt get hurt the most when interest rates rise.

The reemergence of equity and bond bubbles are being debated in the financial media. But what is less known to investors is the massive amount of forced hot air that has been blown into the commercial real estate market. For example, commercial real estate prices have increased by double digits for the past six years, according to The National Council of Real Estate Investment Fiduciaries. Also, according to the Real Estate research firm Green Street Advisors, commercial property prices now exceed the 2007 prior peak by 24% overall. And in cities such as Manhattan, preferred office buildings and apartment complexes are 60% higher than what existed during the previous housing bubble. Of course, such lofty values have driven National Retail cap rates down to the subbasement of history, at just 6.5%. But this Fed induced famine has caused yield-starved investors to embrace low income streams in the hopes if they ignore this current bubble it won’t pop in the same manner as it did eight years ago.

In fact, this new real estate bubble has grown so large that it has even caught the myopic and inflation-blind view of the Fed. San Francisco President John Williams and Boston President Eric Rosengren have both recently warned about the rapid rise in commercial real estate prices saying that these inflated values pose a risk to financial stability.

It should be self-evident that eight years’ worth of unprecedented money printing and interest rate manipulations have caused the greatest distortion of asset prices in history. Therefore, the inevitable conclusion is for an unprecedented economic contraction to occur once the party inevitably comes to a close. The primary questions for investors are to know how to best ride this bubble, when to get out and how to profit from its collapse.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Why Puerto Rico Defaulted and Greece Did Not
May 16th, 2016

The Caribbean island of Puerto Rico is in the throes of a debt crisis that recently reached a breaking point when it missed a $422 million bond payment due May 2nd. When asked in a subsequent interview about the likelihood of making future payments on the remaining $72 billion of debt, Puerto Rican Governor Alejandro Garcia Padilla noted that the U.S. territory “does not anticipate having the money.”

Even a cursory review of Puerto Rico’s finances confirms Padilla’s claim of insolvency. The government is expecting deficits to grow from $14-$16 billion over the next five years, and for revenue to fall by $1.7 billion over that same five-year period. To makes matters worse the U.S. territory's unemployment rate is a lofty 12.2 percent.

The problem is simple: Puerto Rico’s debt burden is equal to over 100% of its GDP when including the $43 billion worth of unfunded pension liabilities. This situation is exacerbated by falling population growth and perpetually shrinking GDP.

This is an unsustainable burden for the Caribbean island that is home to 3.5 million residents. To put this in perspective, if Puerto Rico were a state it would be similar in size to Iowa, which carries a comparatively meager $15 billion in public debt and a debt to GDP ratio of just 11%. In fact, even big spending states such as New York only carry a debt to GDP burden that is just 25%.

Puerto Rican debt has been the darling of Hedge Funds and financial advisors for years because of the desperate search for yield that has been exacerbated by the Fed’s ZIRP and by the government’s triple tax-free status of its bonds.

Sadly, this debt story has been told before. Politicians, lured by power, convince citizens that economic prosperity comes from debt-fueled government spending. But when the promised growth never materializes tax payers are saddled with debt payments that far transcend the tax base.

The Island’s coveted tax-exempt status, coupled with no requirements for a balanced budget, allowed Puerto Rico to ignore the fetters of typical state spending and encouraged them to follow the fiscal policy of Greece.

When Greece adopted the Euro back in 2001 the prestige of a stronger currency enticed them into taking on debt beyond what their tax base could support.

In 2010 Greece began to experience its own crisis of confidence in the government’s ability to pay back its enormous debt load that had climbed to nearly 150% of GDP. This caused bond yields to become intractable; by 2012 the yield on the Ten-year Note ballooned to over 40%.

Then, assurances made by the ECB President, Mario Draghi, to do whatever it takes to bring down borrowing costs eventually brought rates back down to earth. And they have remained relatively quiescent ever since; despite Greece’s debt to GDP ratio hovering around 180% for the following three years after the bond market collapsed.

The fact is compared to Greece Puerto Rico is in better financial condition; it has a much lower debt to GDP ratio and has similar demographics and growth. So why does the Greek Ten Year Note yield just 7.5%? In comparison, $422 million of securities sold by Puerto Rico’s Government Development Bank recently displayed a yield of 1,600%. So what is the reason for the trenchant difference in borrowing costs? The answer is simple: Puerto Rico cannot print their own currency and it does not have a central bank willing to monetize the debt.

This yield differential supports the theory that the current $8 trillion worth of negative yielding global sovereign bonds would be displaying yields significantly higher. In fact, if global investors were not convinced that central banks would always supply a bid for sovereign debt the bond yields of Japan, Europe and the U.S would be closer to those of Puerto Rico, or at least Greece circa 2012. This is because not only do these nations have a debt to GDP ratio that is higher than Puerto Rico, but also because they share similar faltering growth patterns.

The simple fact is a nation does not ever have to repay its debt; but must always convince bond holders that it has the ability to do so. And without a viable tax base all these nations have to lean on is the printing press. The sad truth is without continuous central bank intervention the yield curve for the entire sovereign debt complex would spin inexorably out of control. This is the real reason why central bankers are panicked about deflation and have inextricably inserted themselves into financial markets.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Japan: An economy of Zeros
May 9th, 2016

The red sun on the flag of Japan symbolizes its position as the land of the rising sun. However, during WWII that round shape was pejoratively referred to as a zero. And now, since Japans economy is emitting so many zeros it can, unfortunately, once again be referred to as the land of zeros.

Prime Minister Shinzo Abe’s economic plan known as Abenomics consists of three arrows. The 1st Arrow is aggressive money printing known as QQE in order to bring about yen depreciation. The 2nd arrow is massive deficit spending. And the 3rd arrow is structural reform, which is political claptrap for feckless growth proposals like increasing workforce diversity.

Therefore, the core strategy of Abenomics is to derive growth by increased government spending and flooding the world with the yen. If Abenomics were only about yen depreciation it would be considered a huge success. The yen lost 35% of its value between 2012-2015. Likewise, if the goal were to run huge deficits Abenomics has also achieved its goal. Since December of 2012 fiscal deficits have ranged between 6-8% of GDP.

What did the Japanese citizens get for losing 35% of their purchasing power? A ten year note that has hovered around 0% for most of this year. Inflation that has been stuck around zero percent and growth that has been virtually zero for years. But most importantly, in an example of how addicted asset prices have become to Japan’s perpetually increasing stimulus, The fact that BOJ president Kuroda didn’t expand on his 80 trillion yen annual bond buying spree caused the Nicki Dow to drop over 1100 points in the 2 trading days following his announcement.

Japan isn’t the only nation with a zero economy.

The Fed printed 3.7 trillion dollars since 2008 and has artificially pushed short-term rates near zero percent for almost 90 months. Yet, all we have to show for this massive intervention in markets is 0.5% annualized GDP growth in Q1. And Q2 doesn’t look any better. The usual Wall Street predictions of a Q2 rebound don’t look all that promising as the Philly Fed (-1.6), ISM Manufacturing (50.8), Productivity (down 4 of the last 6 quarters) and ADP employment data (156k) all disappointed the Street and pointed to an economy that is merely bouncing around that anemic 0% level. The weak US economy has caused the Dollar Index to fall below 94; a place where it has found support 6 times in the past year.

The weak data in Japan, China, Europe, the United States and the rest of the world should be clear evidence that interest rate manipulation and money printing cannot produce viable growth. Therefore, the big surprise for dollar bulls still lies ahead. While short-term rates are near 0% across the globe, the U.S. is the only nation in the developed world that has been able to produce core inflation of 2.2%. Therefore, real interest rates in the United States are the most negative among all our major trading partners and the level of real interest rates is the primary driver of currency values.

That key 94 support level on the DXY was recently breached and there is no real support until it retreats back to 80 from where it first bounced in July 2014. The main point is while there are no central bankers in the world that are anxious to raise nominal interest rates, the US is the only nation that has been able to achieve CPI above the new 2% goal universally adopted by Keynesian central bankers.

We have a condition of stagflation here in the US. This is occurring in the context of a record $45.2 trillion total non-financial debt, which is growing at an incredible 3.44 times GDP. This is the truth as to why the Fed cannot normalize rates. If it did bring the Fed Funds rate back towards the pre-Great Recession level of around 5%, asset bubbles would collapse along with the tax base of the economy. This would make that already unsustainable ratio of debt to GDP growth explode even higher. You and your portfolio should be on high alert, the market chaos has just begun.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Save the Environment and Your Retirement: Sell Tesla
May 4th, 2016

The stock price of Tesla Motors (TSLA) has soared along with the recent announcement that pre-orders (i.e. a fully-refundable $1k deposit) for its Model 3 are approaching 400,000 units. The Model 3 is purported to sell eventually for an estimated $35,000; and is Silicon Valley’s inexpensive electric vehicle (EV) offering that appears to be affordable for everyone; except Tesla that is.

After all, Tesla loses more than $4,000 on each of its high-end Model S electric sedans; and that model’s cost is between $70 and $108k. With margins like that one has to assume a $35k Model 3 can’t be the answer to solving Tesla’s red ink.

Tesla’s income statement reveals the company is hemorrhaging cash at a robust clip. Furthermore, according to “The Street Ratings”, their net profit margin of -26.38% is significantly below that of the industry average. The company has a quick ratio of 0.49, which means they have .49 cents in available cash to pay every $1 of current liabilities.

Worse than its lousy earnings and cash flow, Tesla is grossly overvalued compared to its peers. Tesla’s market cap is $33 billion, compared to Fiat Chrysler (FCAU) at just $10 billion and Ferrari at $8 billion. Being valued at 3x more than FCAU--an established and profitable company--looks especially absurd when considering FCAU produces annual sales of over $120 billion while TSLA produces revenue of only $4 billion.

Furthermore, Tesla’s market cap is 66% of General Motors market cap. This is despite the fact that General Motors has a history of selling ten million cars at a profit each year and Tesla sold less than one hundred thousand cars last year at a loss. They would have to sell 6.6 million cars this year to justify its current valuation. With less than 400,000 cars on pre-order that doesn’t appear likely anytime soon. And those orders for the Model 3 are fading fast. During the first week of reservations Mr. Musk indicated there were 325k pre-orders. In week two the company claimed it received pre-orders that were “approaching” 400k. And in week number three, Tesla reported the total number of orders were “almost” 400k. At that rate it will be hard to imagine it could reach that 6.6 million vehicles sold benchmark.

But perhaps Tesla isn’t about current profitability or cash flow; Tesla is all about the man and the company’s future… after all, Elan Musk landed a rocket on a barge.

But those who actually know the auto industry are not so sure. In a February interview with CNBC’s Squawk Box, Former GM executive Bob Lutz notes that “[TSLA] costs have always been higher than their revenue…They always have to get more capital. Then they burn through it.”

First, he notes that on the back of falling oil prices demand for electric vehicles (EVs) is slowing. Second, there is growing competition that will cut into Tesla’s margins as prices for EVs fall. Tesla has a lot of competition over the next few years. The industry is already awaiting the Apple car with baited breath that is set to launch in four years. And GM's Chevy Bolt is similarly priced with a similar range and is set to come out this year. And then we have the Nissan Leaf expected to more competitive in the coming months and years. And add to that first generation vehicles like the BMW i3.

And in China, they have the EV Company LeEco, which recently unveiled its very first electric car that includes self-driving and self-parking capability using voice commands via a mobile app. Besides LeEco, there is another Chinese EV automaker that sold more electric cars last year than Tesla, Nissan or GM, it’s called BYD Co. and is now targeting the U.S. market.

Lutz believes that competition from industry heavyweights like these could “kill” Tesla in the future. “The major OEMs like GM, Ford, Toyota, Volkswagen, etc…they have to build electric cars, a certain number, in order to satisfy the requirements in about half of the states. Those have to be jammed into the marketplace, otherwise they can no longer sell SUVs and full-size pickups and the stuff that they really make money on. So that is going to generically depress the prices of electric vehicles,” Lutz warns.

Lutz also explains that companies such as General Motors will not be making any money on their “Tesla killer”. They are making these vehicles to appease Washington. Luz notes, “The majors are going to accept the losses on the electric vehicles as a necessary cost of doing business in order to sell the big gasoline stuff that people really want. Well, Tesla does not have that option.”

But Musk has a strategy for driving down the cost of his electric car that hinges on achieving economies of scale, bringing down the production cost of the battery pack by 30%. This hinges on the success of their future Nevada home called the “Gigafactory”.

The Gigafactory is a one-stop shopping in battery pack production. The company currently buys battery packs through a deal with Panasonic and has partnered with Panasonic in this venture. Production volume at the Gigafactory is anticipated be the equivalent of 30 gigawatt-hours per year; this would mean the Gigafactory would produce more storage than all the lithium battery factories in the world combined. The $5 billion dollar plant is as big as the Pentagon Tesla, and Tesla is hoping to produce 500,000 lithium ion batteries annually.

Musk recently laid out his Energy-branded battery ambition in rock star glory. At the event spectacle, Musk declared that his batteries would someday render the world's energy grid obsolete. "We are talking about trying to change the fundamental energy infrastructure of the world," he said.

Musk envisions his affordable, clean energy will one day power the remote villages of underdeveloped countries as well as allowing the average homeowner in industrial nations to go off the grid.

But before you sever your ties with your electrical company, it’s worth noting that not everyone thinks Musk’s plans are achievable – at least not in the time frame he envisions.

Panasonic, the supplier of the lithium-ion cells that form the foundation of Tesla’s batteries, and partner on the company’s forthcoming battery factory – calls Musk’s claims a lot of hyperbole.

Phil Hermann, chief energy engineer at Panasonic Eco Solutions, notes: “We are at the very beginning in energy storage in general.” “Most of the projects currently going on are either demo projects or learning experiences for the utilities. There is very little direct commercial stuff going on.” “Elon Musk is out there saying you can do things now that the rest of us are hearing and going, ‘really?’ We wish we could, but it’s not really possible yet.”

And far from the grand stage with little fanfare buried in their November 10Q Tesla also sought to tamper investor’s expectations: “Given the size and complexity of this undertaking, the cost of building and operating the Gigafactory could exceed our current expectations, we may have difficulty signing up additional partners, and the Gigafactory may take longer to bring online than we anticipate.”

With a company saddled with debt and cash-strapped, who is going to shoulder the burden of a delay in the Gigafactory realizing its full potential? That would be shareholders through stock dilution or the American tax payer – but most likely a combination of both. There are those who believe that Musk’s real genius is in following government subsidies.

According to the Los Angeles Times, all of Musk’s ventures: Tesla Motors Inc., SolarCity Corp. and Space Exploration Technologies Corp., known as SpaceX, together have benefited from an estimated $4.9 billion in government support. The figure underscores a common theme running through his emerging empire: a public-private financing model underpinning long-shot start-ups.

Tesla’s model relies strongly on a “green” administration. In a recent filing they note:“ We currently benefit from certain government and economic incentives supporting the development and adoption of electric vehicles. In the United States and abroad, such incentives include, among other things, tax credits or rebates that encourage the purchase of electric vehicles. Nevertheless, even the limited benefits from such programs could be reduced, eliminated or exhausted…” In certain circumstances, there is pressure from the oil and gas lobby or related special interests to bring about such developments, which could have some negative impact on demand for our vehicles.”

The promise is that the Tesla stockholders and the tax subsidizing public will greatly benefit from major pollution reductions as electric cars break through as viable alternative and gain access to mass-market production.

But are electric cars really good for the environment?

First, it’s important to note that at this time, these cars don’t power themselves – they are plugged into an outlet in your garage that connects to an electric power plant, and there is a good chance that you may be one of the 33% of Americans whose power plant is burning the dirtiest fossil fuel of all…coal. So in effect, you may as well be filling up your gas tank with coal, and coal-burning power plants emit not only CO2 but also other venomous gases such as nitrogen oxides and sulfur dioxide in greater quantities than traditional gas-powered cars.

Furthermore, there are a lot of environmental questions about the lithium battery itself. In a 2012 study titled “Science for Environment Policy” published by the European Union, a comparison was made of the lithium ion batteries to other types of batteries available such as; lead-acid, nickel-cadmium, nickel-metal-hydride and sodium Sulphur. They concluded that the lithium ion batteries have the largest impact on metal depletion, making recycling more complicated. Lithium ion batteries are also the most energy consuming technologies requiring an equivalent of 1.6kg of oil per kg of battery produced. Furthermore, they ranked the worst in greenhouse gas emissions with up to 12.5kg of CO2 equivalent emitted per kg of battery.

Next, you need to understand how lithium is mined. Lithium, in its purest form, must be mined through hard rock or salar brines. According to Friends of the Earth, an environmental group, salar brines, the most economical way of obtaining lithium, destroys the environment. They state: “The extraction of lithium has significant environmental and social impacts, especially due to water pollution and depletion. In addition, toxic chemicals are needed to process lithium. The release of such chemicals through leaching, spills or air emissions can harm communities, ecosystems and food production. Moreover, lithium extraction inevitably harms the soil and also causes air contamination.”

Simply stated, batteries such as Panasonic's automotive grade li-ion batteries that are developed jointly by Panasonic and Tesla and are in the Model S have a substantially negative effect on health and the environment.

The plain truth is owning a Tesla is not as green as Elon Musk would like you to believe. And for environmentalists to put all of their faith on Evs to cut down on greenhouse gases could end up diverting attention from greener alternatives to power autos. And although Musk is a genius and a visionary; it is also true that Tesla has an unproven business model and a stock that is massively overpriced. According to industry experts, Musk will find it improbable ever to turn a profit with its mass-produced Model 3. Even if some year in the distant future there exists the charging infrastructure and pricing available to make Electric Vehicles conducive to supplant the internal combustion engine, Tesla faces an onslaught of competition that will most likely drive its profit margins further into the red for years to come. Avoiding TSLA stock at the current mindless valuation could not only benefit the environment…but also end up saving your retirement as well.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Stocks or Dollar About to Enter a Bear Market
April 19th, 2016

The first month and a half of 2016 were brutal for the U.S. equity market, as the major averages plunged over 10%. The culmination of the decline came on Feb 11th when the Dow Jones Industrial Average dropped 1.6%, and the S&P 500 decreased 1.2%. Since then, the market has managed to hobble back to its 2015 closing level, leaving major averages relatively flat for the year.

But to understand where the market is heading from here we need to recognize what caused the selloff in early 2016 and what led to the recent rebound.

December 2015 ushered in the first rate hike by the Federal Reserve in nearly a decade. The Fed’s liftoff from ZIRP was highly anticipated by a massive rally in the U.S. dollar that began in July of 2014.

On January 25, 2016, the dollar index (DXY), which measures the greenback against a basket of six major currencies, hit a short term high of 99.52. Since then, it dropped to a low of 93.62, which was a drop of 6%. The decrease in the dollar was the primary contributor for the rebound in the major averages. Investors sold dollars because Fed Chair Janet Yellen backed away from her previously threatened four rate hikes during 2016.

The fall in the dollar provided crucial support to global markets by boosting distressed commodity related debt held by financial institutions, improved the projected earnings of U.S. multinational corporations and also bolstering banks’ holdings of dollar-denominated foreign debt. In other words, the FOMC temporarily bailed out the global banking system on the back of the greenback.

But now the DXY is once again bouncing around that crucial 94 support level from where it has bottomed five times in the past year. And to keep the global equity bubble inflated, the FOMC must determine if it wants to engender a dollar bear market or allow equities to crash.

Wall Street puts its hope on a sinking dollar

The sad truth is there isn’t any solid fundamental factor to drive stocks higher. Therefore, investors have misplaced their hopes on betting the inflation produced from a falling dollar will be able to bail out the entire market.

A coordinated central bank attempt to depreciation the dollar is the Last desperate hope to keep the bubble inflated because the overvalued stock market isn’t being supported by earnings or GDP growth.

The U.S. is not the only country suffering from secular stagnation. The slowdown in global growth has been fully acknowledged by the International Monetary Fund (IMF). Firstly, the IMF just took down its outlook for U.S. growth to 2.4 %, from 2.6 %. And despite aggressive monetary policies implemented by the Bank of Japan, it has halved their forecast for Japanese growth this year to just 0.5 %. In 2017, when a consumption tax hike takes effect, the IMF expects the Japanese economy to shrink actually shrink once again—as it has the habit of doing—this time by 0.1 %.

The nineteen countries that share the euro currency are projected to collectively expand 1.5% this year, down from the 1.7 % projection. And Latin America, still suffering from China's slowdown, is expected to shrink 0.5 % this year, down from a January forecast of plus 0.3%. This contraction is led by Brazil whose economy is projected to shrink 3.8 % this year.

All this bad news has led the IMF to cut its global growth forecast for the fourth time in the past year, this time from 3.4%, to 3.2%. Last year the global economy grew 3.1 %, its slowest pace since the recessionary year of 2009.

U.S. Q1 GDP, according to the Atlanta Fed Model, is set to grow by a meager 0.3%. The Atlanta Fed’s model doesn’t include an estimate for nominal growth, but using last quarter’s GDP deflator we can glean that Q1 nominal growth (inflation + real growth) will be about 1.2%. Nominal GDP growth of just 1.2% is beyond pitiful. And since S&P 500 earnings tend to grow with nominal GDP, we can make the same sorry assessment about the health of U.S. corporations.

Hence, according to Zack’s Financial Research, total earnings for Q1 are expected to be down 11.1% on negative 2.3% revenues. Earnings growth is expected to be negative for 11 of the 16 sectors that Zack’s covers. The negative earnings growth in Q1 will be the fourth quarter in a row of earnings declines for the S&P 500 index.

The weak dollar may provide some temporary relief to the stock market. However, the major averages are still extremely overvalued and overleveraged:

Margin debt as a percent of the economy is higher today than both 2000 and 2007.

The median price-to-earnings ratio that sits at 22.6, is at a higher level than the market peak in 2007. And at 22.6, the S&P 500 index is currently 25.3% above its median fair value.

The Prices-to-Sales Ratio is now not only higher than in 2007; but also at any other time in history with the exception of the top of the internet bubble in 2000. And finally, the total market cap of corporations in relation to the economy is also higher than any other time in history outside of the NASDAQ craze.

All things being equal the combination of falling corporate earnings and revenue, along with peak market valuations and leverage should cause the equity market to collapse. This is why the Fed has decided to hold in abeyance future rate hikes, in hopes the falling dollar will continue to bail out the global financial system.

But a falling dollar isn’t a long-term or viable strategy to generate economic prosperity. All you have to do is look at Japan to realize that growth doesn’t come from a crumbling currency. The yen has dropped 35% in the past few years and Japan’s economy and has been mired in a perpetual recession. At best, the USD breaking 94 on the DXY will provide only temporary relief for the major averages. But inflation and currency destruction is the bane of viable growth and will lead to yet a further dislocation between asset prices and underlying economic growth…and that means the eventual day of reckoning will be much more pernicious.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Time to Invest for Stagflation
April 8th, 2016

Whether you call it a 1970’s style stagflation or, as we call it, a recessflation, investors need to prepare their portfolios to profit from a protracted period of rising prices in the context of zero growth. Here are some facts: Growth in the U.S. has averaged just 2% since 2010. However, Q4 2015 GDP growth grew at a 1.4% annualized rate and the Atlanta Fed model has Q1 GDP growth slowing to just 0.4%. The simple truth is that the rate of growth is slowing towards 0%, just as asset prices continue to rise to record levels due to vast intervention from central banks.

The U.S. is now in the process of moving away from an environment of disinflation and slow growth, to one of inflation and recession. Indeed, the entire global economy is careening towards an epic recessflation crisis.

Central bankers have bombarded the world with unprecedented levels of QE, ZIRP and NIRP for the past 7 years, which has produced a significant amount of inflation in equities, real estate and bond prices--especially in relation to income and GDP growth. Now, all this money printing has finally started to spill over into core consumer prices. In the U.S., CPI has risen 2.3% year-on-year, which is the largest increase since May 2012, and well above the Fed’s 2% inflation target. The home price to income ratio has soared back to 4.4:1 and the ratio of total market cap to GDP at 117 is in extreme overvalued territory. This bubble in stock prices is evident despite the fact that the S&P 500 is in a revenue and profits recession.

But a recessflation isn’t just an issue here at home. China exports fell 11.2% in January, while imports dropped 18.8% from the year prior. Yet, that sign of economic stagnation hasn’t stopped home prices in Shanghai from soaring over 50% from January 2015!

What is the game plan of global governments to combat falling GDP growth and rising asset inflation? More stimulus of course. Japan’s Prime Minister, Shinzo Abe, has proposed to increase government spending by 5-10 trillion yen in this year’s fiscal budget to encourage more consumption. But Japan has already run budget deficits worth 8% of GDP for the past several years, which has piled onto the nation’s government debt that is now nearly 250% of GDP. Nevertheless, despite over three years’ worth of Abenomics (money printing and deficit spending), business sentiment in Japan hit a three-year low this March.

Over in Euroland, where ECB head Mario Draghi has been busy pushing sovereign debt into negative territory, he has now resorted to buying non-bank corporate debt. Indeed, 15 billion euro’s worth of business debt now trades with a negative yield. Even debt in the primary market is being sold with yields less than zero percent. Mario Draghi has so distorted the capital markets that corporations are now being paid when they issue debt.

There are now $7 trillion worth of sovereign debt (30% of the developed world’s total) with a negative yield.

Not to be outdone by her foreign counterparts, Janet Yellen (the Queen of the dole of doves that perch at the FOMC) promised recently in a speech before the Economic Club of New York to move slower than a frozen dead snail when raising the Fed Funds Rate. This was a clear attempt to prevent the dollar from rising any further against our major trading partners.

The truth is governments and central banks “solved” the Great Recession by creating the greatest global bubble in real estate, stocks and fixed income in economic history. Now the fuse has been lit for complete market chaos and the achievement of central banks’ inflation goals will lead to its destruction.

Central banks are incapable of producing viable GDP growth. The only condition these money printers have ever been able to achieve throughout history is inflation. But inflation isn’t the product of economic growth, nor does it come from a low unemployment rate--unlike what modern day Keynesians contend to be fact. It doesn’t even come from the piling up of excess bank reserves. Rather, it comes from a deliberate government-led attack on the value of paper currency. It is accomplished through direct central bank monetization of humongous deficits. And, unfortunately for the world’s middle classes, this is exactly where we are headed.

But what central bankers seem unable to understand is that economic growth comes from productivity; not a weakening currency. Inflation kills growth by destroying the purchasing power of consumers and savers, just as it also encourages huge capital imbalances and a massive accumulation of non-productive debt.

There’s a tremendous shock coming to markets when it becomes clear that inflation and growth are not joined at the hip. And that governments were competent in their ability to create inflation, but completely whiffed on producing growth. In fact, history has proven that inflation coupled with recessions are the more likely pairing of economic conditions.

Until central banks learn that they aren't a viable alternative to free markets, we will suffer through steep recessions that are also marked with periods of both deflation and inflation. Investors must now be prepared to weather such volatile conditions. A dynamic strategy that incorporates the ability to own precious metals and also short the broader market is an essential hedge towards the goal of preserving the purchasing power of your wealth.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Goldman is Dead Wrong on Gold
March 24th, 2016

Goldman Sachs has been predicting the demise of gold for the past few years. Back in July of 2015, Jeff Currie (Global Head of Commodities Research at the investment firm) went on record predicting the price of the yellow metal would fall below $1,000 per ounce by the start of 2016. However, that prediction failed to materialize; despite the fact that gold was already below $1,100 at the time he made the call.

Nevertheless, being wrong on the direction of gold last year did not prevent him from once again urging investors to short the commodity in February of this year; claiming it would fall to $1,000 per ounce within 12 months. His rationale for anticipating the price decline is that gold is primarily a “safe haven” asset in times of economic and market turmoil and that the U.S. faced very little recession risk—so there is no reason for investors to seek the shelter of gold.

However, Goldman Sachs, which is a bastion of Keynesian apologists--like most on Wall Street, fails to grasp what really drives the price of gold…and what has caused it to surge 18% so far in 2016.

Gold is not merely a “safe haven” asset; it is rather the best form of money know to humankind because of its scarcity and indestructibility. Financial houses hate gold because it tends to do best when the securities they sell head south. And governments hate gold because it best reveals the persistent destruction of the purchasing power of the middle class through central bank debt monetization.

The major rationale Wall Street has used for years to eschew the metal is that it pays no interest. After all, why own an asset that pays you nothing if you can safely earn money on bank deposits and short-term sovereign debt? But now this is no longer true. With negative interest rates on sovereign debt and near-zero percent customer deposit rates now the norm, there are no lost opportunity costs for owning gold.

More importantly, with $7 trillion (30%) worth of the developed world’s sovereign debt trading with a negative yield, you don’t even need there to be any inflation to cause real yields to become negative. Inflation has traditionally been great for gold because it is a necessary ingredient to push positive nominal rates down into negative territory. And, of course, when your real return on cash is negative, investors flock to a commodity that has a long history of retaining its purchasing power. What Goldman fails to recognize is that since central banks have already pushed rates into the basement, inflation need not be present to make real interest rates negative.

Therefore, the argument against gold has completely flip-flopped. Now investors realize the perceived “safety” of holding sovereign debt is no longer there since you are guaranteed to lose money on your principal when holding it to maturity?

What’s worse is that central bankers are moving further into unchartered territory in pursuit of their inflation targets. ECB head, Mario Draghi, recently increased his QE level to 80 billion euros per month, from 60 billion, and is now buying corporate debt to achieve a sustainable degree of inflation. In fact, central banks around the world have vowed to do “whatever it takes” to reach a 2% inflation target. Hence, investors will soon have to subtract 2%--at a minimum—from the already negative yields on sovereign debt and zero offering on money market funds to calculate their real return.

Gold is surging in this environment because citizens across the globe are facing a huge loss in the real purchasing power of their savings.

In this new Keynesian dystopia, growth and inflation are deemed as one and the same. Their game plan for success is simple: print money to create inflation. This will boost asset prices and lower borrowing costs, which will, in turn, lead to more debt creation. And more debt outstanding will eventually—according to these Keynesians--boost aggregate demand and cause economic growth.

But the most pernicious part of being an addict is that it takes more and more of the substance to achieve the desired result. Global economies have become a bunch of debt addicts and governments are finding it necessary to constantly lower borrowing costs in order to force more loans onto the debt-disabled public and private sectors.

Mr. Currie and Goldman Sachs fail to understand that negative nominal rates coupled with rising inflation expectations are the rocket fuel for gold--especially since central banks are trapped in this vortex of persistently reducing the value of their currencies vis a vis their trading partners. Even our Federal Reserve found it necessary to renege on its plan to raise rates four times this year after the markets fell apart in January.

But from this folly there is no end. The intervention of central banks in the capital markets has become so extreme that they are now incapable of selling their securities and fighting inflation without sending equities and bond prices crashing. In effect, the inevitable binary outcomes have now become intractable inflation or depression. And this is the real reason why the bull market in precious metals has just begun.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

May the Phillips Curve Rest in Peace
March 21st, 2016

In 1958, economist William Phillips claimed there was a historical inverse relationship between the rate of unemployment and the corresponding rate of inflation. His conclusion was that full employment (whatever that means) was inflationary. He illustrated his claim through a chart referred to as the Phillips Curve.

The 1970’s stagflation outbreak in the U.S, which featured high unemployment coupled with inflation, dispelled Phillip’s broad correlation between those two conditions. This led many Keynesian economists to embrace a new, yet even more fatuous model called NAIRU, or the non-accelerating inflation rate of unemployment. This theory argued that the relationship between unemployment and inflation only presents itself when unemployment falls below its natural rate.

However, NAIRU provided little guidance as to what level of employment propels an economy into the hypothetical inflation vortex. Despite the fact this specious model has never been borne out in actual historical data, it remains peculiarly ingrained in the psyche of all modern-day central bankers.

But the truth is that inflation has nothing to do with how many people are employed. Inflation is solely the market’s reaction to a lack of confidence in the purchasing power of a nation’s currency.

NAIRU and the Phillips Curve are merely Keynesian red herrings used to convince the citizenry that central banks are not the primary culprits behind the growing trenchant wealth gap and the constant erosion in living standards of the middle class. To prove the point that inflation isn’t the product of too many people working we can view the current inflation battle in Brazil.

Since 2014, Brazil’s inflation has jumped from about 6%, to over 10%. If the Phillips Curve were correct, we would expect that unemployment in Brazil had plummeted during this same time-period; and that the inflation Brazils is experiencing is a byproduct of all the new paychecks entering the economy. However, this is not the case; since 2014 the unemployment rate has nearly doubled, going from a little over 4%, to almost 8%

It is evident the newly employed are not the cause of rising inflation in Brazil. Rather, inflation has come—as it always does--through an erosion in the market’s valuation of a fiat currency’s purchasing power. In 2014, it took two Brazilian real to buy one US dollar, today it takes nearly four real to buy one US dollar.

US$/Brazilian Real

The decline in the real is more likely a result of the market’s reaction to Brazil’s economic mess: credit-rating agencies have downgraded Brazil’s debt to junk status. Joaquim Levy, the finance minister, appointed to stabilize the public finances, quit in December of 2015 after less than a year in the job. Brazil’s economy is predicted to shrink by 2.5-3% in 2016. Brazil’s governing coalition has been plagued by scandals including bribery surrounding Petrobras, a state-controlled oil company, and the president is facing impeachment proceedings in Congress. Add overspend on the upcoming Olympic Games to this mess and it’s easy to see why Brazil’s budget deficit has ballooned over the past few years.

There it is once again. The same dynamic has proven itself throughout economic history: growth comes from productivity and a thriving labor force, which is a good thing that does not lead to inflation. And just as high unemployment does not lead to low inflation, low unemployment does not lead to a rise in inflation. To illustrate this we can look at the United States, where the unemployment and inflation rate are moving in tandem.

US Unemployment Rate

Consumer Price Inflation

Economic history is replete with such examples that prove the Phillips curve is a specious theory that should be suffering from rigor mortis. Brazil is just the latest case study. The truth is a dangerous bought with Inflation has never, will never, and can never be the product of prosperity. Inflation is all about debt that becomes intractable, which forces the central bank into perpetual debt monetization and an expanding money supply. Sadly, this is where we are headed in China, Japan, Europe and the U.S.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

President Obama is the One Peddling Fiction
March 14th, 2016

In his final State of the Union Address, President Obama chided, “Anyone claiming that America's economy is in decline is peddling fiction." Following the recently released February Non-farm Payroll Report, which showed a net increase of 242 thousand jobs, he doubled down on that same contention. The seemingly robust number of new jobs created prompted the President to remark, "The numbers and the facts don't lie, and I think it's useful given that there seems to be an alternative reality out there from some of the political folks that America is down in the dumps. It's not. America is pretty darn great right now."

But the truth is, that headline jobs number for February was very misleading, and it is you, Mr. Obama, who is peddling fiction.

First, even though there were 242 thousand net new jobs created, there were fewer hours worked during the month. The Index of Aggregate Hours Worked shrank by 0.4 points to 104.9, from 105.3 in January. This means there were actually less total hours worked in the economy during February than in January.

This could only be the case if the number of full-time jobs diminished at a faster clip than the amount of part-time jobs created. In fact, the Household Employment Survey hints at this conclusion, as the number of part-time jobs created outstripped the number of full-time jobs by 7.5 to 1.

It makes perfect sense that this part-time, Uber-driver economy would also produce an average hourly work week that shrank by 0.2 hours, to 34.4; and that average hourly wages declined for the month by 3 cents.

Then we have the labor-force participation rate, or the share of American non-institutionalized civilians over the age of 16 who are either working or looking for a job. This ratio dropped dramatically in the wake of the 2008 financial crisis, yet has also failed to make a meaningful rebound since.

Adding to this number of despondent would-be workers, is the fact that those who enjoy gainful employment have suffered with a lack of real income growth.

A falling work week, dropping wages and fewer hours worked does not make for a good employment report or a healthy consumer. However, it isn’t just the employment conditions in the U.S. that depict a weak economy.

According to the Census Bureau, a record 46.2 million persons, roughly one in seven Americans (14.2%), currently live below the poverty line. That rate was 12.5% before Obama took office. And we have an astonishing 51 million Americans who live just above this official threshold--making 50% of all Americans living in or near the penury class.

Despite the recovery myth touted by Mr. Obama, the amount of wealth held by the bottom 50% of the U.S. population declined to 1.05% in 2013. This is less than half of what it was in 2007, when the share of the country’s wealth held by the poorest 50% of the population was 2.5%.

According to government statistics, the rate of poverty for every year under the Obama presidency has been higher than it was for each year during the horrific economic stewardship of George W. Bush’s presidency.

In addition, the number of beneficiaries on the Supplemental Nutrition Assistance Program (SNAP), also known as food stamps, has surpassed 46 million, according to the Department of Agriculture (USDA)--that’s 14.6% of the population. Back In 2008 there were 28.2 million people on food stamps, or 9.2% of the population. To put this in perspective, in 1969 participation in the SNAP program stood at $2.8 million, or just 1.4% of the population.

With Americans living less prosperously, it’s not surprising that household debt has increased back to 2007 record levels of $14.1 trillion. Business debt has also ballooned from $10.1 trillion, to $12.6 trillion. And our National Debt boomed from $9.2 trillion, to $19 trillion. And to keep all this debt more palatable, the Fed’s balance sheet has exploded from $880 billion, to $4.5 trillion. All this means the tenuous and anemic state of the U.S. economy is merely held together by the tape and glue provided by the Fed’s artificially-low interest rates.

To be sure, President Obama is clueless about what will happen to the fragile U.S. consumer after interest rates normalize. But once inflation targets are achieved by the Keynesian counterfeiters that run global governments and central banks, interest rates will indeed spike. And then it will become shockingly clear that the economic recovery was just a mirage created by the real fiction peddlers in Washington, Beijing, Brussels and Tokyo.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

The Rebound in Stocks Won't Last
March 7th, 2016

After taking a beating in January the S&P 500 has rebounded by about 5% in February, and this uptrend has continued into March. But before you think it’s safe to jump back into long positions, it’s important to realize why the market went down in the first place, and why February’s rebound won’t last.

In December of 2015, the Federal Reserve ended its Zero Interest Rate Policy (ZIRP). At that time the Fed’s median dot plot showed the Federal Funds Rate was expected to rise to 1.5% by the end of 2016. The market plunged on the expectation that the Fed, now that it actually showed the willingness to move off of zero, would then follow through on subsequent planned rate hikes. The combination of sub-par growth coupled with a hawkish Fed policy led to the worst start of any year in stock market history.

But as the stock market began to crash, more and more Fed voting members started to walk back the notion that the U.S. economy was strong enough to endure a rising rate environment. Adding to this dovish sentiment, the formerly-hawkish James Bullard began voicing concerns about reaching the Fed’s 2% inflation target based on the plunge in oil prices. Talking to a group of bond traders, St. Louis Fed President James Bullard recently said: “The Federal Reserve must act to stop inflation expectations from getting too low.”

But the truth is that oil prices had already plunged from $105 in the middle of 2014, to below $48 per barrel by the end of 2015. So, the commodity plunge wasn’t a new issue.

Therefore, you have to ask yourself: why was the Fed suddenly so concerned about not achieving its inflation target?

The real reason the Fed claims to be so worried about reaching its inflation target and is changing its tune on future rate hikes has little to do with falling oil prices; but rather, everything to do with a falling stock market. This faux concern about inflation supports my contention that the Fed is an institution whose sole creation and existence is to help banks and Wall Street.

The Fed Funds Futures Market began pricing in just one rate hike for all of 2016, instead of the four telegraphed by the FOMC. Taking three rate hikes off the table served to weaken the dollar, which put upward pressure on commodities, relieved pressure on foreign dollar denominated debt and improved the perceived potential earnings power of U.S. multinationals.

But the simple reason this equity rally won’t last is because the markets have become completely addicted to money printing, a weak dollar and perpetually falling interest rates in order to perform their levitation act. Without the Fed adopting negative interest rates and/or launching another QE program, the U.S. dollar will not weaken substantially from its current level. The divergence between monetary policies between that of the U.S., and in particular the ECB and BOJ should, stop the dollar from falling further. Therefore, expect more downward pressure on commodities, stress on U.S. multinationals and a significant percentage of defaults on debt held by corporations in the commodity sector.

Furthermore, China’s crash landing is now upon us. This is despite the Sino Scam Artists that run the communist country trying to kick start the debt-disabled nation by constantly lowering the reserve requirement ratio. But this doesn’t change the fact that the two biggest economies in the world are beginning to tighten monetary policy. The Fed has ended QE and has started raising rates. And China has been forced into selling US treasuries to support the yuan, which drains bank reserves.

This pace of decline in China’s reserves accelerated as the PBOC attempted to keep the yuan’s value from falling too rapidly in the midst of speculative selling offshore and capital flight at home. All of this is made worse by China’s slowest economic growth in 25 years.

The Fed ended Quantitative Easing (QE) in October of 2014 and went off ZIRP in December of 2015. China’s selling of US Treasuries to support the yuan has an effect of shrinking its monetary base, and this is causing asset bubbles to burst worldwide.

This condition will remain in place until the Fed seeks to aggressively weaken the dollar on a more permanent basis. Thankfully, the FOMC is not ready to admit defeat yet and switch to a dovish monetary policy. Therefore, there will another leg down in stocks as the free market attempts to unwind these massive imbalances. Of course, wrecking your currency isn’t a long-term solution. In fact, it will lead to complete economic chaos and meltdown on a global basis once central bank inflation targets are finally achieved.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

China's Newest Export: Empty Buildings
February 29th, 2016

A little over six months ago the owners of the Baha Mar, a $3.5 billion Bahamian resort, filed for bankruptcy. Shoddy construction from the China State Construction Company led to delays resulting from leaking plumbing, porous Chinese concrete and large cracks at critical stress points. The doomed project even led to the death of two Chinese workers. Although the building is 97% complete, the structural deficiencies make it uninhabitable. Given the Chinese proclivity to build ghost towns, it makes you wonder if their construction crews are accustomed to erecting buildings that are never intended to be occupied.

The Bahamian Baha Mar can now join the Hall of Shame of Chinese exports that include cancer causing laminate flooring, noxious drywall and exploding hover boards…just to name a few. As if they don’t have enough vacant edifices of their own, one has to also wonder if the Sino Scam artists in Beijing have now resorted to exporting empty cities.

But perhaps the most troubling export from China has yet to come. It is the financial crisis that will unravel with the unwinding of the country’s $30 trillion credit bubble. At the World Economic Forum in Davos, Harvard professor Ken Rogoff described China’s credit bubble as the “Last big domino to fall as the global debt super cycle unwinds.”

Professor Rogoff believes the stated 1.5 percent rate of non-performing loans held by banks is just as fictitious as China’s inflated GDP data. He considers the real figure to be between 6 and 8 percent.

The growth of China’s bad loans is troubling; they have risen by 256 percent in the past six years, even as the ratio to total lending has dropped. The actual amount of delinquent debt is unknown because banks conceal bad loans by rolling them over. But the problem is that the credit in China is now growing much faster than the economy.

Therefore, it doesn’t appear that China will be growing out of their bad debt anytime soon but will instead be headed for a crash landing. January exports fell by 11.2 percent year over year and imports were down a whopping 18.8 percent. In fact, Chinese imports have now plunged for 15 months in a row.

The slowing economy is making it harder to sustain surging debt levels. According to Bridge Water Capital, it now takes four yuan of extra debt to generate a single yuan of economic growth; that ratio was almost one to one a decade ago.

The China Bulls would gladly tell you that the nation has unlimited room for error thanks to its enormous cash reserves. While these reserves are still impressive, they are shrinking at an alarming rate. A year and a half ago China held as much as $4 trillion in foreign exchange reserves. Those foreign reserves have dropped by $700bn to $3.3 trillion, as capital flight overwhelms the inflows from the country's trade surplus. And more than a third of the shrinkage has been in the last three months, prompting speculation about how much longer Beijing will be able to mitigate the fall in the value of the yuan.

With debt growing at a rapid pace, it is uncertain if China's banks are healthy enough to handle a new wave of defaults. And because of the smaller pool of reserves, their leaders have less room to manage currency depreciation.

None of this is lost on the megalomaniacs who mismanage the Chinese economy. However, in the government’s typical short-sighted fashion, instead of curbing lending and asking banks to write off bad credit, they are reducing the ratio of provisions that banks must set aside for non-performing loans. And has recently cut the Reserve Requirement Ratio for banks for the fifth time in the past 12 months. This latest reduction was by 50 basis points, to 17%.

After all, one way to keep the ratio of nonperforming loans under control is to increase the number of loans outstanding (the denominator in the ratio); and then hope that the new loan creation will steadily outpace the number new non-performing loans. In the short term the scheme is working to force banks to push more debt on the debt-saturated economy. China's new yuan loans jumped to a record 2.51 trillion yuan in January significantly surpassing the 1.9 trillion median estimate of Bloomberg News. Aggregate financing, the most comprehensive measure of new credit, also rose to a record 3.42 trillion yuan.

In fact, the number of troubled loans in China ($645 billion) has already risen to a greater level than the entire sub-prime mortgage market ($600 billion) back in 2006.

Eventually, the despots in Beijing will lose control of their banking system and exchange rate, causing capital to flee at a pace that is beyond the ability of their currency reserves. While significant capital reserves may afford them a few more months at the helm of their currency; it is only a matter of time before their entire economy is exposed to be as hollow as their vacant cities and the communist house of cards collapses.

But this isn’t just a Chinese problem. Global government suppression of interest rates, along with massive new debt issuance just for the sake of hitting centrally-directed growth targets has resulted in unproductive and unsustainable GDP growth--and an unprecedented misallocation of capital. This, along with a humongous debt overhang that cannot be serviced at a free-market interest rate, has virtually guaranteed to produce a global recession of historic proportions…one in which governments have largely become impotent to rectify.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Central Bank Inflation Targets: Be Careful What You Wish For
February 18th, 2016

Did you ever ask yourself what this central bank obsession with inflation is really all about? After all, it is highly ironic that these erstwhile stewards of price stability have now perversely morphed into the frantic pursuit of currency destruction. This is because the current doctrine adopted by global central bankers is that growth comes from inflation; and without inflation there can be no growth. Therefore, as their new dogma dictates, inflation must be achieved at any cost.

One of the new strategies deployed by central bankers to raise prices is to push interest rates into negative territory. But negative interest rates are certainly not about paying consumers to take on new debt. And they aren’t really so much about compelling banks to lend money by charging them to park fallow reserves at the central bank. Rather, the truth is negative interest rates are mostly about keeping insolvent governments afloat by constantly reducing debt service payments. In fact, there is currently about $7 trillion worth of global sovereign debt with yields that are less than zero.

Thanks to record low interest rates in the U.S. (although not yet negative), the Treasury spent just $223 billion (6%) of Federal revenue to service its publicly traded debt during 2015. However, if Treasury yields went back to where they were prior to the Great Recession of 2008, that figure would jump to about $700 billion, or 21% of all Federal revenue.

Since the U.S. is barely growing at record low rates, it would likely be a severe economic shock if debt service costs were to spike in such a manner. And achieving the Fed’s 2% inflation target is exactly the type of thing that would the cause such a surge in borrowing costs. That’s what makes the Fed’s inflation quest all the more insane.

But the consequence of central bank “success” in reaching a 2% inflation target in Japan would be much more destructive than in the United States. Japan officially announced the move to negative interest rates on bank deposits on January 29th. Yields on sovereign debt, which were already negative going out seven years along the curve, subsequently went negative out to 10 years. As a result of these extremely favorable interest rates, the Japanese government currently pays about 15% of its revenue to service the debt. However, if interest rates were to increase back to 2%--the level seen before the Financial Crisis—Japan would be forced to pay a whopping 60% of its revenue for debt payments.

Japan has been mired in an economic morass for decades. The nation recently announced Q4 2015 GDP shrank at a 1.4% annualized rate. Indeed, Japan is flirting with its fifth recession in the last seven years and has suffered negative growth in two of the last three quarters. If debt costs were to surge from 15-60%, the Japanese economy would move from a perpetual recession to a devastating depression in short order.

It is a good bet that central banks will eventually be able to achieve their inflation targets—they have historically always been able to do so. They may resort to circumventing the banking system by directly purchasing newly issued government debt if ZIRP, NIRP and QE don’t satisfied their inflation goals.

And this is why central banks are guaranteed to fail miserably in their effort to produce viable growth through inflation. Once inflation targets are reached they will have to begin winding down purchases of sovereign debt or risk pushing prices out of control. If not, it would lead to utter currency destruction, soaring yields on all fixed income assets and economic chaos. Therefore, they will be forced to switch from deflation fighters to inflation fighters.

But this change in monetary policy will come after these central bankers have so massively distorted the bond and equity markets in relation to the economy that it could cause both equity and bond prices to crash simultaneously. This is because investors will rush to front-run the offer to sell sovereign debt and equities from central banks. It is no coincidence that the S&P 500 began its topping process once QE ended in October 2014 and that the average stock had fallen 25% in January of this year after the Fed began to raise interest rates.

The real purpose of all the extraordinary and unprecedented measures taken by central banks over the past few years isn’t about achieving an arbitrary inflation target. I don’t believe the Fed, the European Central Bank or the Bank of Japan really believes 2% inflation is better for productivity and labor force growth than having no inflation at all. The reality is these central banks need an excuse to continue manipulating bond yields inexorably lower in order to accommodate soaring debt levels.

But in this endeavor there is no easy escape. The equity and bond markets have become absolute wards of central bankers and central banks cannot stop buying government debt without causing markets and economies to crash. Of course, they will eventually have to stop in order to avoid runaway inflation. That is the huge dilemma facing global central banks. And unfortunately, this means the real economic and market volatility is yet to come.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Inflation Doesn’t Come From Seasonally Adjusted Employment
February 15th, 2016

According to the Bureau of Labor Statistics (BLS), there were 151k, 000 net new jobs created in the month of January, and the unemployment rate fell to 4.9%. The continuing increase in new job creation and removal of slack in the labor market is causing the Phillips-curve-obsessed Fed to maintain a tightening stance on monetary policy.

However, not only is Ms. Yellen and company wrong about the progenitor of inflation, the Fed is also obsessing about job growth that isn’t real. According to that same BLS, in December of 2015 thru January 2016 the economy actually lost 2,999,000 jobs, or 2.08% of the workforce. The Labor Department arrived at a positive employment number because the BLS seasonally adjusts the data—my friend David Stockman had more to say about his in his excellent blog.

On a seasonally adjusted basis the U.S. economy created 413k, 000 jobs during that timeframe. Of course, it makes sense to adjust the jobs data for hiring and firing around the Christmas season. But it makes much more sense to look at the data year over year for a more accurate assessment of the labor market. During December 2014 thru January 2015 the economy shed 2,820,000, or 1.99%.

Therefore, the economy not only lost 179,000 more jobs this year during the post-Holiday layoff season than it did the year prior, but it also suffered a greater percentage of job losses than it did during the comparative time frame.

What makes this layoff picture even worse is the number of retail corporations that are in the process of closing their brick and mortar presence. For example, Walmart is closing 154 stores in the United States and is laying off 10,000 employees. There are also about 6,000 other major retailers that are in the process of shuttering up their stores. This means the part-time, retail-job growth economy, which has been the staple of hiring since the recovery began, will be shedding more jobs at an increased rate going forward.

And please don’t believe today’s 4.9% U-3 unemployment is comparable with times past. The last time the unemployment rate was 4.9% was February of 2008. At that time the Labor Force Participation Rate (LPR) was 66 and the Employment to Population Ratio (EPR) was 62.8. Today’s low unemployment rate comes with a LPR of only 62.7 and an EPR of just 59.6.

But the major point here is that a low unemployment rate can never lead to inflation. And this is especially true when all of that job growth is the seasonally adjusted phantom variety. The Keynesian squatters who inhabit the FOMC believe dogmatically that inflation is the result of too many people being employed. However, what they fail to understand it that inflation is all about a loss of confidence in the purchasing power of a currency. That can never be the result of a low unemployment rate.

Nevertheless, Yellen and her Philips-curve junkies indicated clearly in the Semiannual Monetary Policy Report to Congress on February 10th that the FOMC will lean toward hiking interest rates until the U-3 unemployment rate begins to rise. This means the Fed will be threatening to continue tightening monetary policy into an incipient global deflationary depression. But Yellen will not be able to increase the Fed Funds rate above the 75bps level before the bottom completely falls out on the global economy. Perhaps she will be pretend the world isn’t collapsing around her for a little while longer. But we all know better and it won’t be long before the Fed joins the rest of the developed world’s central bankers into perpetual QE and NIRP.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Oil’s True Message
February 8th, 2016

The pervasive narrative on Wall Street is that the collapse in oil prices will, any second now, restore consumers to their profligate spending ways. In fact, financial pundits have been calling for plunging energy prices to imminently rescue the economy for the past 18 months. Most importantly, these same gurus, who love to espouse the benefits of a collapse in oil prices, never connect the dots to what this collapse says about the state of global growth. Instead they argue it is solely a function of a supply glut that is the result of increased production.

West Texas Intermediate Crude (WTI) fell from $105 a barrel in June of 2014, to well below $30 in January of this year. The cratering price of WTI did not occur from a sudden surge in crude supply, but rather due to the market beginning to discount future plummeting demand coming from a synchronized global deflationary recession. According to the U.S. Energy Information Administration, world crude oil production has increased by just 3.3% since June 2014. Therefore, it is sheer quackery to maintain that such a small increase in crude production would result in prices to drop by 75%.

Oil prices are either discounting an unprecedented surge in supply, or a rapid destruction in demand. The Baker Hughes Rig count on an international basis is down by 218 rigs y/y. Therefore, despite any marginal increase in new supply from the lifting of Iranian sanctions, the drop in prices has to be due to the market’s realization that demand for this commodity is headed sharply south.

It’s not just the oil price that has tanked. Stock market cheerleaders have to ignore commodity prices in aggregate and a plethora of economic data to claim the global economy is faring well. Nearly all commodities are trading at levels not seen since the turn of the millennium. It’s not just energy that has crashed but base metals and agricultural commodities as well. In addition, half of US stocks are down more than 25% and the equity market carnage is much greater in most foreign shares. High-yield debt spreads to Treasuries also indicate a recession is nigh.

But to prove the point most effectively, why would the Dow Jones Transportation Average be down nearly 25% y/y in light of the fact that the cost to move goods has dropped so severely? If the economy was doing fine, dramatically lower fuel costs would be a gigantic boon for the trucking, railroad and airline industry. In sharp contrast, these companies have entered a bear market as they anticipate falling demand.

Also, why have home building stocks crashed by nearly 20% in the last 2.5 months if the economy was doing well? Especially in light of the fact that long term rates are falling, making homeownership costs more affordable. And interest rates certainly aren’t falling because governments have balanced their budgets, but because investors are piling into sovereign debt seeking safety from falling equity prices and faltering global GDP growth.

Market apologists are also disregarding the blatant U.S. manufacturing recession confirmed by Core Capital goods orders that are down 7.5% y/y. And the ISM Manufacturing survey, which has posted four contractionary readings in a row. And now the service sector is lurching toward recession as well: the ISM Non-manufacturing Index dropped to 53.5 in January, from 55.8 in the month prior.

It’s not just the U.S. markets that are screaming recession. Indeed, equity market havoc is evident in North America, South America, Europe and Asia. In the vanguard of this mayhem is the Shanghai Composite, which has lost 50% of its value since June 2015; as the debt disabled communist nation tries in vain to migrate from the biggest fixed asset bubble in history to a service based economy.

The chaos in global markets: from high-yield debt, to commodities, to equites is all interrelated. It is no coincidence that the oil price began its epic decline around the same time QE ended in the U.S., and intensified as the Fed began to move away from ZIRP. The termination of Fed balance sheet expansion caused commodities and equities to roll over, just as the USD started to soar; putting extreme distress on the record amount of emerging market dollar denominated debt.

Therefore, it is inane to keep waiting for lower gas prices to save the consumer--that point is especially moot because whatever savings they are enjoying at the pump is being consumed by soaring health insurance premiums. The collapse in the oil price is a symptom of faltering global growth for which there is no salve immediately available. This is because there isn’t anything central banks can do to provide further debt service relief for the public and private sectors because borrowing costs are already hugging the flatline.

And that leads to the truly saddest part of all. If the deflationary recession were allowed to run its course lower asset prices, including energy, would eventually lead to a purging of all such economic excesses and imbalances. However, since deflation is viewed as public enemy number one, no such healthy correction will be allowed to consummate. To the contrary, what governments and central banks will do is step up their attack on the purchasing power of the middle class in an insidious pursuit of inflation through ZIRP, NIRP and QE.

That's the truth behind the oil debacle. Don’t let anyone convince you differently.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

The Davos Confetti Club
February 1st, 2016

The Keynesian elite gathered in Davos Switzerland this past week to pontificate on global economic issues and to strategize the engineering of The Fourth Industrial Revolution. This new so called “revolution” includes a discussion on the future of Artificial Intelligence. Judging by the comments coming from most of the list of attendees, it seems obvious the intelligence on display was indeed faux. But the most important take away from this venue was that central bankers have made it clear to the markets that the level and duration of quantitative counterfeiting knows no bounds.

European Central Bank (ECB) President, Mario Draghi, used the platform to assure investors he’ll do whatever further is needed to reach his absurd inflation goal: “We’ve plenty of instruments, said Draghi.” “We have the determination, and the willingness and the capacity of the Governing Council, to act and deploy these instruments.”

Central bankers love to use words like instruments and tools to describe the methods and strategies available to them because it makes what they actually do appear less primitive. But truth be told, the only instrument or tool central banks have is the impious power to create money and credit by decree.

Not to be outdone by the Europeans, Japan’s chief money printer, Haruhiko Kuroda, appeared downright giddy from monetary intoxication when discussing what he refers to as his QQE--Quantitative and Qualitative Monetary Easing program. As if adding that additional “Q” somehow makes it more palatable and effective than the generic form of Quantitative Easing.

When asked by a reporter if the Bank of Japan (BOJ) had more room to ease, Kuroda glibly chuckled that the BOJ has “only” purchased 33% of all existing Government Bonds and conveyed the willingness to monetize every available sovereign debt note issued by the insolvent government of Japan.

And since Mr. Kuroda thinks destroying your nation’s currency is funny, he certainly has a lot more than Mr. Draghi to laugh about. The ECB’s balance sheet stands at roughly 25% of the Eurozone’s Gross Domestic Product; while the BOJ boasts a whopping 78% of Japan’s GDP.

In fact, it wasn’t long after Davos that Kuroda stepped up his assault on the yen by announcing Friday that the deposit rate will move 0.1% into negative territory starting February 16th. Apparently, printing 80 trillion yen a year isn’t wrecking the currency fast enough for the BOJ.

As of Jan 20, 2016 the BOJ’s balance sheet had risen to 389.6 trillion yen. At the start of QQE in April of 2013 its balance sheet was just 174.7 trillion yen. For those keeping track at home that is a 123% increase in the monetary base…and they are just getting started. All this makes you wonder if the additional “Q” really stands for central bank “Quackery”.

Mr. Kuroda averred he has two thirds more JGBs to buy before he runs out of sovereign debt. But once all JGBs are owned by the BOJ the money printing won’t stop. The BOJ President said he will not balk at buying much more of the so called "lesser quality assets" such as equity ETFs and Junk bonds. But buying assets that have a lower quality than a 0.1%, 10-year Japanese bond is a difficult feat to accomplish! Especially in light of the fact that the nation has a debt to GDP ratio of 250% and has an inflation-obsessed central bank.

Turning back to Europe’s Chief Counterfeiter Mario Draghi, he has been buying 60 billion euros a month worth of European sovereign debt and has being do so for quite some time. The total goal had been to add 1.2 trillion euros ($1.4 t) to the ECB’s balance sheet; taking the total up to 3.3 trillion euros. However, that 60 billion euro per month QE program was extended until March 2017 less than 60 days ago. But now, less than two months from expanding the program, he is still not satisfied with rate of euro dilution and told the markets he’s ready to do more!

It is becoming obvious to the worldwide investment community that these central bankers will not quit printing money until inflation becomes an intrinsic and sustainable aspect of the global economy.

But the last seven years has clearly taught us that QE is great for asset prices but is ineffectual at providing viable economic growth. We don’t have to look any further than Japan for this proof. In nominal terms Japan’s GDP is up a measly 5.5% since the currency wrecking regime known as Abenomics took control in December of 2012. Meanwhile, the Nikkei Dow has surged over 100% during that same timeframe.

It is also becoming obvious to the equity markets that there is no escape from this monetary madness. After all, is there anyone who really believes that Kuroda can finally stop printing money when inflation eventually hits his arbitrary 2% target?

The central bank already owns over one third of JGBs and over half of all ETFs. What will happen to the Japanese stock market once the BOJ announces it will begin winding down ETF purchases; and has started down the path to becoming a seller?

And won’t the bond market tank after Kuroda proclaims that its bid for JGBs will be removed? The Ten-year Note must soar from 0.1%, where it is today, to at least where the 2% inflation target now stands. Then throw in a few hundred more basis points for the fact that nation’s tax base cannot service its debt at the higher interest rate.

Therefore, since the obvious result would be a complete collapse in equity and bond prices, which would lead to an unprecedented economic meltdown, the BOJ has unwittingly become trapped into an endless QQE program.

Indeed, the entire global real estate, equity and bond markets have become completely addicted to perpetual and ever increasing quantities of QE and ZIRP. It is no accident that the S&P 500 began its topping process once QE ended in October 2014. The US equity market also has become reliant on ZIRP and QE to move higher.

Asset prices and economies have become wards of central banks and their endless ability to increase the rate of new money creation. Therefore, since the global elites have placed all their faith in the fiat confetti spewed out by central banks, investors would be wise to increase their exposure to the only genuine form of money there ever was…gold.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

This Is Not 2008: It’s Actually Worse
January 18th, 2016

The S&P 500 has begun 2016 with its worst performance ever. This has prompted Wall Street apologists to come out in full force and try to explain why the chaos in global currencies and equities will not be a repeat of 2008. Nor do they want investors to believe this environment is commensurate with the Dot.Com Bubble that caused the NASDAQ to plummet 78% and the S&P 500 to shed 35% of its value. In fact, they claim the current turmoil in China is not even comparable to the 1997 Asian Debt Crisis: when dollar-denominated debt loads couldn’t be repaid and the Thai baht lost half its value, and the stock market dropped 75%.

Indeed, the unscrupulous individuals that dominate financial institutions and governments seldom predict a down-tick on Wall Street, so don’t expect them to warn of the impending global recession and market mayhem. But a recession has occurred in the U.S. about every five years on average since the end of WWII; and it has been seven years since the last one—we are overdue. Most importantly, the average market drop during the peak to trough of the last 6 recessions has been 37%. That would take the S&P 500 down to about 1,300; if this next recession were to be just of the average variety.

But this one will be worse.

A major contributor for this imminent recession is the fallout from a faltering Chinese economy. The megalomaniac communist government has increased debt 28 times since the year 2000. Taking that total north of 300% of GDP in a very short period of time for the primary purpose of building a massive unproductive fixed asset bubble. Now that this debt bubble is unwinding, growth in China is going offline. The renminbi's falling value, cascading Shanghai equity prices (down 40% since June 2014) and plummeting rail freight volumes (down 10.5% y/y), all clearly illustrate that China is not growing at the promulgated 7%, but rather isn’t growing at all. The problem is China accounted for 34% of global growth, and the nation’s multiplier effect on emerging markets takes that number to over 50%. Therefore, expect more stress on multinational corporate earnings as global growth continues to slow.

But the debt debacle in China is not the primary catalyst for the next recession in the United States. It is the fact that equity prices and real estate values can no longer be supported by incomes and GDP. And now that QE and ZIRP have ended, these asset prices are succumbing to the gravitational forces of deflation. The median home price to income ratio is currently 4.1; whereas the average ratio is just 2.6. Therefore, despite record low mortgage rates, first-time home buyers can no longer afford to make the down payment. And without first-time home buyers, existing home owners can’t move up.

Likewise, the total value of stocks has now become dangerously detached from the anemic state of the underlying economy. The long-term average of the market cap to GDP ratio is around 75, but it is currently 110. The rebound in GDP coming out of the Great Recession was artificially engendered by the Fed’s wealth effect. Now, the re-engineered bubble in stocks and real estate is reversing and should cause a severe contraction in consumer spending.

Nevertheless, the solace offered by Wall Street is that another 2008 style deflation and depression is impossible because banks are now better capitalized. However, banks may find they are less capitalized than regulators now believe because much of their assets lie in Treasury debt and consumer loans that should be significantly underwater after the next recession brings unprecedented fiscal strain to both the public and private sectors. But most importantly, even if one were to concede financial institutions are less leveraged; the startling truth is that Businesses, the Federal Government and the Federal Reserve have taken on a humongous amount of additional debt since 2007. Even Household debt has increased back to a its 2007 record of $14.1 trillion. Specifically, Business debt during that timeframe has grown from $10.1 trillion, to $12.6 trillion; the Total National Debt boomed from $9.2 trillion, to $18.9 trillion; and the Fed’s balance sheet has exploded from $880 billion, to $4.5 trillion.

Banks may be better off today than they were leading up to the great recession but the government and Fed’s balance sheets have become insolvent in the wake of their inane effort to borrow and print the economy back to health. As a result, the Federal Government’s debt has now soared to nearly 600% of total revenue. And the Fed has spent the last eight years leveraging up its balance sheet 77:1, in its goal to peg short-term interest rates at zero percent. Therefore, this inevitable, and by all accounts brutal upcoming recession, will coincide with two unprecedented and extremely dangerous conditions that should make the next downturn worse than 2008.

First off, the Fed will not be able to lower interest rates and provide any debt service relief for the economy. In the wake of the Great Recession Former Fed Chair, Ben Bernanke, took the overnight interbank lending rate down to zero percent, from 5.25%, and printed $3.7 trillion and bought longer-term debt in order to push mortgages and nearly every other form of debt to record lows. The best the Fed can do now is to take away its 0.25% rate hike made in December. Secondly, the Federal Government increased the amount of publicly traded debt by $8.5 trillion (an increase of 170%), and ran $1.5 trillion deficits to try to boost consumption through transfer payments. Another such ramp up in deficits and debt—which are a normal function of recessions after revenue collapses--would cause an interest rate spike that would turn this next recession into a devastating depression.

It is my belief that in order to avoid the surging cost of debt service payments on both the public and private sector level, the Fed will feel compelled to launch a massive and unlimited round of bond purchases. However, not only are interest rates already at historic lows, but faith in the ability of central banks to provide sustainable GDP growth will have already been destroyed given their failed eight-year experiment in ZIRP and QE. And adding $1.5 trillion dollars per year to the $19 trillion U.S. debt won’t be taken well by the bond market either. Therefore, the ability of government to save the markets and the economy this time around will be extremely difficult, if not impossible. Look for chaos in currency, bond and equity markets on an international scale throughout 2016. Indeed, it already has begun.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Junk Rhymes with Subprime
January 11th, 2016

On December 16th 2008, in what Ben Bernanke averred took a tremendous amount of “moral courage”, the Federal Reserve officially arrived at its Zero Interest Rate Policy. ZIRP was a huge win for borrowers because it drove down the carrying cost of debt to historic lows. Unfortunately, savers didn’t fare as well.

Those frantic savers were forced to reach for yield far out along the risk curve. And an obliging Wall Street issued over $1 trillion in new junk bonds at the lowest spreads to Treasuries in the 35 year history of the junk debt market. To put this in perspective, the entire high yield market had previously hit its frothy peak of $1.2 trillion in the bubbly days of 2007, in October of last year junk bond debt alone hit $1.7 trillion, adding to the total $2.6 trillion high yield debt market.

Through these newly issued Junk-bonds investors generously financed America’s shale boom that is now going bust. Junk debt also provided the lowest-grade borrowers cushy terms such as covenant-lite offerings and PIK (Payment-in-Kind toggle), which allows issuers to pay some of the interest due by borrowing new debt. And also financed lavish dividend payments for those debt holders.

But now the Fed’s mission is to prove to Wall St. and Main St. that nearly eight years’ worth of ZIRP has succeeded in saving the economy. Therefore, it has finally embarked on its path to interest rate normalization. However, on the way down this road to normalization the junk debt market has started to discount increased borrowing costs and a U.S. recession, which is the bane for high-yield debt.

The carnage has just begun. Lucidus Capital Partners—an investment manager specializing in corporate credit--recently announced it was liquidating its entire portfolio and returning $900 million to clients next month. Third Avenue rattled markets when it announced December 9th that it's liquidating a $788.5 million corporate debt mutual fund and delaying distribution of investor cash to avoid even bigger losses. And Stone Lion Capital Partners has also halted cash redemptions for its investors.

But as usual the Wall Street cheerleaders quickly provided a myriad of excuses for these individual failures and eagerly offered reasons why this isn’t systemic. They claim Third Avenue focused on ultra-high risk illiquid assets that didn’t belong on a mutual fund platform. And that Lucidus had one large investor who wanted his money back. Or, that outside of energy these junk bond funds are rock solid. However, within the Third Avenue Focused Credit Fund 78% of the top ten holdings were not energy related at all.

This is eerily reminiscent of similar assurances given at the onset of the sub-prime fund failures back in 2008. As the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund brought down the legendary investment bank that bears its name, most pundits were confident that these particular funds represented isolated cases. Those same Wall Street apologist were busy pontificating that the failure of Bear Stearns was due to a mismanagement issue and not part of a larger problem in the mortgage market; and certainly had nothing to do with a systemic problem in financial institutions or the global economy.

Likewise, this time around the issue is not limited to just a small subsection of high-yield junk. Remember those CLO’s (collateralized loan obligations) that almost brought down the entire economy in 2008? They are back and are now being issued at a record pace. Yield hungry institutional mangers and retail investors have been lured into these debt securities that are collateralized by loan pools consisting of highly illiquid bank loans.

To make matters worse, leveraged bank loans outstanding, which have been the engine of the recent financial engineering of M&A and stock buybacks, amounts to nearly $900 billion, up 80% from the post crisis bottom.

Investors in search of a higher yield coveted the mortgages of unqualified homeowners leading up to the Great Recession. Today, they have turned their pursuits to low-credit corporate debt and the leveraged loans of distressed borrowers.

In 2007 the entire mortgage market was worth $10.7 trillion dollars; $4.6 trillion of which was composed of sub-prime and Alt-A loans. Currently, the high-yield debt market is more than 55% of that amount today. However, just like the carnage in the Sub-prime mortgage market was not at all contained, the entire credit market spectrum from Junk to Sovereign debt is now in a bubble. And because prices have been artificially manipulated by the Fed for so long, all bond yields will eventually spike either due to inflation and/or insolvency.

For seven years our economy, and especially our stock market, have grown off the back of asset bubbles and artificially suppressed interest rates. As these misallocations of capital are revealed Janet Yellen and company will realize our fragile economy cannot withstand the pressures of interest rate normalization. Therefore, she will be compelled to take back her quarter point rate hike in an act that I’m sure Wall Street will categorize as “mortified courage.”

Perhaps the most important take away from the Great Recession was that the blowup in sub-prime eventually exposed the bubble in real estate and the banking system as a whole. And as the market begins to see the forest behind the high-yield trees, it will realize that after seven years of ZIRP and QE the true bubble exists in the entire universe of fixed income.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Pento’s Predictions for 2016
January 5th, 2016

2015 was a year where nearly every asset class failed to provide any returns at all. If fact, the S&P 500 hasn’t gone anywhere in about the past 400 days. An analysis of that Index’s performance at the end of the 3rd quarter by S&P Capital IQ showed that over 250 stocks were down more than 20% from their 2015 highs and 25% of the S&P 500 Index had plummeted more than 30%.

The 30-year Treasury bond has fallen over 2.0%, cash in money market accounts have returned just +0.11% (so after taxes and inflation your return was solidly negative), and the CRB index is down nearly 25%.

So what should investors do with their money when nothing is working? Before I get to that I want to very briefly explain why nothing has worked for so long. The global economy has become debt disabled and market prices have been massively distorted by governments and central banks. The Free market has been eviscerated and supplanted by money printing and deficit spending on an unprecedented scale. The bottom line is that there is now a historic and humongous gap between stock prices and economic fundamentals. And a gigantic gap between fixed income yields in relation to the underlying credit quality.

Evidence of the crumbling economic foundation can be found everywhere you look.

The US manufacturing sector is now clearly in a recession. The latest confirmation of this came from the Dallas Fed survey, which was announced this past Monday, showing a drop of -20.1. Commodity prices, junk bond spreads and money supply growth all indicate the global economy is not only weakening but approaching the Great Recession levels realized in early 2009. After all, investors would have to believe that commodity prices, taken in aggregate, which are trading at prices reached during the nadir of the Great Recession, say nothing about global demand in order to maintain the economy isn’t in serious trouble.

So here are a few of my predictions and trading strategies for next year:

  • The S&P 500 falls more than 20% as it finally succumbs to the incipient global recession
  • Janet Yellen states in the 1st half of 2016 that the Fed will not increase the Fed Funds Rate any further and hints at another round of QE before year’s end.
  • The inability to normalize interest rates is taken as a tacit admission by the Fed that it has utterly failed to save the economy from the Great Recession, and as a result the US Dollar crashes below 90 on the DXY.
  • Gold and the miners will be the major winners next year as they will be the primary beneficiary from continued low nominal interest rates, negative real interest rates and a watershed turn in the value of the USD--the yellow metal reaches a high of $1,250 next year.
  • The Ten-year Note yield falls below 2% by June on pervading recession concerns.
  • Continue to short high-yield debt and own put options on high-flying NASDAQ momentum stocks that are trading at monstrous PE ratios and whose prices should collapse given a deceleration in the US economy.
  • Finally, after the dust settles from this anticipated huge selloff, there will be a tremendous opportunity from owning high-divided paying foreign stocks, which have already been mercilessly beaten down during the commodity bear market of the last few years.

Why will 2016 bring about the long overdue equity bear market? It is not just because the Fed has finally started to raise interest rates and will continue to slowly do so until the US economic recession fully manifests. But also the catalyst for this imminent recession is that debt levels and asset prices have increased to a level that can no longer be supported by incomes and underlying economic growth. Any additional increase in the cost of money will only expedite and exacerbate this condition. Q4 2015 GDP growth is predicted to post a reading that is barely above 1%, according to the Atlanta Fed model. Therefore, we don’t have much room left below before the economy enters contraction mode; and the trend is solidly in that direction.

I cannot stress how important this watershed change in US monetary policy will be for markets in early 2016. The major markets (meaning currencies, bonds and equities) have been anticipating a graceful exit from QE and the trillions of dollars’ worth of deficit spending that have been deployed since 2008. In other words, global capital markets have been banking on the success of central banks. In the vanguard of this belief has been the universal carry trade of going long the US dollar and equities, while shorting precious metals.

I believe in realities not fantasies. I’m betting that you cannot solve the debt crisis evident during the Great Recession by taking on a record amount of debt. And that you cannot fix the asset bubbles evident during the Great Recession by artificially pushing them to record high prices through QE and ZIRP. It is this reality that will take its vengeance in 2016. And it is the unraveling of this delusion that is the basis of Pento Portfolio Strategies’ investment model and is the opportunity we are prepared to profit from.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Beware of Central Bank Success
December 21st, 2015

The most important question investors will soon have to face is: “what’s going to happen once central banks finally meet their inflation targets?”

For example, let’s assume after years of monetizing government debt, bidding up equity prices, and forcing debt on the public by keeping borrowing costs at or below zero; that the ECB is finally able to achieve its inflation target rate of 2%. This would only occur once money supply growth becomes both robust and sustainable. It is silly to believe ECB President Mario Draghi can bring inflation to just 2% and nail it at that level. Inflation will continue to rise past 2% until the ECB raises interest rates by reducing its pace of bond buying. So, we will have the environment where inflation is rising north of 2% and the central bank will be forced to start cutting back its purchases of debt and preparing the market for eventual outright sales.

Here’s the problem: there is $2.1 trillion dollars, or 1/3 of the $6.3 trillion European sovereign debt, with a negative yield. The ability to produce sustainable inflation that is rising past the ECB’s 2% target along with the removal of the massive central bank’s bid for sovereign debt should cause the most violent interest spike in history.

Indeed, asset bubbles exists all over the planet due to central bank overreach for which there is no escape. The carnage will be especially acute in Japan where a 2% inflation rate won’t jive too well with a 10-Year Note that yields just 0.3%. The Bank of Japan (BOJ) certainly cannot keep wrecking the value of the yen at its current pace of depreciation (down over 30% since 2013) without eventually creating a currency and inflation crisis. Therefore, Japanese investors will soon have to deal with imploding bond and stock prices, as investors try to front run the huge sell orders coming from the BOJ trying to unwind its massive 385 trillion yen balance sheet (75% of its GDP) to boost the value of the currency. However, the BOJ’s balance sheet now consists of both bonds and trillions of yen worth of stocks. The inevitable ending of the BOJ’s support for bond and equity prices will cause an unprecedented economic crisis in Japan.

The laws of economics state that an unprecedented and humongous level of money printing must eventually produce inflation. Up until now most of this high-powered money has sat fallow with central banks. However, the growing level of sovereign debt dictates that increasing amounts of this money must be put to work buying government debt in order to keep the illusion of solvency intact. Inflation has always been, and always will be, the inevitable result.

Central bank “success” in creating inflation will produce a period of stock market chaos such as the world has never seen, as the economic environment moves violently between inflation and deflation cycles. This is what happened during the Great Recession of 2008-2009 and is destined to reoccur with greater intensity. The challenge for investors will be the ability to model these changes and to prosper during times of unprecedented market volatility. And is the inspiration behind the creation of the Pento Portfolio Strategies’ Inflation/Deflation Portfolio

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Ten Investor Warning Signs for 2016:
December 14th, 2015

Wall Street’s proclivity to create serial equity bubbles off the back of cheap credit has once again set up the middle class for disaster. The warning signs of this next correction have now clearly manifested, but are being skillfully obfuscated and trivialized by financial institutions. Nevertheless, here are ten salient warning signs that astute investors should heed as we roll into 2016.

  1. The Baltic Dry Index, a measure of shipping rates and a barometer for worldwide commodity demand, recently fell to its lowest level since 1985. This index clearly portrays the dramatic decrease in global trade and forebodes a worldwide recession.

  2. Further validating this significant slowdown in global growth is the CRB index, which measures nineteen commodities. After a modest recovery in 2011, it has now dropped below the 2009 level—which was the nadir of the Great Recession.

  3. Nominal GDP growth for the third quarter of 2015 was just 2.7%. The problem is Ms. Yellen wants to begin raising rates at a time when nominal GDP is signaling deflation and recession. The last time the Fed began a rate hike cycle was in the second quarter of 2004. Back then nominal GDP was a robust 6.6%. Furthermore, the last several times the Fed began to raise interest rates nominal GDP ranged between 5%-7%.

  4. The Total Business Inventories to Sales Ratio shows an ominous overhang: sales are declining as inventories are increasing. This has been the hallmark of every previous recession.

  5. The Treasury Yield curve, which measures the spread between 2 and 10 Year Notes, is narrowing. Recently, the 10-year benchmark Treasury bond saw its yield falling to a three-week low, while the yield on the Two-year note pushed up to a five-year high. This is happening because the short end of the curve is anticipating the Fed’s December hike, while the long end is concerned about slow growth and deflation.

    Banks, which borrow on the short end of the curve and lend on the long end, are less incentivized to make loans when this spread narrows. This chokes off money supply growth and causes a recession.

  6. S&P 500 Non-GAAP earnings for the third quarter were down 1%, and on a GAAP basis earnings plummeted 14%. It is clear that companies are desperate to please Wall Street and are becoming more aggressive in their classification of non-recurring items to make their numbers look better. The main point is why pay 19 times earnings on the S&P 500 when earnings growth is negative–especially when those earnings appear to be aggressively manipulated by share buy backs and through inappropriate charges.

  7. The rising US dollar is hurting the revenue and earnings of multi-national companies. Until recently, multinational companies have enjoyed a slow and steadily declining dollar from its mid-1980’s Plaza Accord highs. This decline boosted the translated earnings of multi-national companies. As the dollar index breaks above 100 on the DXY, multinational companies, which are already struggling to make earnings from a slowing global economy, are going to have to grapple with the effects of an even more unfavorable currency translation. In the long-term, a rising US dollar is great for America. However, it in the short-term it will not only negatively affect S&P 500 earnings, but also place extreme duress on the over $9 trillion worth of debt borrowed by non-financial companies outside of the U.S.A.

  8. Recent data confirms that the US is currently in a manufacturing recession:

    • The November ISM Manufacturing Index entered into contraction for the first time in 36 months posting a reading of 48.6. This is a decline from the anemic October reading of 50.1 and marked the fifth straight month this index was in decline.
    • The Chicago purchasing manager's index (PMI) came in at 48.7 for November signaling contraction.
    • The latest Dallas Fed Manufacturing Business Index fell to -4.9, from -12.7 in the preceding month.
    • The Empire State Manufacturing Survey came in at -10.7, a fractional increase from last month's -11.6, signaling a decline in activity and registering close to the lowest levels since 2009.
    • The November Richmond Fed Manufacturing Index dropped 2 points to -3 from last month’s -1.

  9. Credit Spreads are widening as investors flee corporate debt for the safety of Treasuries. The TED spread, the difference between Three-month interest rates on Eurodollar loans and on Three-month T-bills, has been on a steady rise since October of 2013; at the end of September it was at its widest since August of 2012 at the height of the European debt crisis.

  10. The S&P 500 is at the second highest valuation in its history:

    • The Cyclically Adjusted Price-Earnings (CAPE) ratio, was 26.19 in November, a value greater than 25 indicates that the stock market is overpriced in comparison to its earnings history. The CAPE ratio has averaged 17 going back to 1881.
    • The Q RATIO, the total price of the market divided by the replacement cost of all its companies, historically averages around .68, but is now hovering around 1.04.
    • The P/E RATIO of the S&P 500 is around 19 – above the long-term historic average of 15.
    • Total Market Cap to GDP ratio is 122, ten percentage points above the 2007 level and eighty percentage points higher than it was in 1980.
    • The Price to Sales Ratio for the S&P is 1.82. That is higher than 2007, when it was 1.52 and is at the highest since the end of 2000.
    • And finally, Advisors Perspectives chart of inflation-adjusted NYSE Margin Debt and the S&P 500 demonstrates the profoundly over-leveraged condition of the market. Margin debt in real terms is now 20% greater than it was at the peak of the dotcom bubble

  11. If those ten warning signs weren’t enough to rattle investors…this should. The Fed is threatening to do something highly unusual; to begin a rate hiking cycle when the global economy is on the brink of recession. Ms. Yellen has virtually promised to raise rates on December 16th and continue to slowly hike the cost of money throughout next year. Investors should forget about the “one and done” rate hike scenario. The truth is the Fed will be very slowly tightening monetary policy until the fragile US economy officially rolls over into a contractionary phase and the meaningless U3 unemployment rate begins to move higher.

    This current economic expansion is now 78 months old, making it one of the longest in U.S. history. There have been six recessions since the modern fiat currency era began in 1971. The average of those has brought the S&P 500 down a whopping 36.5%. Given that this imminent recession will begin with the stock market flirting with all-time highs, the next stock market crash should be closer to the 2001 and 2008 debacles that saw the major averages cut in half.

    Total U.S. public and private debt levels have climbed to the staggering level of 327% of GDP. Therefore, humongous debt levels and massive capital imbalances have set up the stock market for its third major collapse since the year 2000. Investors should proceed with extreme caution now that the warning signs have been blatantly explained.

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    Unwinding Carry Trades and Unintended Consequences
    December 8th, 2015

    The European Central Bank under the auspices of Mario Draghi has created a market destabilizing condition known as the euro carry trade. Mr. Draghi recently telegraphed to the markets a more aggressive attack on the value of the currency heading into the ECB meeting held on December 3rd. In fact, he went on record saying the ECB’s imperative is to, “Do what we must to create inflation as quickly as possible.” Because Draghi promised to destroy the euro at an even quicker pace than it was already falling, financial institutions front ran the ECB’s increased bid for bonds and equities, sending these prices soaring in the weeks prior to the meeting.

    The euro carry trade was in full swing. These banks and hedge funds also borrowed euros and bought higher-yielding dollar denominated assets. And, the falling euro/rising USD furthermore served as a green light to sell short most commodities, including precious metals.

    A great example of how the euro carry trade works can be found in the market for U.S. Treasuries. In the weeks leading up to the December 3rd ECB meeting the U.S. Ten-year Note Yield fell from 2.88% on November 9th, all the way down to 2.26% on December 2nd, as traders sold euros and bid up Treasury prices. The trade was a double-win because Treasuries offered a higher yield than European bonds and was denominated in a rising currency. European traders could earn more income on their money while also benefitting from an improving currency translation.

    But Mr. Draghi threw a wrench into this carry trade when traders became disappointed with the outcome of the meeting. The ECB did not increase the amount of monthly QE purchases as was highly anticipated. Draghi kept the level of monthly purchases at 60 billion euros. However, he did extend the program by 6 months and lowered the deposit rate by 10bps. This caused the euro to soar against most major currencies and sent carry trade speculators scrambling to sell bonds and stocks, and then sell dollars to cover their short euro position.

    Of course, only in the twilight zone of today’s fiat currency system would a cut in the deposit rate to -0.3% and an extension of QE by another 360 billion euros cause a currency to rise. But this illustrates how much the ECB overpromised on its efforts to create inflation. The markets simply became over extended in driving up the price of the dollar and the value of stocks and bonds.

    Therefore, immediately after the ECB announcement the German DAX dropped 400 points (over 3.5%) and the US market reaction was volatile as well, with the Dow Jones shedding over 1.4% by the close, after falling over 300 points earlier in the day. US Treasuries also reacted violently, as 10-year Note prices plunged, sending the yield soaring higher by 7% on Thursday. The German 10-year Bund yield soared as high as 0.59%, from the low of 0.45%, and 2-year bond yields in Spain and Italy leapt from negative into positive territory.

    This is just a taste of what is to come because the euro carry trade is just one small example of the huge distortions that have been created. The simple truth is all currencies, bonds and equities have all been so massively manipulated by the heavy hand of governments that there is now no easy escape. Last week’s market action was merely the warmup act for the unintended and baleful consequences that will result from completely abandoning free markets to the control of global central planners

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    Don’t Sell Your Gold Because of Draghi
    November 30th, 2015

    European Central Bank President, Mario Draghi, has been trying to lower the value of the euro by promising to pursue inflation with a vengeance. His inflation rhetoric was stepped up during a speech he gave to Germany on November 20th of this year. In that speech Mr. Draghi vowed to “do what we must to raise inflation as quickly as possible.”

    Draghi’s efforts to crush the euro have somehow been taken by Wall Street as a great opportunity to sell gold. But there shouldn’t be a person alive having an IQ greater than a mentally challenged ameba that can rationalize why it is appropriate to sell gold simply because of Mario Draghi’s obsession with creating inflation and destroying the euro.

    Most investors will tell you that the primary driver for the price of gold is the direction of the U.S. Dollar Index (DXY). Therefore, the only due diligence Wall St. recommends regarding the direction of the gold market is to take a perfunctory glance at the DXY, and to hit the sell button on paper gold ETFs if it is up. While it is true that the purchasing power of the dollar is a key metric to judge the direction of gold prices, the DXY will only tell you what the dollar is doing against a basket of 6 other flawed fiat currencies.

    The main component of the Dollar Index is the euro currency, which represents nearly a 58% weighting in that basket of currencies. Therefore, if the euro is falling the Dollar Index usually rises, regardless of the fundamental condition of the currency. When it comes to valuing gold investors must first determine what is going on with the real, or intrinsic, value of the dollar. In order to truly access the intrinsic value of the dollar you must determine: the level of real interest rates, the rate of growth in the money supply and the fiscal health of the U.S. government. When analyzing the dollar using those metrics, it becomes clear that the intrinsic value of the dollar is eroding and, therefore, should cause the dollar price of gold to increase regardless of what is going on with other fiat currencies.

    The One Year Treasury note is now yielding just 0.49% and the increase in year/year core Consumer Price Inflation is up 1.9%. Therefore, real interest rates are now negative, which should reduce investors’ appetites to hold dollars, as it increases their willingness to buy gold. Negative real interest rates also cause consumers, businesses and governments to borrow more money. When money is borrowed into existence, the supply of money grows. Increasing the money supply reduces the value of dollars already in existence; especially when those dollars are growing faster than the mine supply of gold—which historically runs about 1-2% per annum.

    The YOY change in M2 money supply growth is 6%. Since total U.S. economic output is around 2%, the supply of goods and services is growing far below the rate of money supply growth. This causes aggregate prices to rise and reduces the intrinsic value of the dollar, while boosting the value of gold.

    Finally, our government just agreed to suspend the debt ceiling through mid-March 2017. U.S. debt stands at over $18.6 trillion and is larger than our GDP.

    More importantly, U.S. debt amounts to nearly 600% of all annual Federal revenue. And despite our politicians’ self-praise for bringing deficits down from crisis levels, October’s deficit, which marks the start of the 2016 fiscal year, totaled $136.5 billion -- up 12.2% from October 2015. The sad truth is debt and deficits are running far away from our tax base and will need to be massively monetized for years to come.

    The simple truth is the U.S. dollar is under increased assault from negative real interest rates, years of money printing courtesy of the Fed, and a national debt the government will try to inflate away – these facts aren’t made less painful just because the Europeans are on a mission to destroy their currency. The announcement by Draghi that he will move heaven and earth in an effort to immediately create inflation should be sending the citizens belonging to the nineteen member nations of the European Union who use the Euro into a panic. Central bankers are causing the holders of all fiat currencies to eschew that paper in favor of gold.

    But in today’s world of trading robots and dullard money managers, the algorithms are programmed to sell gold ETFs whenever the DXY is in the green. However, once it becomes clear that the economies of Europe and the United States are not that different, the ECB and Fed will have similar monetary policies. When that happens the U.S. dollar will rollover against the euro and send Wall Street scrambling back into gold ETFs, as the intrinsic value of the dollar takes a dramatic step lower.

    Global central banks are printing fiat currency at a record pace in order to keep borrowing costs at an all-time low. Indeed, all fiat currencies have gone extinct throughout history. Massive and unprecedented money printing on a global scale will not alter history’s fate.

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    The Success of Irish Austerity: The Joke is on Krugman
    November 23rd, 2015

    During the late 1990s, Ireland’s economy was booming. This was mostly due to a low corporate tax rate of just 12.5% and an international real estate bubble that boosted global Gross Domestic Product (GDP). For a myriad of reasons Ireland was a magnet for foreign direct investment and the envy of Europe.

    Buoyed by cheap money, the Irish government embarked on a debt-fueled property boom from 1997 to 2006, which caused the price of an average house to jump more than four-fold. Flush with tax revenue the government also went on a spending binge: investment in Ireland's health service soared by five times and pay for government workers doubled.

    Unfortunately, the world-wide financial crisis sent Ireland's boom economy to bust almost overnight; GDP declined more than 14% in the following two years. And, the government's budget went from surpluses during 2006 thru 2007, to a staggering deficit of 14.3% of its GDP in 2008.

    In response to this economic crisis the Irish people and elected officials did something few countries are willing to do: they embraced fiscal austerity. The government slashed spending and raised taxes. Since 2008, seven budgets have taken €28 billion ($38 billion) out of the economy in spending cuts and tax hikes, which amounts to 17% of today’s GDP.

    Fiscal austerity runs counter to the popular Keynesian dogma that in times of crisis governments should spend their way out of economic downturns--regardless of the current level of debt. And while I would have preferred Ireland cut additional spending in lieu of raising taxes, I applaud the people’s resolve to embrace smaller government in place of the reckless deficit spending that is in vogue today.

    However, Ireland’s belt tightening hasn’t garnered similar favor by all economists. And it has particularly gotten under the skin of the king apologist for Keynesianism….Paul Krugman.

    Krugman, who is completely chagrinned by Irish austerity, has devoted an inane amount of time and ink scolding Ireland’s austerity plan and has consistently predicted the country’s imminent economic demise. Even making it personal in a 2010 column where he mocked, “The best thing about the Irish right now is that there are so few of them.” This leaves anyone familiar with the history of Ireland’s sad past with famine that wiped out over one million people, justified to question the true conscious of this particular liberal.

    Krugman asserts budget-cutting should be postponed until Ireland is no longer embroiled in a “liquidity trap”. This liquidity trap he fears is in actuality the free market’s way of healing the economy through debt reduction. However, Krugman is convinced that only reckless government deficit spending can free economies from this so called trap. And that Ireland should emulate Japan, which is suffering through its third recession in as many years, a multitude of lost economic decades, a cascading currency, and on the way to spending themselves into a debt to GDP ratio of 250%. That’s a hell of a price to pay in order to avoid economic reality while patiently awaiting freedom from their “liquidity trap”.

    It is clear Krugman fears Ireland’s success with austerity will serve to counter John Maynard Keynes’s deficit spending doctrine. Thus, calling into question everything he holds dear. So let’s have some fun and see who is faring better – the austere Emerald Island or the Land of the Rising Budget Deficits. After all, there is no better anti-austerity experiment than the nation of Japan.

    In the immediate wake of its austerity plan, Ireland’s economy expanded slowly during the 2010-12 period. However In 2014 the Irish economy grew at a pace of 4.8%, making it the fastest-growing country in the European Union, and with a faster growth rate than the United States in each year since the Great Recession. The Irish economy grew 1.9 % for the second quarter ending in June of 2015, following an upwardly revised 2.1% expansion in first quarter of 2015—which was way above Krugman’s and the market’s expectations.

    Ireland achieved this growth while dragging their budget deficit down to 4.1% of GDP, from the 14.3% in 2008. The country was also the first Eurozone country to exit a rescue program by the IMF. Ireland’s seasonally adjusted jobless rate fell below 9% for the first time since 2008, to 8.9% in October of 2015.

    For a fleeting moment in December 1989, the Japanese stock market (Nikkei 225) surpassed the U.S. market in size as it hit its peak at 38,916 and a P/E ratio of 80 times; Japanese real estate accounted for half the value of all land on earth at US$24 trillion. When Japan’s real estate and stock market bubble burst the Japanese were diligent Keynesians embarking on spending programs in the 1990’s totaling more than 100 trillion yen. Where has all this spending gotten Japan? Two and one half consecutive lost decades and counting.

    Much to Krugman’s delight, in 2012 the Japanese embraced Abenomics, an economic strategy that doubled down on the same specious spending and money printing the Japanese were already engaged in. With one of Abe’s three arrows directed at increasing government deficit spending, Japan is currently running a budget deficit that is 8% of GDP. With another arrow aimed at currency destruction to goose exports. However, we just learned that Japanese exports fell in October for the first time in fourteen months. And in fact, the only target Abe’s arrows appears to be accurately hitting is a recession.

    Most recently, the Japanese economy shrank 0.2% for the September of 2015 quarter and has been unable to provide a sustainable recovery in GDP growth since the end of the Great Recession.

    More strikingly, Japanese GDP has gone nowhere in nominal terms during the past decade and, thanks to its currency debasement strategy, has sharply contracted in real terms.

    But none of this dissuades Krugman from believing the only thing lacking in Abenomics is its conviction to do more of the same. Krugman selects to trust his lying eyes, preferring to pursue lost decades over a few austere years. In a column penned in 2013 he childishly blustered that, “The repeated invocation of Ireland as a role model has gotten to be a sick joke.” Nevertheless…It appears this time the joke is on him.

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    How the Great Depression 2.0 Will Soon Unfold
    November 16th, 2015

    Those who place their faith in a sustainable economic recovery emanating through government fiat will soon be shocked. Colossal central bank counterfeiting and gargantuan government deficit spending has caused the major averages to climb back towards unchanged on the year. Zero interest rate and negative interest rate policies, along with unprecedented interest rate manipulations, have levitated global stock markets. But still, sustainable and robust GDP growth has been remarkably absent for the past 8 years.

    Equity prices have now become massively disconnected from underlying economic activity, and the recession in corporate revenue and earnings growth is exacerbating this overvalued condition. Throw in the fact that earnings have been manipulated higher by Wall Street’s recent prowess in the art of financial engineering, and you get an extremely combustible cocktail.

    I have been on record saying this will end in chaos and here is how I think it will unfold:

    Global central banks have universally adopted inflation targets, yet claim those goals have yet to be met. This is because of the inaccurate way governments measure consumer price inflation. Nevertheless, most of the new money created has been pushed directly into real estate, equities and bonds by financial institutions; thus primarily inflating the asset prices of the rich and increasing the wealth gap. And since these economic leaders equate growth with inflation, the inability to achieve inflation targets is viewed also as the primary reason why growth has remained so elusive.

    To bring inflation sustainably above the stated goals of 2% the private banking system would have to be able to push credit directly onto debt disabled consumers, which is impossible unless real income growth, after decades of falling, suddenly begins to surge; and/or consumer debt levels were dramatically pared down.

    Therefore, central banks would need to inject credit directly into consumer’s bank accounts while pushing deposit rates sharply into negative territory. In order for that to be truly effective they would also have to ban physical currency. To date no central bank has dared to use these drastic measures to meet their inflation targets…although if they did, intractable inflation would be guaranteed.

    Governments have failed to reach their stated inflation and growth targets through the current “conventional” strategies of currency depreciation and manipulating the yield curve to record lows. The salient issue being that chronically low nominal GDP growth rates are resulting in an insufficient tax base to handle the sharply mounting global deficits and debt. Japan is a perfect example of the flawed strategy of producing growth through inflation: the nation is suffering through its third recession since 2012, despite Prime Minister Abe’s monumental efforts to lower the value of the yen and ramp up government deficits.

    Enormous increases in government debt have historically caused sovereign debt yields to spike, causing debt service payments to become unmanageable. The recent European debt crisis is a perfect example of this:

    Back in 2012, creditors grew wary of the countries referred to as PIIGs (Portugal, Ireland, Italy and Greece); and their ability to pay back the massive amount of outstanding debt they had accumulated. Consequently, creditors drove interest rates dramatically higher to reflect the added risk of potential defaults. For example, in Portugal the Ten-year Note went from 5% to 18%, as government debt to GDP soared from 70%, before the crisis, to where it sits today at 130%. But thanks to their European Central Bank’s (ECB) policy of buying ever-increasing amounts of Portuguese debt, that yield today stands at just 2.7%

    The ECB, the Bank of Japan (BOJ) and the Peoples Bank of China (PBOC) have already promised the markets to artificially hold borrowing costs at record lows as they try to inflate their way out of a debt crisis. This is why ECB head Mario Draghi felt compelled to “do whatever it takes” to keep bond yields quiescent. This commitment of government to usurp control over the entire sovereign debt market is spreading across the globe.

    The Federal Reserve is about to join these other central banks once the insipient U.S. recession manifests, even to the eyes of an economically-blind member of the FOMC. This dilating epiphany will occur as annual deficits vault once again over one trillion dollars and pile onto the $18.6 trillion dollar debt. It will be at that point all major global central banks will be in a position of permanently monetizing most, if not all, of the massive sovereign debt issuances.

    The mandatory strategy of allowing deflation to rebalance debt levels and return asset prices to a sustainable equilibrium has become anathema to global leaders because the temporary depression that would result is politically untenable. Instead, Gov't Leaders are 100% committed to the flawed and baneful strategy of trying to create viable GDP growth through prodigious currency depreciation, interest rate domination and inflation.

    In order to facilitate this inflation scheme, Central banks, in full cooperation with governments, are swiftly moving to the strategy of circumventing the banking system and directly monetize sovereign debt. The bottom line is intractable inflation has been the inevitable and tragic fate of all insolvent governments.

    But this scenario of central bank over reach is not just the ramblings of some Cassandra. The new Economic Counselor for the International Monetary Fund (IMF), Maurice Obstfeld, called for unconventional intervention in an interview ahead of the annual IMF research conference. This economic leader of the new world order said, “I worry about deflation globally…It may be time to start thinking outside the box…at the zero lower bound, our options are much more limited…In order to bring inflation expectations firmly back to 2% in the advanced countries, where we’d like to see it, it’s probably going to be necessary to have some overshooting of the 2% level…”

    And if that wasn’t telling enough here is a striking excerpt from a paper prepared by Adair Turner who is a member of The Bank of England’s Financial Policy Committee, which supports my contention that central banks are exploring the option to directly finance government spending. From the Wall Street Journal:

    “One option is for central bankers to overtly finance increased budget stimulus with permanent increases in the money supply. Japan will be forced to use such ‘monetary financing’ within the next five years and the policy should become a normal central bank tool for all economies facing stagnation.”

    We now have the all conditions in place for an unprecedented breakout of worldwide stagflation; secular economic stagnation, insolvent governments and central banks that are willing to enable a humongous increase in deficit spending by permanently monetizing that debt. Sadly, the fiscal and monetary conditions for global economic chaos have now been set in stone. It’s only a matter of time. And unfortunately, that time is short.

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    U.S. Manufacturing Renaissance Turns Into the Dark Ages
    November 6th, 2015

    The October ISM Manufacturing Index, which has been the official barometer of the U.S. manufacturing sector since 1915, came in with a reading of just 50.1. This was a level barely above contraction.

    Of the 18 industries surveyed in the Regional Manufacturing Survey, 9 reported contraction in October: Apparel, Leather & Allied Products; Primary Metals; Petroleum & Coal Products; Plastics & Rubber Products; Electrical Equipment, Appliances & Components; Machinery; Transportation Equipment; Wood Products; and Computer & Electronic Products. And of those nine, the energy market in particular continues to struggle the most. One respondent in the survey noted that the effects of the weak energy market are now beginning to bleed into other areas of the economy.

    In addition to this, new orders for U.S. factory goods fell for a second straight month in September (down 1.0 %), confirming the manufacturing sector in the United States has hit a downturn. In fact, U.S. Factory Orders have fallen y/y for 11 of last 14 months; and contracted 6.9% from September 2014.

    Furthermore, demand for durable goods fell 1.2% in September. While demand for nondurable goods (goods not expected to last more than three years) fell 0.8%. This placed downward pressure on GDP in the third quarter leading to a disappointing 1.5% GDP read.

    During the month of September a majority of U.S. states reported jobs losses, as the slowing manufacturing sector weighed on hiring nationwide. The Labor Department recently announced that 27 states actually lost jobs in the month of September. This data belies the rosy headline 271k Non-Farm Payroll report issued for October: the Labor Department releases individual state data a month in arrears.

    All this bad news begs the question: Has the former manufacturing renaissance in the United States officially turned back into the dark ages?

    Despite huge kudo’s to U.S. ingenuity for inventing fracking and horizontal drilling technologies, the viability of these innovations depends upon an unsustainable bubble in oil prices. Fracking is just one example of the misallocation of capital resulting from faulty price signals derived from central banks’ manipulation of interest rates.

    And this failure isn’t limited to our Federal Reserve. The strategies of central banks all over the world are failing.

    The European Central Bank (ECB) to date is in the process of printing the equivalent of $67 billion of QE per month, which will amount to a total of $1.2 trillion (or 1.1 trillion euros) by the time Mario Draghi’s QE program is slated to end in September of 2016.

    Considering all that money printing, GDP in the Eurozone was only a pathetic 1.2% larger than it was one year ago.

    Once the star of the Eurozone economy, German GDP disappointed with growth of 0.4% for the second quarter instead of the 0.5% analysts had been expecting. The French figure came in completely flat, and Italy, the Eurozone’s third biggest economy, disappointed with growth of just 0.2%.

    Italy’s unemployment rate managed to fall in September, even as its economy lost 36,000 jobs during the month. This was because more discouraged workers left the workforce. As growth rates languish and economies lose jobs, central banks are getting more and more desperate to create inflation, which they like to masquerade as growth.

    But the sad truth is even with over a trillion Euros of new money printed, governments are not achieving the inflation rates or the GDP growth they are seeking.

    And then we have Japan, which is entering into its 3rd recession since the Abenomics regime took control in December 2012. The BOJ has been in the habit of printing 80 trillion yen each year! Nevertheless, its debt to GDP is approaching 250%, and annual deficits are 8% of GDP. The BOJ is buying 90% of all the bonds issued, and now owns half of all Japanese ETF’s. Yet despite a train wreck of an economy and horrific debt and deficits the 10 year note—in a perfect example of a central bank distorting economic reality--is yielding just 0.3%.

    Our Fed has printed $3.5 trillion since 2008 in a futile attempt to get the economy growing at what Keynesians term as escape velocity. However, we have only averaged 2% growth since 2010. And growth in 2015 appears to be even less, as the all-important manufacturing sector is now clearly in a recession, and is now dragging down the rest of the economy.

    Today, there are no free markets left anywhere in the world. Governments control the fixed income, equity and real estate sectors; and therefore control the entire economy. And what was once touted as the U.S. manufacturing renaissance has morphed into another example of how government’s abrogation of free markets will ultimately result in economic chaos and entropy.

    Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

     

    Global Fiscal and Monetary Madness
    November 2nd, 2015

    Last week China’s central bank (the PBOC) cut borrowing costs for the sixth time in a year and eased the reserve requirement ratio (RRR) for the third time this year, in a desperate attempt to achieve the prescribed growth target of 7% off the back of ever-increasing credit issuance. The PBOC lowered the one-year benchmark bank lending rate by 25 basis points to 4.35%, the one-year benchmark deposit rate was also lowered by 25 basis points to 1.5%.

    In addition to this, the RRR was cut by 50 basis points for all banks, bringing the ratio to 17.5% for the biggest lenders, while banks that lend to small companies and agricultural firms received an additional 50-basis-point reduction to their RRR.

    This latest round of easing followed a report showing that despite a surprise devaluation of the yuan in August, economic growth in the third quarter was the slowest in six years. Goldman Sachs Group Inc. estimates the easing will release 600 to 700 billion yuan ($94 billion to $110 billion) into the financial system, keeping borrowing costs at the regime’s all-time low.

    These destabilizing moves come on the heels of a steep stock market decline in August and concerns that Communist China’s growth fairy tale has come to an unhappy end. Here are some troubling economic statistics about China’s growth aggregated by Zero Hedge:

    • China export trade: -8.8% year to date
    • China import trade: -17.6% year to date
    • China imports from Australia: -27.3% year over year
    • Industrial output crude steel: -3% year to date
    • Cement output: -3.2% year over year
    • Industrial output electricity: -3.1% year over year
    • China Manufacturing Purchasing Managers Index: 49.8 (below 50 is contractionary)
    • China Services Purchasing Managers Index: 50.5 (barely in growth category)
    • Railway freight volume: -17.34% year over year
    • Electricity total energy consumption: -.2% year over year
    • Producer price index (PPI): -5.9% year over year, 43 consecutive months of declines
    • China hot rolled steel price index: -35.5% year to date
    • Shanghai Stock Exchange Composite Index: -30% since June

Yet despite data points that indicate a significant slowdown in growth, China alleges it had a 6.9% growth rate in the 3rd quarter. Unfortunately, fantasy GDP numbers don’t feed the masses or calm social unrest. Recent actions from Beijing clearly indicate China is more concerned about avoiding a recession than it is about raising GDP growth above its supposed current 6.9%.

But here’s a news flash for the Communist nation and all other global fiscal and monetary planners: Money printing and government deficit spending doesn’t lead to viable economic growth.

For years China bought into to the popular Keynesian myth that mindless government spending spawns sustainable long term growth. In order to fabricate a consumer class to rival the United States, the government built cities, bridges and airports with no viable productive value. Unfortunately, they are now reaping the downside of investing in non-productive assets: when the feckless spending ends you are left with non-productive assets, but still stuck with the debt that was used to erect them.

But this misallocation of capital has not only left empty cities, but empty pockets as well. Many of the loans used to finance idle construction will never get repaid; yet these banks continue to roll over these loans in the same manner as Japan’s 1990’s Zombie banks.

Most importantly, what the PBOC, ECB, BOJ, Fed et al, all fail to understand is that cutting the cost of money and flooding the banking system with credit only leads to the piling up of excess reserves on central bank balance sheets. The point here is that lowering interest rates and cutting the cash to deposit ratio doesn’t lead to a huge increase in consumer borrowing when the private sector of the economy is debt disabled. And even if governments were able to increase the money supply and the rate of inflation, it would only lead to more capital imbalances and the further evisceration of the middle class—not viable growth.

The economies of the developed world have been living under the fantasy that if you can shove more credit upon debt-disabled consumers the economy will be saved from slow growth and deflation. Increasing the purchasing power of consumers is actually essential for true economic healing to occur, but that is anathema to those that currently hold sway.

Since the government mandated inflation and growth goals have not been achieved after seven years of unprecedented efforts, I believe central banks will soon resort to completely circumnavigating the banking system and directly force credit onto the public sector. But that still won’t lead to economic nirvana…instead it will ensure that the economy will suffer through its first worldwide inflationary depression.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Fed Headed into Inflation Overdrive
October 23rd, 2015

Seven years of extraordinary fiscal and monetary stimuli are proving ineffective towards achieving the growth and inflation targets laid out by the Federal Reserve. The Consumer Price Index (CPI), the Producer Price Index (PPI) and Gross Domestic Product (GDP) have all failed to grow over 2%. This is because asset prices, at these unjustified and unsustainable levels, need massive and ever increasing amounts of QE (new money creation) to stave off the gravitational forces of deflation. Fittingly, it isn’t much of a mystery that the major U.S. averages have gone nowhere since QE officially ended in October of 2014.

According to the highly accurate Atlanta Fed model, GDP for Q3 will be reported at an annual growth rate of just 0.9%. And things don’t appear to be getting any better for those who erroneously believe growth comes from inflation: September core retail sales fell 0.1%, PPI month over month (M/M) was down 0.5% and year over year (Y/Y) was down 1.1%. CPI was down 0.2% M/M and the Y/Y headline level was unchanged.

While the deflation effect from plummeting oil prices wears off by years-end, there is no reason to believe the same deflationary forces that sent oil and other commodities down to the Great Recession lows won’t start to spill over to the other components, such as housing and apparel, inside the inflation basket. This would especially be true if the Fed continued threatening to raise interest rates and driving the U.S. dollar higher.

Central banks and governments can always produce any monetary environment they desire. It is a fallacy to believe that deflation is harder to fight than inflation. Deflation is currently viewed as harder to fight because the policies needed to create monetary inflation have not yet been fully embraced—although this is changing rapidly.

The Fed just can’t seem to grasp why its newly minted $3.5 trillion since 2008 hasn’t filtered through the economy. But this is simply because debt-disabled consumers were never allowed to deleverage and markets were never allowed to fully clear.

But the Fed isn’t one to let the truth get in the way of its Keynesian story. And why should it? Financial crisis is the mother’s milk of increased central bank power. For example, before the last financial crisis the Fed was unable to buy mortgaged back securities; rules were then changed to allow it to purchase unlimited quantities of distressed mortgage debt. The Fed is perversely empowered to continue making greater mistakes, thus yielding them greater authority over financial institutions and markets.

Since 2008 the rules and regulations fettering Central Banks have become more malleable depending on the level economic distress. Congress has mandated that the Fed can not directly participate in Treasury auctions. But there is no reason to believe in the near future that this law won’t be changed to better accommodate fiscal spending.

Strategies such as: pushing interest rates into negative territory, outlawing cash, and sending electronic credits directly into private bank accounts may appear more palatable in the midst of market distress. The point is that Central Banks and governments can produce either monetary condition of inflation or deflation if the necessary powers have been allocated.

In the Fed’s most recent dot plot (a chart displaying voting member’s expectations of future rates) the Minneapolis Fed’s Kocherlakota was mocked as the outlier for placing his interest rate dot below zero. However, persistent bad economic news has quickly driven the premise of negative rates into the mainstream. Ben Bernanke told Bloomberg Radio that despite having the “courage to act” with counterfeiting trillions of dollars, he thought other unconventional issues (such as negative interest rates) would have adverse effects on money market funds. However, anemic growth in the U.S., Europe and China over the past few years has now changed his mind on the subject.

Supporting this notion, the president of the New York Fed, William Dudley recently told CNBC, “Some of the experiences [in Europe] suggest maybe can we use negative interest rates and the costs aren’t as great as you anticipate.” Indeed, over in Euroland, ECB President Draghi hinted recently that the current 1.1 trillion euro ($1.2 trillion) level of QE would soon be increased, its duration would be extended and deposit rates may be headed further into negative territory.

Statements such as these have me convinced that negative interest rates in the U.S. are likely to be the next desperate move by our Federal Reserve to create growth off the back of inflation. After all, the Fed is overwhelmingly concerned with the increase in the value of the dollar. Keeping pace with other central banks in the currency debasement derby is of paramount importance. Outlawing physical currency and granting Ms. Yellen the ability to directly monetize Treasury debt and assets held by the public outside of the banking system could also be on the menu if negative rates don’t achieve her inflation mandates.

Instead of repenting from the fiscal and monetary excesses that led to the Great Recession the conclusions reached by government are: debt and deficits are too low, asset prices aren’t rising fast enough, Central Banks didn’t force interest rates down low enough or long enough, banks aren’t lending enough, consumers are saving too much and their purchasing power and standard of living isn’t falling fast enough.

The quest of governments to produce perpetually rising asset prices is creating inexorably rising public and private debt levels. The inability to generate inflation and growth targets from the “conventional” channels of interest rate manipulation and the piling up of excess reserves are leading central banks to come up with more desperate measures.

We can see more clearly where Keynesian central bankers are headed by listening to NY Times columnist Paul Krugman’s suggestions for Japan to escape its third recession since 2012. He recently avowed that Japan needs much more aggressive fiscal and monetary stimulus to escape its “liquidity trap” and “too-low” rate of inflation. However, his spurious argument overlooks that the Bank of Japan is already printing 80 trillion yen each year, its Federal Debt is spiraling north of 250% of GDP, and the annual deficits are currently 8% of GDP.

Here it is in his own words: “What Japan needs (and the rest of us may well be following the same path) is really aggressive policy, using fiscal and monetary policy to boost inflation, and setting the target high enough that it’s sustainable. How high should Japan set its inflation target…it’s really, really hard to believe that 2 percent inflation would be high enough.”

You see! According to this revered Keynesian economic expert if what you’ve already done in a big way hasn’t worked all you need to do is much more of the same.

Unfortunately, Krugman and his merry band of arrogant Keynesian haters of free markets represent the conscious of global governments and central bankers. What they indeed are creating is a perfect recipe for massive money supply growth and economic chaos. Therefore, if these strategies are followed, it will inevitably lead to a worldwide inflationary depression. And this is why having a gold allocation in your portfolio is becoming increasingly more necessary.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Tea Party is Drinking Too Much Decaf
October 19th, 2015

On December 16th, 1773 the Sons of Liberty in Boston, in protest of the Tea Act, destroyed an entire shipment of tea sent by the East India Company, in a political protest referred to as the Boston Tea Party.

Following the Wall Street bail-outs in 2009, a political movement also protesting their lack of representation in government sought a reduction of the U.S. national debt and deficits by reducing government spending and lowering taxes. They were referred to as The Tea Party, named from the aforementioned Boston variety.

Since then, supporters of the Tea Party have had a major impact on the internal politics of Republicans and have helped secure both houses of congress. But these representatives who were elected to bring fiscal discipline to Washington have failed to deliver on their promises.

A year before The Great Recession the Federal deficit was $162 billion, it peaked in 2009 at $1.45 trillion and this year came in at $439 billion, and is projected to increase significantly after 2018. All this overspend has driven our national debt to over $18 trillion dollars, which is already north of 100% of the Gross Domestic Product.

The Congressional Budget Office (CBO) is on record stating the relationship between debt and GDP is on, “a trend that cannot be sustained indefinitely,”

Just recently, the Treasury department announced the government will reach its borrowing limit around Nov. 3th, causing Republicans to circle the wagons and threaten to shut the government down. But their threats were not really aimed at Washington’s overspend, instead the Tea Party Republicans are linking the battle over the continuing resolution to keep the government operational, with the fight to defund Planned Parenthood.

Whatever your opinion is on Planned Parenthood, my own is that it is an institution that doesn’t need government funding and its practice of selling aborted babies’ body parts is beyond despicable, it still doesn’t solve our long-term trend towards insolvency.

In fact, the United States government has recorded surpluses for only five years since 1969. In 1995–96 the Republicans shut down government as a result of conflicts over the funding of Medicare, education, the environment, and public health in the 1996 Federal budget. They suffered the consequences of unpopular press that led to the re-election of Bill Clinton and the resignation of House Speaker Newt Gingrich. But the positive impacts of the shutdown included the balanced-budget deal in 1997 and the first four consecutive balanced budgets since the 1920s.

The U.S. government's total revenue is projected to be $3.525 trillion for Fiscal Year 2016, this will only pay for 88% of spending, creating an estimated $474 billion deficit. And that rosy revenue projection includes a GDP estimate of 3.1%--a growth rate not seen in the last 10 years. Also, the U.S. economy is in the sixth year of expansion and a recession is more than likely next year.

$2.543 trillion of this 2016 spending is deemed as “mandatory”. Social Security is the largest mandatory expense, at $938 billion. Medicare is next, at $583 billion, followed by Medicaid at $351 billion.

Social Security is split into two parts Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI); the combined acronym for both is OASDI.

Both programs have their challenges, however since the Great Recession DI has been misused as an extension of unemployment benefits and is set to run out of funds in 2016.

Until 2010, there was more collected in tax revenue paid into the OASI Social Security Trust Fund than being paid out. That surplus was just lent to the Federal government to cover general expenses. Thanks to interest on those “investments”, the OASI Trust Fund is still running a surplus. However, the Board of the Fund estimates that this “surplus” will be depleted by 2036. At that time, Social Security revenue from payroll taxes will cover only 77% of the benefits promised to retirees.

Then we have Medicare which is already underfunded. Medicare taxes don't pay for all benefits, so this program relies on general tax dollars to pay for a portion of it.

According to the Medicare Trustee Report projections indicate that Medicare faces a substantial financial shortfall and is not adequately financed. The trust fund becomes depleted in 2030. The Trustee report states: “Such legislation should be enacted sooner rather than later to minimize the impact on beneficiaries, providers, and taxpayers. The Board recommends that Congress and the executive branch work closely together with a sense of urgency to address these challenges.”

The respective boards are petitioning Washington to address the solvency of the Social Security and Medicare Programs, yet President Obama prefers to preach about Global Warming. When these programs become insolvent due to Washington’s inaction the next generation of seniors are going to hope the planet really gets a lot warmer because many will be forced to live on the street.

The fastest growing mandatory payment is the interest on our ballooning national debt. The U.S. has been fortunate for the past few years because interest rates have been artificially manipulated to record lows. However, eventually yields will mean revert and so will interest payments.

The greatest real risk to all Americans is the burden of future interest payments on government debt. The CBO’s baseline projects that net interest payments will more than triple under current law, climbing from $231 billion in 2014, or 1.3 percent of GDP, to $799 billion in 2024, or 3.0 percent of GDP. However, the truth is interest payments are much more likely to reach 30% of GDP if rates were to normalize more quickly.

Discretionary spending is the part of the U.S. federal budget negotiated between the President and Congress each year as part of the budget process. The Constitution gives Congress, not the President, the authority to raise and spend money for the Federal government. Therefore spending can be changed or even reduced to zero if Congress desires.

This is where the remaining 37% of spending is divvied up. Discretionary spending is projected to be $1.168 trillion. About 2/3 of this goes toward military spending; $563 billion pays for other domestic programs like Health and Human Services ($79.9 billion), Education ($70.7 billion), Housing ($41 billion) and the judicial system ($14.9 billion).

In 2013 Congress passed a budget sequestration aimed at reducing discretionary spending. These were automatic spending cuts that came out of the Budget Control Act of 2011 (BCA). The Sequester sought to lower spending by a total of $1.1 trillion versus pre-sequester levels over the 8-year period from 2013 to 2021, with reductions coming equally from defense and other domestic discretionary spending. However the recent passage of the National Defense Authorization Act serves to nullify the promised reduction in defense spending and it is becoming clear both Democrats and Republicans prefer to remove the sequestration spending handcuffs all together.

With the current system of career politicians in place, our elected officials are incapable of fiscal responsibility. Government agencies are warning that our out of control deficit spending is unsustainable. It may take runaway inflation, a deflationary depression, or maybe an inflationary depression—leading to a massive default on the nation’s debt--before fiscal responsibility is forced on Washington.

The Tea Party Representatives need the guts to take on the old two-party establishment system, just like the Sons of Liberty for whom they are named did 240 years ago. As a speaker at a rally back in 2009, I warned the Tea Party not to lose focus on its core platform of hard money and balanced budgets; or to become co-opted by main stream Republicans---unfortunately that is exactly what has occurred.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

One Step Back From the Ledge
October 12th, 2015

I started Pento Portfolio Strategies three years ago with the knowledge that the unprecedented level of fiat credit creation had rendered the globe debt disabled and would result in mass global sovereign default. As a consequence, there would be wild swings between inflation and deflation dependent upon the government provisions of fiscal stimulus, Quantitative Easing and Zero Interest Rate Policies…

For much of the third quarter the US Federal Reserve has avowed to raise rates. This in turn caused a sharp stock market correction on a worldwide basis. The flattening of the Treasury yield curve and the strengthening of the US dollar were the primary culprits. But then the September Non-Farm Payroll Report came in with a net increase of just 142k jobs, which was well below Wall Street’s expectation. The unemployment rate held steady at 5.1% but the labor force participation rate dropped to the October 1977 low of 62.4%. Average hourly earnings fell 0.04% and the workweek slipped to 34.5 hours. There were also significant downward revisions of 22k and 37k jobs for the July and August reports respectively.

The jobs data had previously been heralded by the Fed and Wall Street as the one bright spot in an otherwise dull economic picture; and gave the Fed extra incentive to move off of zero—as if offering free money to banks for seven years wasn’t compelling enough. But at least for now the weak data has caused the Fed to step back from jumping of the cliff on raising rates, which has caused a swift move lower in the value of the dollar and boosted the prospects for multi-national corporate earnings.

The reasons why Wall Street is so enamored with ZIRP and QE are clear. Here is a partial list of what will start to occur once the Fed moves away from the zero-bound range:

  • Debt service payments will begin to rise on the soaring outstanding $44 trillion in total non-financial US debt–$12 trillion of which was accumulated in the last decade. This will render the already debt-disabled consumer increasingly unable to borrow and spend.
  • The value of US high-yield (junk) debt outstanding has doubled since 2009. Many companies have survived by rolling over this debt at record-low and perpetually falling yields. Default rates will spike as Junk-bond prices begin to fall and yields start to rise.
  • Rising rates will decrease the home ownership rate of 63.4%, which is already at its lowest level since 1967. A rate rise will also cause home prices to fall back toward the historic home price to income ratio of 2.6; it is now 4.4.
  • The Mean reversion of interest rates on the $13.2 trillion of US publicly traded debt would then take about 30% of all the Federal tax revenue. Rising rates would also cause annual deficits to jump back to $1.5 trillion as they did in the great recession, causing outstanding debt levels to rise inexorably, thus eating up a much greater portion of tax revenue.
  • There is $9.6 trillion of US dollar denominated debt owned by non-US borrowers. As the US dollar rises debt payments become more challenging to manage and would cause rising defaults on marginal foreign corporate holders.
  • It will sharply attenuate the amount of stock buy backs, which were done mostly by taking on new debt ($2.9 trillion worth since March of 2009) for the purpose of artificially boosting EPS. This would cause EPS and PE multiple contraction, sending the stock market into freefall.
  • The impaired credit of hundreds of trillions’ worth of interest rate derivatives, such as credit default swaps and interest rate swaps, which will need an unprecedented bailout from the government once the counterparties become insolvent.
  • Finally, pension plans will become bankrupt once the Fed succeeds in flattening the yield curve and completely crashing the stock market and the economy. Pension plans need 9% annual returns to fulfill their obligations. But the stock market has gone nowhere in the past 14 months even though the Fed has assured the country that there would be no competition for stocks from the fixed income sector for the past 7 years. Rising rates would most likely cause the stock market to lose half its value for the third time in the last 15 years.

Those are the reasons why the Fed is so afraid to start hiking interest rates.

The highly accurate Atlanta Fed’s GDP model is predicting Q3 growth of just 1.1%. As a consequence, the Fed Funds Futures Market now is predicting that ZIRP will be in place until March of 2016. Will five more months of ZIRP be enough to levitate stocks? The answer to that question is probably yes in the short term; but it will lead to a catastrophe in the long term.

The simple truth is QE and ZIRP blow up asset prices to an unsustainable level, but do nothing in the way of supporting viable economic growth. The proof of this can best be found in Japan, where the Bank of Japan is printing 80 trillion yen ($665 billion dollars) per annum but has rendered the nation in a perpetual recession. Indeed, after three years of Abenomics the nation will probably suffer through its third recession in as many years—Q2 GDP came in at an annualized minus 1.6%.

Further evidence of the ineffectiveness of central planning can be found in the United States, where we have experienced sub-par 2% growth for the last 5 years despite unprecedented monetary easing. And 2015 is now on track to underperform that low five-year bar.

The IMF recently lowered its global growth projection by 0.2 percentage points to 3.1%. This includes an overly optimistic 6.8% read on China growth.

The Real Danger

The real danger is that the higher asset prices get pushed by central banks and governments with fiscal and monetary stimuli, the more precariously they become perched high on top of a hollow economic foundation.

With ZIRP in place for another five months, this ominous condition should only worsen. However, it also means that whenever the Fed resumes its bluster about raising rates, the markets will careen lower from an even higher level. In addition, central banks’ inability to engender the promised prosperity is rapidly eroding confidence in these institutions. Therefore, there is a growing risk that the markets will collapse despite perpetually free money—especially in real terms. Such will be the unfortunate but inevitable consequences of obliterating honest money and free markets.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Jobs Report Moves Fed One Step Closer to QE IV
October 5th, 2015

The September Non-Farm Payroll Report came in with a net increase of just 142k jobs. The unemployment rate held steady at 5.1% and the labor force participation rate dropped to the October 1977 low of 62.4%. Average hourly earnings fell 0.04% and the workweek slipped to 34.5 hours. There were significant downward revisions of 22k and 37k jobs for the July and August reports respectively.

Just as important as today’s NFP report, but mostly overlooked, was the Challenger’s Job-Cut Report released on Thursday. It showed the September layoff count jumped from 41,186 in August to 58,877. The total number of layoffs year-to-date is 493,431, which is already higher than all of last year and is on a trajectory to be the greatest number of layoffs since 2009.

The tenuous state of our economy has led to an unskilled and unproductive labor force. According to the Bureau of Labor Statistics (BLS) an employed person constitutes anyone who worked for pay during the survey week. Therefore, if you provided one Uber ride around the block the BLS considers you employed with the same economic relevance as a full-time brain surgeon. In fact, our part-time low-paying job market is the reason productivity growth has averaged a meager 0.45% annually during the past four years.

So Where Does This Lead the Fed?

The real issue is despite Yellen’s recent nod to a slowing global economy, the FOMC still remains obsessed with the relatively low unemployment rate. This is because of the wrong-minded belief that too many workers will suddenly hyper-inflate our deflating worldwide economy.

While Yellen and Company busily tinker with their Phillips Curve models--in a fatuous attempt to determine how many Americans they should allow to find work--they are missing the crumbling economic fundamentals all around them. The flattening yield curve, plummeting commodity prices, and weakening U.S. and international economic data; all illustrate that the asset bubbles created by central banks have started to pop.

Despite today’s disappointing jobs report, the Federal Reserve continues threatening to commence a rate hiking cycle in the misguided fear of inflation emanating from a meaningless U-3 unemployment rate. What Keynesian central bankers fail to understand is Inflation only becomes manifest when the market loses faith in a fiat currency’s purchasing power, not from more people becoming productive. Nevertheless, the Fed’s models stipulate that a low unemployment rate breeds intractable inflation and the liftoff from ZIRP is set for the end of 2015. That is unless the U-3 unemployment rate turns around and starts heading north.

However, this go around the Fed will be raising rates into a yield curve that is already flat in historic terms and becoming narrower, and credit spreads that are already blowing out. Ms. Yellen will be hiking rates into falling long-term Treasury yields, falling Core PCE inflation data, slowing global GDP growth, and tumbling equity and junk bond prices. The only good news here is the Fed is moving towards a free-market interbank lending rate; and in the long term this is great for markets and the economy. But in the short term it will resume the cathartic deflation of asset prices and debt that was short circuited back in 2008.

Over 100 of the S&P 1500 stocks have fallen more than 50% and 600 are down more than 25% from the high. The S&P 500 dropped nearly 8% in Q3 and is down two consecutive quarters. The Dow Jones Industrial finished down three quarters in a row. Meanwhile, the manufacturing numbers in the US are in freefall and the Atlanta Fed forecasts growth of just 1.8% during Q3. And the IMF is set to lower its overall forecast of global growth again next week from its already anemic 3.3%.

On top of the slowing global growth and hawkish-sounding Fed, we find stock market valuations that are still the second highest in its history. For these reasons I believe the S&P 500 is going to trade down to the low 1,600 area in the next few months before possibly stabilizing. But exactly how low we end up going at least partially depends on how long the Fed blusters about normalizing interest rates. However, with the gravitational forces of deflation getting stronger, the FOMC will not be able to get far off the zero-bound range.

Hence, the next big prediction of mine is that the Fed will soon change to an easing monetary policy stance and cause weak-dollar investments to rebound, as the USD falls back towards 80 on the DXY. Pento Portfolio Strategies has held 40-50% cash since the end of 2014 in anticipation of this current bear market and recommends holding only those investments that will profit from a turn in Fed policy away from a hawkish position. While more ZIRP and QE may not rescue the overall market or economy, it should at least supply a bid for the beleaguered precious metals sector.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

In Defense of Gold
September 28th, 2015

There has been an unprecedented attack on gold and mining shares over the past three years emanating from financial institutions in order to support the government’s supposed success in bringing the economy back to health. And even though gold mining shares are down 85% during this tenure, the case for owning gold-related investments have never been more compelling.

The reason to own gold is the same today as it has been for thousands of years: it is the perfect store of wealth. Gold is portable, divisible without losing its value, beautiful, extremely scarce, and virtually indestructible. It is simply the best form of money known to mankind.

The case for keeping your wealth in gold only becomes more bolstered when real interest rates are negative, faith in fiat currencies is crumbling, and nation states are insolvent. The massive and unprecedented Quantitative Easing programs and Zero Interest Rate Policies among the Bank of Japan, Peoples Bank of China, European Central Bank and Federal Reserve clearly show that Central Banks have no escape from manipulation of their bond market, currencies, equities and economies. Ms. Yellen’s recent tacit admission that the Fed Funds Rate must remain at zero percent for at least a full seven years was a clear validation of this premise.

For example, if the BOJ were to stop buying every Japanese Government Bond issued; interest rates would skyrocket, the stock market would crash and the economy would melt down in a matter of days. This is because any nation that has a debt to GDP ratio of 250%, over a quadrillion yen in debt, and is in a perpetual recession should never be blessed with a 0.3% 10-Year Note yield.

Turning back to the Fed’s recent decision to hold rates at zero, its inaction should lift the veil on its omnipotence. As Clark Kent can attest, being “Superman” is easy; returning to normal can be awkward.

With $44 trillion in total non-financial debt, which is up $12 trillion in the last 10 years alone, we have also become a highly indebted nation that has become completely addicted to lower rates. The U.S. high-yield bond market, which was the catalyst of the 2008 financial crisis, has grown to $2 trillion in size--a full $1 trillion of these new loans have been added since 2009.

But high yield isn’t the only lesson unlearned since the 2008 crisis. According to CNBC, nearly two-thirds of the high risk Ginnie Mae guaranteed securities are issued by independent mortgage banks, affectionately referred to as part of the “shadow banking system”. And those independent mortgage bankers are deploying some of the most sophisticated financial engineering that this industry has ever seen…sound familiar? With credit scores of 520 and down payments of just 3.5%, indeed it is clear that subprime mortgages are back with a vengeance.

Therefore, a rise in rates would further cool the already lukewarm housing market. According to the National Association of Realtors, sales of existing homes dropped 4.8% in August month over month to a seasonally adjusted annual rate of 5.31 million. Home ownership rates at 63.4% are already at the lowest level since 1967. Rising interest rates would not cause renters to become homeowners. Instead, it would likely send the home price to income ratio, which is currently at 4.4, crashing back to its long-term average of 2.6.

Turning to the interest paid on U.S. bonds, it is clear that mean reversion of the 10-Year Note would bankrupt the Treasury. This is because that average rate is north of 7%. If the Treasury was forced to service the existing $13.2 trillion of publicly traded sovereign debt at that rate it would take about 30% of all Federal tax revenue. Just imagine what will occur when rising rates cause the economy and revenue to decline, as deficits explode. Remember that annual deficits soared to $1.5 trillion during the Great Recession; and that was with interest rates plummeting towards 2%.

And then we have emerging markets, where a rise in US interest rates will reveal one of the great instabilities in the global economic system today. A total of $9.6 trillion in U.S. dollar denominated debt is owned by non-U.S. borrowers. When the U.S. dollar strengthens the cost to those foreign borrowers rises…a lot. Emerging-market economies’ debt is now 167% of their gross domestic product, this is up 50 percentage points since the end of 2007, according to figures from the Bank for International Settlements.

This led the economy of Brazil, which was already suffering the effects of a slowdown in China, to announce austerity measures totaling $17 billion to bridge the gap in its budget, after Standard & Poor’s Ratings Services downgraded the country’s rating to below investment grade.

Turing back to the U.S. stock market, low interest rates have fueled a whopping $2.5 trillion stock buyback binge since the end of March of 2009. Higher interest rates would see the end of this corporate buyback scheme that provides an artificial boost to EPS and share prices.

And not to forget the several hundred trillion dollars’ worth of interest rate sensitive derivatives, including credit default and interest rate swaps underwritten by institutions, which will have to once again crawl back to the government for another bailout once their bets become insolvent.

Finally, seven years of ZIRP has forced pension plans far out along the risk curve in search of higher returns: vastly increasing the amount of equity exposure in the portfolios in an attempt to generate the necessary 9% average annual returns. However, the Dow Jones Industrial Average is already dropped to a two-year low without one single basis point rate hike in the last nine years. Ms. Yellen and company must be aware if a cycle of rate hikes were to take place now it would not only bring increased competition for stocks but also help push the anemic global economy into a recession. The result being that there wouldn’t be a solvent public or private pension plan in the entire nation.

The Fed is beginning to wake up to the fact that there is no easy escape from its artificial zero interest rate policy. The Fed will not be able to move very far off of the zero-bound range before the yield curve inverts and the US, and indeed the entire global economy, melts down. This means real yields will become more negative, the US dollar will lose more of its purchasing power and economic instability will intensify over time—the perfect fundamental backdrop for rising gold prices.

As the credibility and effectiveness of central banks comes more into question, investors will seek comfort in gold because it is the sole monetary solution that has stood the test of time. This is why there is a direct inverse correlation between the faith in fiat currencies and the price of gold. Every few decades a reminder is needed that all fiat currencies throughout history have lost all of their value.

Therefore, if you are among those who own gold and gold mining shares…consider yourself a part of a small and very fortunate club. A cadre of investors that will be able to maintain its purchasing power and standard of living; while those with complete faith in fiat currencies get summarily remanded to the lower class.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

Bear Markets, Recessions and the Bewildered Fed
September 21st, 2015

A popular Wall Street myth is that bear markets are caused by recessions. The contention is as long as the economy isn’t in a recession stock prices won’t drop by more than 20 percent. And since the cheerleaders who dominate Wall Street never predict a recession, it should come as no surprise they never foresee the bear market that always precedes two negative quarters of GDP growth. The truth is Bear markets and recessions do not occur simultaneously, bear markets both predict and help engender a recession to occur.

Typifying this myth is Capital Economics’ Chief Economist John Higgins as he recently argued, "Major declines in the S&P 500 — that is to say, bear markets in which prices drop by at least 20%, which is roughly twice the drop that occurred between 10th and 24th August--have only tended to occur in, and around, recessions…And we doubt very much that one of those is around the corner."

But the truth is bear markets always precede a recession--those who argue otherwise have it exactly backwards. The stock market is a forward looking indicator: it anticipates economic activity yet to come, it doesn’t report on economic conditions that are occurring.

Recent history proves all recessions were preceded by bear markets. Even though the market is guilty of over anticipating a recession, it has never missed predicting one.

For example, the 1987 stock crash brought the Dow Jones Industrial Average down 508 points, a decline of 23%. However, despite the market’s recessionary signal, the US economy did not enter into an economic contraction at all.

Thirteen years later, record valuations drove the NASDAQ down 78% from its highs in the 2000-02 bear market. The market reached its peak on March 10, 2000, with the NASDAQ topping out at 5,132 during intraday trading. However, the economy didn’t produce a negative GDP print until the first quarter of 2001. If you had waited for validation of an economic slowdown you would have lost a lot of money.

Ironically, the economy never entered a true recession with two consecutive quarters of negative GDP data. Instead, we had a negative GDP read in the first and third quarters of 2001, of -1.1% and -1.3%.

Finally, the S&P 500 peaked in October of 2007 but we didn’t see consecutive quarters of negative GDP until the 4th quarter of 2008 (GDP 2008: Q3 -1.9%, Q4 -8.2%). And the recession was still in full force by the time the market reached its bottom in March of 2009. Indeed, Q1 GDP was still shrinking by a -5.4% annual rate.

The jury is still out on whether this recent market sell-off is predicting an official recession. The recent selloff that caused a 12% drop in the S&P 500 may be indeed foreboding a worldwide recession. But unlike the Wall Street carnival barkers who always have good news, the market is at the very least anticipating global economic weakness and the eventual normalization of interest rates. Investors should ignore the message of markets at their own risk.

But the biggest fallacy promulgated on Wall Street today is that the Fed won’t raise rates unless, in divine fashion, it knows the economy will continue to grow at a pace strong enough to sustain a rate hike. This belief suggests the Fed is an oracle of markets.

However, history has proven that the Fed is always clueless about the economic direction. In the FOMC minutes leading up to the 2008 financial crisis, Mr. Bernanke was predicting robust GDP growth and contemplating hiking rates as late as the second quarter of 2008. By this time the markets had declined 15% from the top.

In August 2008, days before the financial markets went into in free-fall, most Fed policy makers convinced themselves that the economy had avoided the worst. Specifically, the Fed minutes from that time stated the following: “Although downside risks to growth remained, they appeared to have diminished somewhat, and the upside risks to inflation and inflation expectations increased.” Nevertheless, in reality the economy was already contracting by -2.7%; and was about to enter into a deflationary depression.

The Fed’s crystal ball led it to conclude the economy was on a modest growth trajectory when it was actually on the precipice of the worst decline since the Great Depression. In fact, GDP dropped a dramatic 8.2% in the fourth quarter.

Unlike free markets the FOMC has no proven predictive powers. What’s worse, its models are all bogus and broken. Therefore, like the cheerleaders on Wall Street, they will have to wait for negative GDP prints before a recession emerges on their radar and for them to become negative on stocks. However, by that time it’s always too late.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

One and Done Fed is a Wall Street Fantasy
September 14th, 2015

One of the current myths promulgated by Wall Street is that the Federal Reserve will raise rates once this year, breathe a sigh of relief, and be done until the “12th of never”. But those who are familiar with our central bank’s history are aware that the Federal Open Market Committee (FOMC) has never tightened the Fed Funds Rate just once. A quarter point hiking cycle has no historical basis and is just wishful Wall Street thinking.

In the spring of 1988 fearing a rise in core inflation, the Fed went on a tightening cycle that lasted from April 1988 to March 1989. During that time the Fed funds rate increased more than 300 basis points. This episode was followed by a recession beginning in 1990, suggesting that the corrective policy actions may have intensified a weakening economy, and that the Fed is prone to being economically tone deaf.

Then, during the fall of 1993, a rise in long rates represented a potential inflation scare and led the FOMC to raise the Funds Rate again another 300 basis points between February 1994 and February 1995.

And finally, as concerns over a potential housing bubble mounted, the Fed began to hike rates in June 2004 and continued through July of 2006, for a total increase of 425 basis points. Soon after, the subprime mortgage crisis was exposed and the Great Recession was in full throttle.

But we don’t have to be Fed soothsayers to predict the planned trajectory of the Funds Rate; the Fed makes its intentions public during four of its eight scheduled meetings. During those meetings the FOMC provides us with a model of the members’ expectations for policy rates in a chart known as the “dot plot.”

While the FOMC is not bound by its "dot plot" predictions, it does provide insight into committee’s monetary policy plans. The markets are aware of their intentions and will begin to price in future interest rates moves as soon as the Fed begins liftoff.

The latest dot plot shows that all 17 members of the FOMC believe the Federal Funds Rate should be under 1% by the end of 2015, with the median member seeing rates between 0.5% and 0.75%. That signals an end to ZIRP (zero interest rate policy). And although members differ on the level of rates at the end of 2016--with the median rate of around 1.6%--all members anticipate rates to rise throughout next year.

Therefore the market shouldn’t expect to see a “one and done” move on interest rates because the Fed has told us not to anticipate one. The only reason overnight rates won’t be moving above 1.5% by the end of 2016 will be if the unemployment rate moves higher due to a collapsing economy, which is not exactly good news for stock prices.

Furthermore, the Fed has worked very hard to be unconstrained by time; it has substituted the word “patient” for the phrase “data dependent.” Therefore, when the Fed raises rates Ms. Yellen will not say at her press conference that it’s a one and done operation, or that the Fed will wait until some appointed future timeframe for the second rate hike to occur. Instead, the Fed can only proclaim that the next rate hike will be based on further progress toward their inflation target.

The problem with that is if you look at the core PCE Index, inflation is currently moving away from their target.

So why would the Fed still move you ask? Because the U-3 Unemployment rate is moving dangerously close to crossing what the FOMC believes is the inflationary Philips Curve Maginot line. This is the imaginary line where Keynesians believe a low unemployment rate triggers rising inflation.

However, anyone who lived through the stagflation of the 1970’s or who looks historically at the relationship between inflation and unemployment rates can proclaim with absolute certainty that the Phillips Curve is completely bogus.

That’s because inflation doesn’t come from more people becoming productive; inflation is a function of the market losing faith in the purchasing power of a currency through its dilution.

Therefore, as long as the Obamacare economy keeps producing part-time food service employees, the unemployment rate will continue to fall south of its current reading of 5.1%; and the Phillips-Curve-obsessed Fed will move more towards its dot plot goal in fear of employment inflation that is never coming.

The 2009 argument for a bull market was the Fed would keep printing money until the stock market and economy improved. Now the complete opposite is true, the Fed will slowly hike interest rates simply to get off the zero bound range it has been stuck at for seven years and because it is worried about a meaningless U-3 unemployment figure’s effect on inflation.

Nevertheless, for the first time in history it will be hiking rates into falling inflation, negative earnings and revenue growth on S&P 500 companies, and falling global GDP growth. Therefore, I predict the Fed will only be able to move the Fed Funds Rate higher by 50-75 bps before it becomes obvious even to the hopelessly confused FOMC that global markets and economies are in serious trouble.

This is the sad truth: either the massively overvalued stock market and artificially inflated economy will continue the insipient rollover that began in the middle of August, causing the Fed to stay on hold; or the Fed will begin to slowly hike rates, causing the yield curve to quickly invert and the economy to completely fall apart. This is why wise investors should now be out of, or short, the stock market. At least until the S&P 500 trades near 1600; or the Fed transitions to an easing stance.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

7 Reasons the Bear Market Has Just Begun
September 3rd, 2015

On March 10th 2009 the US stock market hit an intraday low and put in the now-famous “Haines bottom”--coined after my friend, the late great Mark Haines, who made one of the most prescient calls in market history. It should be noted by the time that fateful day arrived it was virtually impossible to find a single bull out of all the geniuses on Wall Street.

Since then the major indexes have more than doubled. Therefore, today the narrow-minded canyons of Wall Street are littered almost entirely of trend following bulls and cheerleaders that don’t realize how little there is to actually cheer about. Stocks values are far less attractive than they were on that day back in 2009 and this selloff has a lot longer to run. There are hordes of perma-bulls calling for a “V” shaped recovery in stocks, even after multiple years of nary a down tick. But the following are seven reasons why I believe the bear market in the major averages has only just begun:

1. Stocks that were hated in 2009 are now unconditionally loved. This is clearly evidenced by margin debt which recently reached an all-time high. According to the National Inflation Association, margin debt recently jumped over $30 billion, or 6.5% to $507 billion, which was equal to a record 2.87% of U.S. GDP. This surpassed the previous all-time high of 2.78% set in March 2000--the top of the largest stock market bubble in world history. And despite the assurance of many fund managers that investors have boat loads of cash ready to deploy at these “discounted” prices, cash levels at mutual funds sank to their lowest level of just 3.2% of assets by early August. That’s the lowest in history! As a percentage of stock market capitalization, fund cash levels are also nearing the record low set in 2000 when the NASDAQ peaked and subsequently crashed by around 80%.

2. Stocks are overvalued by almost every metric. One of my favorite metrics is the Price to Sales Ratio, which shows stock prices in relation to its revenue per share and omits the financial engineering associated with borrowing money to buy back shares for the purpose of boosting EPS growth. For the S&P 500 this ratio is currently 1.7, which is far above the mean value of 1.4. The Benchmark Index is also near record high valuations when measured as a percentage of GDP and in relation to the replacement costs of its companies.

3. There is currently a lack of revenue and earnings growth for S&P 500 companies. According to FACTSET, second quarter earnings shrank 0.7%, while revenues declined by 3.4% from the year ago period. The Q2 revenue contraction marks the first time the Benchmark Index’s revenue shrank two quarters in a row since 2009.

4. Virtually the entire global economy is either in, or teetering on, a recession. In 2009 China stepped further into a huge stimulus cycle that would eventually lead to the largest misallocation of capital in the history of the modern world. Empty cities don’t build themselves: they require enormous spurious demand of natural resources, which in turn lead to excess capacity from resource producing countries such as Brazil, Australia, Russia, Canada, et al. Now those economies are in recession because China has become debt disabled and is painfully working down that misallocation of capital. And now Japan and the entire European Union appears poised to follow the same fate.

This is in turn causing the rate of inflation to fall according to the Core PCE index.

And the CRB Index, which is at the panic lows of early 2009, is corroborating the decreasing rate of inflation.

But the bulls on Wall Street would have you believe the cratering price of oil is a good thing because the “gas tax cut” will drive consumer spending--never mind the fact that energy prices are crashing due to crumbling global demand. Nevertheless, there will be no such boost to consumer spending from lower oil prices because consumers are being hurt by a lack of real income growth, huge healthcare spending increases and soaring shelter costs.

5. US manufacturing and GDP is headed south. The Dallas Fed’s Manufacturing Report showed its general activity index fell to -15.8 in August, from an already weak -4.6 reading in July. The oil fracking industry had been one of the sole bright spots for the US economy since the Great Recession and has been the lead impetus of job creation. However, many Wall Street charlatans contend the United States is immune from deflation and a global slowdown and remain blindly optimistic about a strong second half.

Unfortunately we are already two thirds of the way into the third quarter and the Atlanta Fed is predicting GDP will grow at an unimpressive rate of 1.3%. Furthermore, the August ISM manufacturing index fell to 51.1, from 52.7, its weakest read in over two years. And while Gross Domestic Product in the second quarter came at a 3.7 percent annual rate, due in large part to a huge inventory build, Gross Domestic Income increased at an annual rate of only 0.6 percent.

GDP tracks all expenditures on final goods and services produced in the United States and GDI tracks all income received by those who produced that output. These two metrics should be equal because every dollar spent on a good or service flows as income to a household, a firm, or the government. The two numbers will at times differ in practice due to measurement errors. However this is a fairly large measurement error and it leads one to wonder if that 0.6% GDI number should get a bit more attention.

6. Global trade is currently in freefall. Reuters reported that exports from South Korea dropped nearly 15% in August from a year earlier, with shipments to China, the United States and Europe all weaker. US exports of goods and general merchandise is at its lowest level since September of 2011. The latest measurement of $370 billion is down from $408 billion, or -9.46% from Q4 2014. And CNBC reported this week that the volume of exports from the Port of Long Beach to China dropped by 10% YOY. The metastasizing global slowdown will only continue to exacerbate the plummeting value of US trade.

7. The Fed is promising to longer support the stock market. Back in 2009 our central bank was willing to provide all the wind for the market’s sail. And despite a lack luster 2% average annual GDP print since 2010, the stock market doubled in value on the back of zero interest rates and the Federal Reserve’s $3.7 trillion money printing spree. Thus, for the past several years there has been a huge disparity building between economic fundamentals and the value of stocks.

But now the end of all monetary accommodations may soon occur while markets have become massively over-leveraged and overvalued. The end of QE and ZIRP will also coincide with slowing US and global GDP, falling inflation and negative earnings growth. And the Fed will be raising rates and putting more upward pressure on the US dollar while the manufacturing and export sectors are already rolling over.

I am glad Ms. Yellen and co. appear to have finally assented to removing the safety net from underneath the stock market. Nevertheless, Wall Street may soon learn the baneful lesson that the artificial supports of QE and ZIRP were the only things preventing the unfolding of the greatest bear market in history.

 

Stock Market Calls Fed’s Bluff
August 31st, 2015

As the Fed nears its proposed first rate hike in nine years the stock market is becoming frantic. The Dow Jones Industrial Average is down around 10% on the year, as markets digest the troubling reality that our central bank may be raising interest rates into an emerging worldwide deflationary collapse.

The Fed normally raises rates when inflation is becoming intractable and robust growth is sending long-term rates spiking. However, this proposed rate hike cycle is occurring within the context of anemic growth and deflationary forces that are causing long-term U.S. Treasury rates to fall.

The yield curve spread, specifically the difference between Fed Funds Rate and the 10-year Note, is usually close to 4 percentage points at the start of major tightening cycles. This was the case at the start of the 1994 and 2004 campaigns to curb inflation. However, this go around the spread is less than 2 percentage points and the benchmark 10-Year Note yield is falling. This means the yield curve will invert very quickly and cut off banks’ profitability and incentives to lend; which will greatly exacerbate the deflationary impulses reverberating across the globe.

These deflationary forces will collide head on with a stock market that is already extremely overvalued as measured by Tobin’s Q ratio (the total value of corporate equities/replacement cost) and the total market cap to GDP.

Tobin’s Q Ratio:


Total Market Cap/GDP:

But the overvalued condition of stocks gets even worse when viewed in the context of anemic growth and the prospect of a hawkish Fed. Revenue growth, or the lack thereof, for S&P 500 companies was a negative 3.3% in Q2, leading to a minus 1% earnings growth for this benchmark Index.

U.S. GDP has not been faring much better, averaging a lackluster 2% annual growth rate since 2010. The highly accurate Atlanta Fed GDP Now has forecast GDP at just 1.3% for Q3, far short of what many perma-bulls on Wall Street are calling for.

For first time in its history the Fed would be raising rates into anemic and slowing GDP growth, negative earnings and revenue growth, and falling long-term interest rates.

And don’t believe Wall Street’s mantra that the deflationary forces emanating from China won’t affect stock prices because, as many claim, it accounts for a small percentage of S&P 500 revenue. This is the same flawed logic that led many of those same Cheerleaders to conclude subprime mortgages were a small subset of housing and would never spill over to national home prices or the economy.

The problem for China is that the government spent $20 trillion since 2007 building an unprecedented and unsustainable fixed asset bubble. Now that misallocation of capital has exhausted itself and the nation is left drowning in debt. Those emerging market economies who supplied China with its infrastructure materials have run out of that bubble-induced demand and are now flirting with recession.

Europe, a major exporter to China, is growing at just above 1%. It is highly likely that following Japan’s negative Q2 GDP print the nation may be entering its third recession since 2012. And two of the highly vaunted BRIC economies, Russia and Brazil, are shrinking as well.

This global deflation and economic stagnation isn’t easily remedied. China cut its reserve requirement ratio and interest rates again this week; but the People’s Bank of China has done so five times since November of 2014 to no avail. It’s becoming apparent: China has lost command and control of their command and controlled markets and economy.

The Fed has deployed a Zero Interest Rate Policy for seven years and has already printed $3.7 trillion to boost markets and GDP growth. And U.S. debt to GDP is over 100%. Japan’s debt to GDP is at 230% and the Bank of Japan (BOJ) is printing 7 trillion yen ($58 billion) per month of QE. The European Central Bank (ECB) is printing $67 billion a month and the European Union (EU) has negative interest rates; but all this easy money and deficit spending isn’t helping these economies move much off the flat line.

There just isn’t much fiscal or monetary policy room left to maneuver. Global debt is up a whopping $60 trillion since the end of the Great Recession and interest rates are at all-time lows.

The problem isn’t that the cost of money is too high or that its availability is scarce. The issue is global economies have become debt disabled and suffer from massive capital imbalances. These conditions can’t be fixed by more money printing.

This brings us back to Ms. Yellen and co. and the Fed’s current threat to raise rates. The Fed is aware there wouldn’t be a solvent entitlement program or pension plan without stock price increases of around 8% each year. A tightening cycle when markets and economies are on life support would put that target very far out of reach.

Therefore, look for the Fed to back away from rate hikes in the next few weeks as the Federal Open Market Committee finally realizes it will be stuck at near zero for many years to come. This should cause the highly overcrowded long dollar trade to roll over sharply very soon and provide investors to profit in anti-dollar investments such as precious metals.

A prudent investor should hide out in cash and hedge their portfolios against more carnage to come in the near term. That is, at least until the Fed’s fire brigade switches to a dovish monetary policy stance and comes running with another round of money printing. Maybe that will temporarily stop the bleeding in stock prices; but please don’t be fooled into believing it will save the economy.

 

Clear Conclusions Concerning QE
August 24th, 2015

Japan was recently slammed with more bad economic news; growth contracted yet again in the second quarter. Gross Domestic Product for the world’s third largest economy fell by an annualized 1.6% in the three months ended in June.

The economic plan known as Abenomics, which promised massive money printing coupled with government spending would put the world's third largest economy on a path to sustainable growth, seems to have hit another roadblock. This latest contraction marks the third such set back since the optimistic launch of Abenomics at the end of 2012. Japan appears to be headed towards a triple dip recession.

As Japan’s economy has been struggling bond prices have soared and yields have crashed. But only because Japan’s Central Bank has been frantically buying JGB’s in a futile attempt to spur on growth. While it is true Abenomics has been hard pressed to reach its inflation targets, it is also a fact that the revenue needed to service Japan’s humongous and mounting debt mountain is quickly diminishing. Therefore, natural market forces should be pushing interest rates inexorably higher despite persistent deflation.

JGB 10 Year

All this money printing has also given a nice bid to the stock market; the Nikkei 225 has increased 100% during the reign of Abenomics, defying the notion that high stock valuations should be the product of strengthening economic growth that leads to rising earnings.

The ECB’s foray into QE provides more proof of the impotency of central banks to generate viable and robust GDP growth. In July of 2012, Mario Draghi promised to do “whatever it takes” to bring growth to the flailing European Union. To make sure his words don’t get lost in translation, in English this means print money and buy debt. After this promise, Europe saw another four quarters of contraction before growth emerged on the positive side. But that anemic growth rate has been stuck between the flat line and 1.6% ever since.

In fact, in the European Union’s latest Q2 data; Germany, France and Italy all posted weaker-than-forecast numbers, while growth in France registered at a nice round 0.0%.

Despite Draghi’s $67 billion a month worth of “whatever it takes” money printing, Eurozone GDP has barely moved off the flat line. Yet despite this, the German benchmark DAX is up 65% during the tenure of the ECB’s promise to keep bond yields in the zero-bound range. And Draghi’s quest to keep sovereign debt yields in a bubble has truly come to fruition—the German Ten-year Note yields just 0.6%.

And in our third case study of QE, let’s see how the US is faring after $3.7 trillion dollars of new Fed credit. Since the end of the Great Recession the US economy has been limping along at around a 2% growth rate, despite perpetual optimism that QE will bring growth to escape velocity. To illustrate how dead the US manufacturing sector has become, just this week the New York Fed's Empire State Index plummeted from 3.86 in July, to -14.92 in August, which was the lowest reading since April 2009.

The highly-accurate Atlanta Fed has 3rd quarter GDP tracking at an anemic 1.3%. Yet despite 7 years of sub-par growth, stocks as measured by the S&P are up 160% from their lows and bond yields are near all-time lows as well. Growth has been slow and is getting worse…and now stock prices are getting a huge wakeup call.

Time has provided three clear and indisputable conclusions about QE: QE pumps stocks to levels that are completely disconnected from the underlying fundamentals of an economy. It allows bond prices to soar and yields to drop to levels the free market could never accept. And perhaps most importantly, QE does not lead to robust economic growth. This is because whatever unsustainable job growth there is comes from the building and servicing of asset bubbles; while it also encourages further unsustainable debt accumulations. The US oil fracking industry is a perfect example this reality.

Central bank cheerleaders hold to the counterfactual that growth may have been worse if governments didn’t implement QE. But QE prevents the economy from truly healing because it keeps asset bubbles and debt levels from contracting. What you end up with is massive capital imbalances, increasingly unsustainable debt loads and financial asset inflation that sits on top of a crumbling economic foundation.

It is now becoming empirically obvious to any objective observer that the philosophy of money printing to generate growth is a complete failure. That bankrupt philosophy led to the biggest bubble of all: the QE-induced faith in central banks’ ability to save the world. The collapse of this deluded fantasy will be the most devastating reality check of all.

 

A Street Car Named Treasuries
August 17th, 2015

In the 1947 Tennessee Williams play "A Streetcar Named Desire" as she is being carted off to the mental institution Blanche Dubois utters these famous words... "I have always depended on the kindness of strangers."

And like Ms. Dubois, the United States has also come to depend on the kindness of strangers to fund a massive $18.3 trillion in debt.

But that kindness the US Treasury has come to depend upon may be waning. Foreign holdings of U.S. Treasury securities fell in May for a second straight month. The Treasury Department reported total holdings were down 0.1% in May to $6.13 trillion. This comes after an even bigger 0.6% decline in April.

In four of last six months, China has been a net seller of Treasuries. According to Bloomberg, China sold $180 billion worth of treasuries from March of 2014 to May of this year. China had $1.65 trillion worth of Treasuries at the peak, now they have $1.47 trillion. And Japan also sold $9.4 billion of long-term treasuries in June alone.

With foreign investment demand waning the US may have a harder time funding its debt. The US savings rate is currently around 5%, that is less than half what is was in 1980 and a full 8 percentage points below its level at the end of the Bretton Woods Era. This begs a question: who will be a buyer of our debt if foreign governments stop buying and even become sellers? The answer of course will eventually be a protracted and unlimited amount of Treasury purchases on the part of our central bank.

Adding to this uncertainty is the Fed’s retreat from QE. We can no longer count on the Fed buying $45 billion per month of long-term Treasuries. And now the Fed is promising to start slowly unwinding its $2.5 trillion of government debt.

How will the lack of demand for the Treasury affect interest rates?

The average yield on the 10 year was over 7% between the years starting in 1971 and the start of Great Recession. However, Central Banks have been actively pushing down the long end of curve for the last seven years. Thus, lowering interest rates and making our massive federal debt easier to service and much more readily increased.

In fact, the CBO projects annual deficits will rise north of $1 trillion within 10 years, which at that time will equal 4% of GDP. This annual increase of one trillion dollars will rapidly pile on top of the already dangerous and unprecedented level of publicly traded debt of $13 trillion.

CBO further projects real GDP will grow by about 3% in 2015 and 2016; and by nearly 2½% throughout the next decade. This rosy scenario does not allow for any economic contraction whatsoever during the next 10 years; despite the fact we are already very far along on this current business cycle. In addition, the projected 2.5-3% growth is also above the 2% average GDP growth experienced since 2010.

The looming burden of entitlement programs is already baked into the demographic cake. Once a source of funding for the deficit, Social Security’s main program ran a $39 billion deficit in 2014. This closed out five years of consecutive cash-flow deficits as the program’s unfunded obligations continue to grow. The 75-year unfunded obligation of the Social Security OASI Trust Fund is $9.43 trillion, a $70 billion increase from last year’s unfunded obligation of $9.36 trillion, according to the 2015 annual Trustees’ Report. After including federal debt obligations that are actually recorded as assets to the Social Security trust fund of $2.73 trillion, Social Security’s total 75-year unfunded obligation is close to $12.2 trillion. In fact, the Social Security and Medicare Boards of Trustees' report shows that both Medicare and Social Security have unfunded liabilities of $50 trillion. That means we need that amount of money sequestered and growing today in order to meet long-term liabilities.

Of course, there is nothing but more IOUs in any of the government’s trust funds. Therefore, these programs act as a drain on the budget the moment tax revenues become less than expenditures.

For the past seven years growth has been anemic and will fall sharply along with the next inventory liquidation that is now overdue. Odds are this next economic contraction will be of the depression variety due to the unsustainable condition of record low interest rates and asset bubbles that must soon burst.

Hence, the notion that we will be able grow our way out of this debt load is pure fantasy—especially in light of dysfunctional governments.

This should be proof positive that the Fed’s inflation quest is pure folly. Growth comes from productivity improvements, not from money printing—a lesson that Keynesian central bankers are either blind to or are purposely ignoring in order to supply an excuse for endless debt monetization. But even with massive manipulation of free markets we are on track for an unprecedented spike in Treasury bond yields due to inflation, insolvency…and now the lack of foreign demand.

The primary purchasers of US debt have been Japan and China. Yet these nations now face their own domestic economic turmoil and will no longer be able to supply a bid for US debt. In fact, China’s $3.6 trillion in currency reserves may be needed to support a Yuan that falls faster than what the PBOC has recently desired. Since China and Japan have become sellers of Treasuries the Fed will have to step up the buying. However, as previously indicated, our central bank has promised to join in on the hit-the-bid parade starting this year. Ms. Yellen is aware interest rates cannot rise very far from the current levels without crippling the bubbles in equities, real estate and the economy as a whole.

In order to combat the next deflationary collapse of the economy, which has already started to engulf the globe, the Federal Reserve will soon have to join in the current currency debasement derby that is being led by China, Europe and Japan. This means the Fed will not only stay near the zero-bound range on interest rates, but will most likely launch another round of QE in the near future. At that point all central banks will be on a full on assault to depreciate the value of their fiat currencies.

Incredibly, gold mining shares are trading at 15 year lows despite record levels of debt and an unprecedented increase in the size of central bank balance sheets that have exploded for the expressed intent to boost the level of inflation. This has set the stage for the next major bull market in gold mining shares that will be starting from prices not seen since the start of last millennium.

 

Ignore the Commodity Message at Your Own Peril
August 10th, 2015

The Thompson Reuters/Jefferies CRB Index (CRB) is back down to the panic lows of early 2009. For those who think the CRB Index says nothing about global growth…invest accordingly at your own peril.

If you believe this commodity crunch is all about some temporary oil supply glut, think again. There are 19 commodities that make up the CRB Index: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat. The value of the weighted average of these commodities is screaming one thing loudly: the rate of global growth is plummeting just as it was at the height of the Great Recession.

This is mainly because the synthetic economy of China, which once sucked up the natural resources of the globe in order to create the world’s greatest fixed asset bubble in history, is now in freefall. And it is driving down the price of commodities as global growth grinds to a halt.

For those who think the U.S. and the rest of the world will be somehow immune to a China slowdown should note that foreign sales accounts for about one third of aggregate revenue for the S&P 500. For years China had been a huge growth market for multi-national companies. However, its recent rut is affecting both domestic and international companies around the globe that once provided China with natural resources during its empty-city building bonanza.

These companies and countries who benefitted from China’s success are now reeling from its collapse. For example; U.S. multinationals such as Caterpillar, Ford, GM, Tesla and Freeport McMoRan have been negatively affected by the slowdown in China, just to name a few. And then we have Apple, whose stock is down 14% in the past few weeks because investors are now realizing Chinese consumers are not going to buy the volume of iWatches that have been predicted.

Strong demand from China had also been a boom to the Eurozone. Germany's auto industry, France and Italy’s luxury goods, Dutch and Finnish chemicals, were all beneficiaries from China’s huge growth. In fact, around 8% of Germany's exports go directly to China.

Sweden's Volvo is also reducing growth expectations in the region and issued a warning to investors that it would have to take a 650 million Swedish Crown ($75 million) charge for expected credit losses.

Expanding credit risks are now prompting some Western banks to rethink their exposure to China. Swiss-based UBS AG has stopped lending money to onshore clients in the communist nation.

But perhaps we see the largest effect of China in the Asia-Pacific region. China’s three major trading partners Taiwan, Korea and Malaysia have seen a significant slowdown. For instance, Taiwan Q2 GDP growth of just 0.64% was the weakest in the past three years.

Australia is known as “China’s quarry” and had enjoyed a decade-long boom selling iron ore. BHP Billiton and Rio Tinto have spent billions of dollars to double iron ore production over the past five years to meet China’s insatiable demand. But now the good times appear to be over. Australia’s July PMI dropped to a 5-month low of 50. While the Markit PMI plunged to 47.8, which was the worst in two years.

And to prove that China’s slowdown spans the entire globe we can also evidence South America. Brazil is one of the ten largest markets in the world; producing steel, cement, petroleum, lubricants, propane gas, and a wide range of petrochemicals. Brazil was also a huge beneficiary of the Chinese real estate bubble.

But their government recently lowered the country's growth output from a small gain to a contraction of 1.5%. Standard & Poor's has downgraded Brazil's debt outlook to "negative" from "stable" a signal they are preparing to drop its credit rating, which now sits just one notch above junk. Brazil’s currency, the real, is the weakest in 12 years against the dollar and the stock market is at a 6-year low.

And this slowdown in South America is also being felt worldwide. Agribusiness multi-national Bunge said its edible oil business was lower due to lower margins and volumes in Brazil. Owens Illinois, one of the world's biggest makers of glass bottles, reported a drop in volume stemming from a sharp drop in beer sales in Brazil. Goodyear Tire reported that sales in Latin America were down 20% compared to last year. Industrial gas manufacturer Praxair also suffered a sales decline year-over-year due to weaker industrial activity in Brazil and China. Whirlpool, which gets 16% of its revenues from Brazil, said sales were down 22 percent year-over-year. And finally, Caterpillar is getting crushed from the commodities rout and reported sales in Latin America were down 26%.

Given the huge global economic risk China and all its related trading partners present you would imagine the Fed would have this looming global recession firmly on their radar. Yet, just recently Atlanta Fed President Dennis Lockhart said he feels confident the economy is ready for a rate hike. After all, when has the Fed ever gotten any economic prediction wrong?

It’s important to understand that in its history, the Fed has never undergone a “one and done” rate hiking campaign. In fact, the current median dot plot from the FOMC assumes a 1.5% Fed funds rate at the end of 2016. Therefore, after the first rate hike takes place, it would be natural to assume the Fed will hold true to its avowed trajectory, unless and until the U.S. economy falls into a recession.

However, with the U.S. economy barely growing at 1.5% for the first half of 2015, it won’t take much more of a slowdown to bring growth into negative territory. Nevertheless, the Fed’s intentions are to slowly begin hike rates in September. But central bankers don’t realize the dystopias they have created: $200 trillion worth of debt disabled and asset bubble ridden economies that have become totally addicted to money printing in order to avoid a deflationary collapse. Once the artificial support is removed these bubbles begin to crater. Therefore, it shouldn’t take long before the Fed inverts the yield curve and money supply growth gets chocked off. When that happens the economy will be in the middle of another 2008 variety collapse.

What is clear is that the CRB index is foreboding a clear message of the danger that lies ahead. Still, U.S. stock values are near record nominal highs and are outlandishly valued in relation to GDP. For those who claim that we are an island economy and don't care if the rest of the world falls apart, I’d like to know what will happen to U.S. multi-national companies’ earnings as global trade evaporates and the Fed sends the U.S. dollar even higher.

According to FactSet, Q2 S&P 500 revenue growth is already at a negative 3.3% and earnings declined by 1.3%. Into this malaise we will have to add cascading global growth and a Fed that seems committed to commencing an interest rate hiking cycle. With the U.S. averages at such lofty levels it seems prudent to heed the warning declared by cratering commodity prices. If you doubt that conclusion just recall how wise it was not to ignore the same commodity message broadcast to investors beginning in the summer of 2008.

 

The Real Message of Plunging Commodities?
July 31st, 2015

The Chinese stock market recently saw its biggest selloff in 8 years as the dramatic 8.5% fall in Shanghai “A” shares also rattled markets around the world.

For the past few weeks China has been balancing its desire to keep the equity market from a complete meltdown, while still courting the international investment community with hopes of being a dominant player in the capital and currency markets.

But recently The International Monetary Fund (IMF) warned China’s government about its concern over limiting investors' freedom to take equity out of financial markets. These concerns were raised when the IMF met with officials in to discuss the chances of including the yuan in the fund's basket of currencies, also known as Special Drawing Rights (SDR).

As China tries to balance the demise of its equity bubble while still keeping the illusion of free markets intact, two delusional narratives have started to circulate around Wall Street.

The first such Wall Street inspired delusion is that the collapsing Shanghai stock market will have no effect on the underlying Chinese economy. However, even though China's 260 million trading accounts may be a relatively small percentage of its total population, it's also the richest and most productive portion of its citizenry, which also happens to be equal to the entire U.S. population in 1993. And Chinese GDP growth accounts for 1/3 of total global growth. Therefore, we can already find the manifestation of slowing Chinese growth from the nascent fall in equity prices.

For example, the profit of China's industrial firms dropped 0.3% in June from a year earlier, that reversed a 0.6% rise in May and 2.6% gain in April. For the first six months of 2015, industrial profits were 0.7% lower than a year earlier.

In June, China's producer price index fell 4.8% on an annual basis, its 39th straight month of declines. In fact, the economy is headed for its poorest overall performance in a quarter of a century.

The second fallacy is Wall Street believes in the TV commercial that claims what happens in Las Vegas stays in Vegas. Or, in this case, what happens to the Chinese economy stays in China.

But the truth is the meltdown in China is already spreading all around the Asia Pacific region. For example, Taiwan’s year over year export growth has hit multi-year lows due to collapsing trade with China.

But perhaps the biggest indicator of the magnitude of China’s slowdown can be found in the global commodities market. Most pundits are trying to link the recent selloff in commodities strictly to the rising dollar as measured by the Dollar Index (DXY). But that Index is actually down about 3% since March. During which time the rout in precious and base metals, energy and agriculture has greatly accelerated.

We see the Bloomberg Commodities index now at a thirteen year low. Copper is down 28% for the year, tin is down 30%, and nickel is down 44%. And then we have gold. Last week China dumped 4 tons on the market, causing the price of the precious metal to fall almost 4% within a matter of seconds. This had little to do with the value of the dollar on the DXY, but it was rather mostly about the waning demand in China from its imploding economy and the need to sell what you can when capital controls are in place.

Indeed, these commodity prices began to plunge concurrently with China’s steep drop in officially reported GDP growth from 12% in 2010, to just 7% today—the real current growth rate in China is closer to 4% when measured by private data. It is no coincidence that the price of copper dropped from $4.52, to $2.37 during this same timeframe.

The true message of plunging commodity markets is that the Chinese government wasted $20 trillion worth of credit digging holes to mollify the fallout from the Great Recession of 2007; primarily creating a huge fixed asset bubble with little economic viability. And then forced another $1.2 trillion in margin debt to engender a consumption-based economy; primarily by creating a stock market bubble after the fixed asset bubble strategy began to fail miserably.

So where does this leave the global economy now? US GDP is growing at a meager 1.5% for the first half of 2015. And the second half looks even worse, as an organic U.S. slowdown meets cascading global trade. Adding to this malaise, it appears as though the handful of U.S. stocks that have led the rally are finally starting to join the hangover party. For instance, social media stocks are now crashing harder than commodity prices, with Yelp recently falling 27% in one day after dropping 60% YOY; Twitter has also tumbled 45% in the last 52 weeks; and Facebook recently dropping nearly 5% after reporting a miss in the number of eyeballs staring at their cellphones checking the like box.

But here is the most important take; the arrogance that led the Fed to believe it could save the world in 2008 by manipulating markets is causing Ms. Yellen and co. to promulgate the idea that it can now raise rates into a global slow down without negative repercussions—thereby, demonstrating its success in rescuing the economy from the Great Recession by proving interest rates can now rise with impunity.

However, the truth is the Fed hasn’t raised interest rates in a decade and will probably never be able to move much off the zero bound range without totally collapsing markets and the economy. I think the Fed is aware of this and that’s why it is continually finding excuses not to start a rate hiking cycle—just like it did yet again in the July meeting. Therefore, the real money to be made is in fading the massively overcrowded trade that believes U.S. stocks are immune from the worldwide economic slowdown and that the U.S. dollar will be in a secular bull market.

 

The Extinction of Markets
July 20th, 2015

China's four-week-long stock market rout wiped out nearly 30% off the Shanghai Composite Index since its highs of June. To stem those losses the Chinese government has formulated an interesting hypothesis: stocks won’t go down if you ban sell orders.

Working off this proposition Beijing has ordered shareholders with more than a 5% interest to stop selling shares; directors, supervisors, and senior management personnel are also barred from reducing their holdings.

China has also launched investigations on those it believes engaged in malicious short selling. The threat of imprisonment has proved an effective deterrent to those who may have been contemplating a short in the Chinese markets.

And even if you don’t fall into either of the above categories of sellers you still will have trouble getting your money out of shares because two thirds of the stocks on the exchange have been halted.

It should come as no surprise that the Communist government of China has fallen off the free market wagon. After all, the government is of the belief that economies grow by building empty cities. So why shouldn’t they think markets work best when not allowing participants to sell?

The reaction on Wall Street has been just as alarming. Deutsche Bank and Bank of America Merrill Lynch have applauded the Chinese governments for doing everything necessary to keep the bubble afloat.

But Wall Street’s counterintuitive and ironic bullishness on China is most evident in the powerhouse investment firm Goldman Sachs. Goldman is urging investors to buy stock in China right now!

In Observing 40 years of statistical history the Goldman team in China believes “…the market is currently experiencing a standard bull market correction, not a transition into a bear market.” This is eerily reminiscent of the Wall Street models that concluded housing prices could never go down on a national basis.

First, I would like to know how anyone could get forty years of honest and consistent data from China. Then tell me where else in that forty year history of data did China expand its debt by $20 trillion dollars in the space of just eight years, as they have today?

Statistical analysis such as this can offer a complement to fundamental analysis in making market predictions. However, this assumes the exchanges where China trades equities bears any resemblance to a market.

A market is a place where a multitude of buyers and sellers freely meet and price is discovered. What China has now created is a roach motel where money moves in but it can’t easily move out—if at all. Therefore, all technical and fundamental analysis goes out the door. And those who choose to participate in this charade are left waiting for Beijing’s next decision on how to direct the market move.

This is the antithesis of capitalism and how free markets work. That’s why it should be shocking to see Wall Street, the supposed bastion of capitalism, embrace such measures. But the sad truth is there are no free markets left in this world, and it’s becoming increasingly evident that most on Wall Street prefer it that way. We have grown so accustomed to market manipulations that we have completely lost sight of how the free market is supposed to function.

In this new market dystopia stocks never go down, companies never fail and countries never default on their debt--central banks just print all the problems away. And where counterfeiting money and lowering interest rates doesn’t solve the problem, governments are trying to demonstrate that market regulations will lead to success.

We can all sleep well knowing that a small group of plutocrats who now control the global economy will make everything turn out right. Genuine market analysis has been supplanted by the need to parse the words of statements from central bankers like students at a bible meeting.

And when you really think about it, why bother analyzing their words anyway. Central bankers don’t understand how markets and economies work; all they have shown the proclivity to do is print more money. So we can all continue in our dystopian slumber.

But the victory over command and control economies by free markets has been decided long ago. However, these hard-fought lessons seem to have been too easily forgotten. Even the Pope has joined on the Capitalist bashing band wagon. Referring to it as ideological idolatry which leads to wage slavery, vast communal dislocation and commodity-market driven hunger. But perhaps he should take a drive on the Pope mobile down the streets of Cuba or Venezuela to witness the living standards of the poor that exist without the “ideological idolatry” of Capitalism.

The truth is there is no place where people live better than in a free market Capitalist economy. And it is only when you stray from this model, as we have for the past seven years, that you see the spread between the rich and poor blow out.

Freedom should have vanquished Egalitarianism forever with the fall of the Soviet Union in 1991. But if those at Goldman still see the merit of investing in a tyrannical command and control economy, perhaps North Korea is the next logical investment to make. I am sure Kim Jong-un has a bridge to nowhere he would be happy to sell them.

Nevertheless, economic freedom and prosperity is rapidly being replaced by markets that are driven by the edicts from autocrats, which is leading to the evisceration of the middle class. People have willingly abandoned most of their freedoms. Why? Because they have been dumbed down dramatically. How else could they have handed over the markets, economies and, most importantly, the structure of the family to governments with such ignorance and alacrity?

The abrogation of markets leads to stagflation, economic collapse and chaos. Sadly, this is the ultimate fate of the entire developed world.

 

The Potemkin Bank of China
July 13th, 2015

In the midst of an intense global economic slowdown that began in 2008, China’s economy amazingly appeared to be unaffected. Defying the world-wide real estate collapse, China’s GDP grew by an impressive 8.7% in 2009. Fueled initially by a $586 billion stimulus package, China would end up plowing and additional $20 trillion dollars into a fixed asset bubble that was designed to produce the government’s desired GDP print.

Perhaps inspired by the movie “Field of Dreams”, the Chinese government believed in the adage “If you build it, they will come”. And for the next 6 years China built empty cities in spades. New construction remains mostly unoccupied to this day; estimates are that 52 million homes are vacant and 90% of those empty units were purchased strictly for investment purposes.

Apartments were snapped up as investments by the nation's wealthy upper and middle classes, then sat empty as the owners failed to find tenants who could meet the pricey rent.

Investors sat on massive mortgages on unoccupied real estate holdings and home prices began to fall when loans from the shadow banking system started to dry up. This caused the Chinese authorities to quickly search for another bubble to create; one in a more convenient and easily manipulated asset class. If the average citizen could no longer afford to buy a house why not try to create a wealth effect by putting equities in a perpetual bull market?

Substituting empty cities for brokerage accounts with little capital, on-line Chinese lenders set up margin accounts with the same fervor as U.S. sub-prime mortgage lenders in 2006. In addition to conventional brokerage accounts, 40 online lenders helped arrange more than 7 billion yuan worth of loans for stock purchases in the first five months of 2015. Lending volumes surged 44% from April to May alone.

China’s margin finance problem quickly reached epic proportions. Margin trading jumped thirtyfold over the past three years on the Shanghai stock exchange. Chinese margin debt has risen 123% year-to-date, reaching a new record of 2.3 trillion yuan ($370 billion) on June 18.

However, some analysts believe the real amount of money borrowed by Chinese investors is likely to be much higher. The amount of shadow margin financing, which includes umbrella trusts and stock-collateralized loans, in the mainland stock market could easily be double or triple that of the balance of conventional margin financing taken through brokerages.

In addition, unlike other major international stock markets, which are dominated by professional money managers, retail investors account for around 85% of Chinese trading.

For a brief moment it was a magical solution to combat the failed real estate bubble. The Shanghai Composite started 2015 at 3,234 and hit 5,023 on June 4th--a 150% surge from the preceding 12 months, before plunging to 3,800 where it sits today.

But the market is still far from trading at a discount valuation. Despite the recent carnage, Shanghai shares are trading at 57 times earnings. That’s down from the June price to earnings ratio of over 100, but it’s still 3x higher than the PE ratio of the S&P 500.

The totalitarian regime is making daily policy modifications in a desperate attempt to stem the fall. But, interest rate reductions by the People’s Bank of China (PBOC), cuts in reserve ratio requirements and relaxations in margin trading rules have done little to calm investors so far.

Brokerage firms and fund managers have now vowed to buy massive amounts of stocks aided by a direct line of liquidity from the PBOC, which is directly monetizing securitized loans from China Securities Finance Corporation (China’s state-backed margin finance company.)

The nation is also trying to coerce corporate officials to buy back their own shares to a great degree. But with China’s questionable accounting practices and stocks prices completely decoupled from fundamentals, this is a little like asking Jim Jones to drink his own Kool Aide. In addition, China has promised to investigate “malicious” shorting of stocks (basically banning short selling unless you want to be a guest in the communist government’s prison system) and has banned selling of shares outright from any shareholders that own at least a 5% stake in a company.

And, to make matters even worse, over 50% of stocks in the primary Shanghai Exchange are in a trading halt. Just imagine how much further down the stock market would be if these shares were allowed to freely trade. Given all this it is a travesty to believe there is actually a stock “market” in China any longer. Perhaps the Chinese government will be able to manipulate stocks from going down much further but it will be powerless to prevent the ultimate collapse of its phony economy.

The current debacle in China is actually much worse than the U.S. equity collapse in 1929 and the Japanese economic bubble in 1989. Despite what the Carnival Barkers on Wall Street are saying, the Chinese economy is now suffering from the evaporation of the wealth effect. New Chinese millionaires, bolstered by their newly found stock market wealth, had been fueling the consumption economy that was supposed to supplant its export-driven growth model.

After a stock-market rout that has erased about $3.2 trillion in perceived value, car sales in June were down 3.2% month over month. This is the first such decline in over 2 years and refutes the claim that China is still growing at the fictitious 7% growth rate the government has sought to produce.

Once the darling of the Keynesian utopian dream, a booming China spoke to those who believed that the power of a command and control economy was far more effective than the power of the free market.

As the Chinese communist economic regime begins to unravel, the bubble in the belief that a small group of central planners can make better decisions than millions of people acting freely in their own self-interest should burst along with it. And the current massive bubble in the credibility of Central Banks to save every market should suffer a welcomed blow as well.

The Chinese are communists masquerading as capitalists. They have no idea what a free market is; instead they have layered an artificial equity bubble on top of a manufactured real estate bubble. And now are busily trying to command both bubbles to perpetually float.

Make no mistake, China is by no means alone in their disdain for free markets and its willingness to create a facade of prosperity at all costs. The governments and central banks of Japan, Europe and the United States have also eviscerated the price discovery mechanism in all asset prices. What we have left are worldwide asset bubbles floating on top of synthetic economies, which has somehow caused—in lobotomized fashion—a universal confidence in governments to borrow and print our way to everlasting prosperity.

These Potemkin central banks will be able to erect only hollow economies built with counterfeit money. Therefore, you must build a strategy that will profit from the inevitable fate of these economies, which is intractable inflation and a protracted depression…at least until governments embrace the power of free markets once again.

 

Greece and Puerto Rico: Previews of Coming Attractions
July 6th, 2015

Governor Alejandro García Padilla of Puerto Rico said this week he does not think the Commonwealth will be able to pay back the $73 billion in debt owed to bondholders. I find this rare bit of honesty totally refreshing. For the past three years some had speculated about the possibility of a Puerto Rican default, but most believed it to be a farfetched notion. Now the question of solvency is no longer in doubt: Puerto Rico is officially broke and is unable to pay all of its debt obligations.

The White House has firmly attested that a Puerto Rican bail out is not in the cards. The U.S. territory is requesting that the Federal government allow them access to chapter 9 bankruptcy, like Detroit used when it was unable to pay its bills. At the moment, only cities, towns and other municipalities are able to declare bankruptcy.

Like Detroit Michigan in 2014 and Stockton California in 2013, we can choose to look at Puerto Rico as an isolated incident. A blip on the debt radar that will only affect Puerto Ricans and about half of all municipal bond funds.

We can continue to delude ourselves into believing that Puerto Rico doesn’t make a larger statement about the solvency of municipalities around the United States; or even the solvency of the United States in total. Investors can just view this as another buying opportunity; much like they were convinced the Country Wide Credit and Indy Mac bankruptcies provided a great buying opportunity. Because, after all, wasn’t the real estate crisis supposed to be contained within the realm of just the 1% sub-prime mortgage borrowers.

But before investors mistakenly press the buy button once again they have to realize that P.R. is simply emblematic of a much larger problem. Puerto Rico is not an anomaly, it is more likely to be the “Bear Sterns” of the inevitable municipal debt crisis in the United States.

And then we have Greece. One thing is clear: Greece will default either through restructuring or debt monetization. The Greeks can remain in the European Union and submit to the austerity dictated to them by their German masters; or they can opt for self-imposed fiscal and monetary disciple under their own currency. In either case, this is a nation with a debt to GDP ratio north of 170%, and which suffers from sharply contracting revenue growth. Chaos and default in Greece is unavoidable; but is best dealt with on its own terms.

And as the rest of the world gawks at Greece and Puerto Rico’s economic misfortunes, what they fail to realize is that China, Japan, Europe and the United States aren’t that much different.

First let’s take Japan, one of the top economies in the world, whose debt is quickly approaching 250% of its GDP. If there was any question if Prime Minister Shinzo Abe’s three Kamikaze arrows would be successful at saving the flailing Japanese economy, this week’s industrial output should provide the clear answer.

Japan’s Industrial output fell in May at the fastest pace in three months, the 2.2 percent decline in output compared with the median estimate for a 0.8 percent drop. This added to fears the economy may be once again be in contraction mode in the current quarter. The irony is that one of Abe’s Arrows sought to destroy the Japanese yen in order to spur exports and economic growth. But Japanese GDP is lower today than it was back in 2010.

The United States is not much better. After seven years of zero interest rates and unprecedented debt monetization, our National debt load ($18.3 trillion) stands at 103% of our phony GDP. In the first quarter of 2015 the US economy contracted by 0.2% and growth is predicted to be around just 2% in Q2-- making growth at or below 1% for the entire first half. The additional $8 trillion in publicly traded debt piled onto the nation following 2007 was supposed to lead to economic nirvana, not a perpetual economic stupor.

And then of course we have China whose market, despite massive government and Central Bank manipulation, has officially entered into bear market territory. Even with recent losses, the Shanghai Composite has surged 25% this year, and the Shenzhen Composite is up 67%. This stock market boom runs contradictory to the slowing pace of growth, which is at its weakest pace since 2009; while corporate profits are actually lower than they were a year ago.

This means exuberance for Chinese stocks isn't backed up by fundamentals. Instead, it appears markets are being levitated by continued government borrowings and manipulations--both of which seem to have lost their magic over the past few weeks.

But the greatest bubble of all is the fairy tale that Central Bank money printing can lead to economic prosperity. The credibility of central banks’ to push asset prices and GDP inexorably higher through endless debt monetization is fading fast. The ugly truth is that debt in the developed world has now grown to such an excess that it has to be restructured or monetized.

This is why there isn’t an honest bond market left in the world. It is why the Bank of Japan is buying every Japanese government bond issued. And why the People’s Bank of China keeps cutting lending rates and reserve ratio requirements to prop up its ailing economy and bubble-addicted stock market. It’s also why the European Central Bank pledged “to do whatever it takes” to keep sovereign bond yields from rising—even in Greece. It is also the sad truth behind why the Fed seems unwilling to raise interest rates higher than zero percent…even after seven years.

These central banks are aware that once interest rates rise the whole illusion of solvency vanishes and the entire developed world will look no different than Greece and Puerto Rico does today. Once interest rates normalize, which is inevitable, these nations will undergo an explosion in debt service costs just as their bubble economies implode; causing annual deficits to skyrocket out of control. Therefore, unfortunately, a worldwide deflationary depression and/or intractable inflation have now become our unavoidable fate.

 

Bubbles Never Pop Painlessly
June 29th, 2015

Investors are obsessed over predicting the timing of the Fed’s first interest rate hike. Will it raise the Fed Funds rate in September, or wait until next year? But it is far more important to get a grasp on the pace of rate hikes. Will it be a one and done move, or does this mark the beginning of an incremental tightening cycle? Those of us who are not in the inner circle are forced to only speculate.

But one thing is certain: If history is any guide, whatever they do the Fed will get it wrong. Most market commentators place unfounded belief in the Fed’s acumen. But the truth is: I wouldn't trust the Fed to tell me what the weather is going to do in the next 30 seconds--even if they were looking out the window.

Once you understand the nature of bubbles—how they are created and how they burst—you can be assured this latest manifestation will also end in disaster. If the Fed raises rates in the manner in which the dot plots currently suggest it will quickly burst the bubbles already created in the real estate, stock and bond markets. On the other hand, if the Fed opts to only make a small token move higher in the cost of money it will allow asset bubbles to spin out of control until inflation destroys the vestiges of economic growth.

Our Central Bank has been deluding itself into believing it can easily escape from its nearly $4 trillion expansion of the monetary base and 7 years of virtually free money. But that is a spurious belief. Bubbles never die slowly and always bring about dire consequences. The bigger the bubbles the worse the backlash--and never before in the history of economics have central banks distorted market prices to this extent.

All bubbles share the conditions of the asset being overpriced, over-supplied and over-owned when compared to historical norms. And all bubbles are built on a massive increase in debt. For examples; the Tech Bubble was fueled by a rapid increase of margin interest, and the housing bubble was fueled by the ownership of properties with little to no equity. Bubbles always sit atop a humongous pile of borrowed money. Today we have a tremendous amount of margin and leverage in both equities and fixed income assets.

For example, we see in this chart from the NYX data website that the percentage growth rate of margin debt vastly outstripped S&P 500 returns in real terms just prior to the collapses of 2000 and 2008.

Continued debt accumulation only makes sense if the underlying asset is increasing in price. Once the principal of the asset stops rising, there is a massive unwinding of leverage, which causes the asset in question to plummet in value. Why do asset prices stop increasing in price? Because the spigot for new credit gets turned off once the cost of borrowing funds becomes unprofitable for banks and/or consumers.

This is why true bubbles always bust in violent fashion. Overleveraged buyers are forced to panic out of the investment as soon as its price plateaus. And that panic selling begets more selling until there is a total washout of leveraged ownership; that is, until prices can be supported easily by highly-liquid investors.

However, the Fed wants investors to believe it can raise interest rates at the absolute perfect pace that will not deflate the bubbles in equities, real estate and all fixed income classes. But this a just a sophomoric and quixotic fantasy.

If the Fed raises rates expediently (in other words, gets ahead of the inflation rate in short period of time) the yield curve will flatten out more quickly than in past tightening cycles. This is because the spread between the Fed Funds rate and the belly of the yield curve is currently at a historically low starting point.

And importantly, the Fed won’t be raising rates into an environment of robust inflation, as in the norm: instead, it will be raising rates just because it has become exceedingly uncomfortable being at the zero bound range for so many years. Once the yield curve flattens or inverts, money supply growth will get chocked off and asset prices will tumble into a deflationary death spiral similar to what occurred in 2008. This is exactly what will occur--after she begins liftoff from ZIRP—if Ms. Yellen doesn’t convince the market that she has fully repudiated the Fed’s current dot plot model, which has the F.F. Rate at 1.625% by the end of 2016.

On the other hand, if the Fed stays at zero, or does a token one-and-done move on rates, asset prices could become even more grossly distorted in the immediate future. Then, after several more quarters of free money and asset bubble growth, the rate of inflation will begin to pick up serious momentum—especially since the rise in the dollar on the DXY from 80, to 100 during the past year will quickly unravel.

In this case, pressure building up on long-term rates should explode in a sudden and violent manner. Rates will soar not because the Fed is increasing short-term rates but precisely because the free market will awaken to the idea that our central bank has, at least temporarily, caused inflation to become intractable.

The Fed’s “success” with creating inflation and the concomitant spike in long-term interest rates will, by definition, pop the fixed-income bubble, which will then cause a pernicious collapse in real estate, most equities and the economy as a whole. There shouldn’t be any doubt that spiking long-term rates will become the bane for the additional $8 trillion increase in non-financial debt piled onto the U.S. economy since 2008.

Our view at Pento Portfolio Strategies is that the Fed will take the latter approach and cause the rate of inflation to grow at dangerous and intractable pace. But a prudent investor needs to be prepared for either scenario because the slope of the central bank’s increase in the Fed Funds Rate will be crucial in determining the outcome. And the investment course will be vastly different for each situation. Most importantly, it is essential to be aware that an unprecedented period of market and economic turmoil lies just ahead. The good news is having the proper preparation and strategy will enable investors to profit from it.

 

Rates Are Rising for All the Wrong Reasons
June 22nd, 2015

Wall Street carnival barkers are relishing in the fantasy that the economy has finally achieved escape velocity. Therefore, they accept with alacrity that this is the primary reason why interest rates have started to rise. However, the fact still remains for the first half of 2015 GDP growth will probably be less than 1%.

GDP contracted by 0.7% in the first quarter of 2015. The Atlanta Fed, whose GDP Now calculation has been on the money, now sees second quarter growth at 1.9%. Therefore, it is prudent to conclude the most optimistic case for growth in the first half of the year will be about 1%. Of course, the perpetually upbeat economists on Wall Street are always convinced the economy will skyrocket in the second half of each year. But still, if the Atlanta Fed is correct—and it looks like it will be spot on given the anemic data already released for April and May—annualized GDP for the first two quarters of 2015 will be running at a pace that is less than half of the 2.2% growth averaged since 2010.

Perpetual optimists will highlight the recent positive data in housing as evidence of a robust recovery. But most of the upbeat numbers in housing are a result of front running the inevitable mortgage rate increases, as people rush to lock into low rates while they still can. And even with this, housing data has been mixed at best. U.S. housing starts in May fell 11.1%, to an annual rate of 1.04 million units from a revised 1.17 million units in April. This rate of new home construction is far below the 1.5 million rate seen in the year 2000, and light years away from the 2.2 million rate at the height of the housing bubble.

And we also have some encouraging data in retail sales, courtesy of the booming auto market. But sales in cars have been driven by the resurgence of the infamous liar loans, loose lending standards and virtually free money that led to the collapse in Mortgage Backed Securities in 2007.

Yet, despite booming car sales and slightly better new home construction rates, the nation’s manufacturing base remains literally in the basement. For example, the Empire State’s business conditions index unexpectedly dropped to -1.98 in June and Industrial Production decreased 0.2 percent in May after falling 0.5 percent in April. May is the fourth negative reading in the last six months on I.P., with the other two readings being flat.

But bond yields have started their inevitable climb higher regardless of the persistent economic malaise. Since mid-April the yield on the 10-year U.S. Treasury has gone from 1.85%, to 2.36%. The yield on the 10-year German bund has surged from essentially zero, to 0.8%. And the Spanish 10-year has gone from 1.45%, to over 2.40%.

One has to wonder, if worldwide economies are barely growing with free money how they will fare as rates start to spike. But the cheerleaders on Wall Street love to site rising rates as evidence the global economy is improving. They argue rising rates are a healthy sign, proof that the U.S. and European economies are strengthening, people are spending, companies are hiring and prices are starting to rise at more normal rates. And more importantly, the risk of too-low inflation—whatever nonsense that means--has ended.

Before you pop the champagne corks remember: this is the same crowd who was convinced rising rates wouldn’t hurt the housing market back in 2008—because a bubble didn’t exist, and even if one did the demise of subprime home buyers wouldn’t spill over to the overall economy.

Wall Street and Washington fail to realize that rates are rising for all the wrong reasons. For instance, the yield on the Ten year in Greece has now skyrocketed to around 12.5%. Is this a result of budding optimism in the Greek economy? No, the rising rates in Greece represent the increasing likelihood of a Greek default.

Here is the truth behind the global rise of interest rates: Interest rates are spiking due to the increased insolvency risks in the American, Japanese and European social welfare states that have piled on an incredible $60 trillion of new debt since the credit crisis.

Rates are also now rising because of the return of inflation, or at the very least the end of deflation. Inflation in Germany crept higher in May, with consumer prices rising by 0.7 percent year-on-year. The index had risen by 0.5 percent on a YOY basis during the month prior. And even more importantly, data collected by Gabriel Stein at Oxford Economics shows M1 money supply in the Eurozone has been growing at a 16.2% annualized rate over the last six months. And broader M3 money supply has been surging at an 8.4% rate, a pace not seen since just before the credit crises blew up.

Rising Rates Forebode Stagflation

In the past, the Fed has viewed itself as a rocket booster: Providing the reagent to launch economic growth; and then retreating once the economy achieved escape velocity. But with growth at 1% for the first half of this year we are still firmly within the earth’s gravitational field—even after seven years of massive market manipulations.

Debt disabled economies that are mired in slow growth will not view rising interest rates as the pathway to economic nirvana--they are simply the product of stagflation. And since rates are rising for all of the wrong reasons how can this be viewed as a benefit to the stock market?

The bottom line is interest rates are now rising because the free market is doing the work that feckless central bankers don’t have the courage to undertake. The stock market currently trades at extremely high valuations; and these inappropriate valuations sit atop little to no revenue, earnings and economic growth. Far from being the harbinger of a strong economy; these rising rates will instead be the dagger for the massive asset bubbles created by governments worldwide.

Perhaps for the immediate future the stock market will cheer the Fed’s abeyance to deal with interest rate normalization. However, asset bubbles grow increasingly more incendiary with each passing day that central banks fail to act. And that means the inevitable collapse will be all the more pernicious.

 

Why the Fed Is Afraid To Raise Interest Rates
June 15th, 2015

Even though the major stock market averages are flat for the first six months of the year, by nearly every measure the stock market is still extremely overvalued. This point is not lost on Ms. Yellen and company, as the Fed Chair herself has recently assented that the current value of stocks are “quite high”. Given this, the Fed must privately be afraid that even a small change in the Fed Funds Rate could serve as the needle that pops the massive bubble in the stock market.

Exactly How Overvalued Is This Market?

First, the median Price to Earnings (PE) multiple on New York Stock Exchange (NYSE) equities is currently off the charts. Using this measure, the 2,800 NYSE stocks are at the highest level since records began since 1945.

Adding to this, the cyclically adjusted PE ratio (CAPE) for the S&P 500, which uses real per-share earnings over a 10-year period, is at a current level of 27.17. This is far higher than the long term average of 16.61, and only slightly below the 32.56 level achieved at the start of the Great Depression in 1929.

And then we have the Q ratio: the total price of the market divided by the replacement cost of company’s assets. Historically this measure averages around .68. Today this ratio sits at 1.14, the highest level recorded since the dotcom bubble, and an increase of 100% from its value in 2009. Using this metric, the value of U.S. equities is more than 10% higher than the cost to replace all of the underlying assets.

Finally we have the Total Market Cap to GDP Ratio, which represents the value of all stocks in the Wilshire 5000 divided by total U.S. output. This value indicator, at 125% of GDP, is higher than any other time in history outside of the dot.com era. And is about 75 percentage points greater than it was throughout the period 1975-1995.

As you would expect, Wall Street commentariats argue the current PE ratios are justified given the level of low interest rates. After all, they will find any excuse to keep pushing products to their clients.

However, what they so conveniently overlook is the growth rate associated with these lofty valuations. According to Case-Shiller, the average historical year over year growth rate of S&P 500 earnings is 3.8%. With earnings currently growing at just 0.7%, the PE ratio in relation to earnings growth, known as the (PEG) ratio, is now off the charts. And that paltry 0.7% earnings growth rate is even more suspect given the huge increase in financial engineering. Likewise, the overall economy is struggling to deliver any growth at all, even while interest rates are at zero percent. Therefore, the salient question to ask is: are these low rates sustainable?

Low interest rates should be the product of hard money policies from central bankers, balanced government budget deficits, and plummeting debt to GDP ratios. However, the current states of global economies and central banks are the complete opposite conditions.

For example, the Fed’s balance sheet has ballooned from $800 billion before the Great Recession, to $4.5 trillion today. In the same vein, U.S. budget deficits have ballooned from less than $200 billion during 2007, to more than half a trillion dollars today. What’s more, these deficits are guaranteed to explode with the ageing population and the eventual mean reversion of interest rates. And, of course, our national debt has doubled from $9 trillion, to over $18 trillion. However, what’s so incredible is these factors should have--if subject to free market forces--sent Treasury yields soaring. Nevertheless, bond yields have inexorably plunged over the past 7 years.

With global interest rates artificially manipulated to record lows by central banks, the search for higher-yielding investments has encouraged humongous risk taking in real estate, sovereign debt and equities. But what will happen to these assets when rates mean revert—or even surge to much higher levels?

Mean reversion is guaranteed to occur when central banks eventually become successful in creating runaway inflation and finally awaken the slumbering bond vigilantes; who will take rates much higher with or without the Fed. Or, rates must rise even if the Fed is unsuccessful in creating growth and inflation. This is because the protracted economic malaise will eventually cause the private sector to arouse to the fact we are an insolvent nation that cannot pay back, or even easily service, that $18 trillion of debt without a sustained period of above trend GDP growth. And the same can be said for other nations who’s Central Banks have artificially manipulated rates into the basement; such as Europe and Japan.

What Happens When The Bond Bubble Bursts?

Household debt service payments are now just 9.9% of disposable income. This is the lowest level since 1980. But this isn’t because households have paid off their debt; it’s just because interest rates are at record lows. In fact, household debt now stands at $13.5 trillion; over $8 trillion higher than it was back in 1980. As a percentage of GDP, it rose from 45% then, to 76% today. Therefore, when interest rates rise and the true burden of debt service is revealed, consumer defaults and bankruptcies will reemerge just as they did during the Credit Crisis.

And then we have the renewed game of flipping real estate courtesy of the Fed. This latest incarnation of the bubble provides us with anecdotes of turning over NYC apartments for, in one recently documented case, a $20 million dollar profit in a matter of months. But what happens to the flippers who once again get stuck with that $70 million penthouse when interest rates rise? We saw this movie already back in 2008; banks stop lending and consumers stop borrowing when the economy crashes due to rising rates. And flippers will be trying to dump penthouses, if not jumping from them.

Turning back to the stock market, ZIRP has led markets to unsustainable levels, and has turned executives into gamblers. According to my friend, David Stockman, using data supplied from Alhambra Investments, $550 billion in junk-bond debt was issued between the years 1996 thru 2002. However, nearly double that amount ($975 billion) has been issued in the last three years alone. The primary purpose of this money was to engage in financial engineering, not to purchase capital goods and to grow the economy.

Once interest rates rise it will become a complete disaster for the bond, real estate and equity bubbles. The Fed’s entire fatuous strategy was to inflate asset prices to generate consumption and boost GDP. But what its free money policy really created was unsustainable asset bubbles that engendered artificial and ephemeral growth.

Therefore, investors should not take any solace from believing the current PE ratio on stocks is merely, “just a little rich.” In truth they are at or near near record valuations; and these levels are even more unjustified and unsustainable given the lack of robust growth and the tenuous condition of low interest rates.

So if you are still wondering why the so called “great employment data” or “improving economy” mantras from the MSM haven’t yet moved the Fed to raise, interest rates it is because 7 years of ZIRP has caused asset prices, and the economy as a whole, to become completely addicted to free money. This is why our central bank is not only petrified to commence the interest rate liftoff; but is more than likely resigned itself into being stuck with some form of ZIRP and QE…forever.

 

Bernanke is Still Bubble Blind
June 4th, 2015

Even though the former Chairman of the Federal Reserve is now getting paid privately for his economic and market prognostications, he is still unable to identify or acknowledge the monumental bubbles that central banks have engineered. Mr. Bernanke, who was recently interviewed in Korea, tried to assure investors that rate hikes (whenever they begin) would be good news for the U.S. economy. He was also very “optimistic” there would not be a hard landing in China. And, not surprisingly, the man who is now gainfully employed at the Brookings Institution, Pimco and hedge fund Citadel, is also “encouraged” by Japanese Premier Shinzo Abe’s growth strategy. This is despite the fact that the thrust of Abenomics has been to depreciate the value of the Yen by 35 percent in the past two and a half years.

However, investors need to question if the solace Mr. Bernanke is trying to once again pervade should be accepted with complete alacrity. After all, the erstwhile Fed Head completely missed the real estate-related credit bubble and the effects of its collapse upon the global economy. And now he has again become blind to the bubbles in China, Japan and the United States.

The command and control communist government of China has been on a debt binge since the year 2000. Total credit market debt has soared 28 times (from $1 trillion to $28 trillion) in the past 15 years! And, in response to the worldwide Great Recession of 2007, the government of China put in place policies that quadrupled the total debt outstanding—rising from 160 percent of GDP, to nearly 290 percent today.

However, this humongous debt accumulation did not occur within the context of robust and accelerating economic growth. In fact, the growth rate in China fell from 13% in 2007, to 7% today. And this decline in the growth rate didn’t weigh on the equity market at all, as the Shanghai exchange has surged 140% since the summer of 2013. But the above data seems to comfort Mr. Bernanke into believing a hard landing in China is out of the question. Nevertheless, investors need to understand that another crash in the Chinese stock market and economy similar to what occurred in 2007 cannot be so easily veiled by another $20 trillion infrastructure plan to build more empty cities.

Likewise, despite Bernanke’s calming characterization of the Japanese economic condition, the retirement-island nation is drowning in debt. It is also an economy that hasn’t grown in five years and sits atop of an epic equity bubble. The Japanese National debt to GDP ratio is fast approaching 250 percent; but this figure does not include corporate and household debt, which balloons to 500% of GDP when factored in. However, the over 100% gain on the Nikkei Dow in just over two years doesn’t bother Ben Bernanke one bit either. Indeed, he has chosen to overlook the surging stock market, crumbling currency and intractable surge in debt. Bernanke remains unshaken even given the fact that the insolvent bubble-ridden nation has a 10-year note that yields an incredible 0.4%--proving the BOJ has completely wiped away the free-market price discovery mechanism and propelled JGBs firmly into the twilight zone. Once the inevitable mean reversion of interest rates occurs, the tsunami of debt defaults will shake the global economy to the core.

Mr. Bernanke’s vision doesn’t become any clearer when viewing our domestic economy. He stated the markets will cheer the Fed’s first rate hike in 9 years; but the truth may be vastly different. The market now stands extremely overvalued by nearly every metric. The median PE ratio on NYSE stocks stands at an all-time record high of over 20 times. The so called “Q” ratio, which measures the market value of U.S. equities in relation to the replacement cost of the firms’ assets, is higher today than at every other time in history outside of the NASDAQ bubble peak. Likewise, the total market cap to GDP ratio now stands at 127%, which is vastly higher than the 82% average and far above the 110% peak witnessed at the start of the Great Recession of 2007.

These peak valuations exist precisely because central banks have forced investor out along the risk curve in a desperate search for a return on their savings. Now the Fed (both current and former members) are on a campaign to convince nervous investors not to sell stocks once liftoff of the Fed Funds Rate begins.

However, the problem is the Fed’s first rate hike will cause investors to begin pricing in future increases by the current Chair Ms. Janet Yellen. This is because the median estimate from the 17 members on the Federal Open Market Committee is 1.8% for Fed Funds by the end of 2016. The first move off the zero-bound range, which the FOMC has virtually promised will occur sometime this year, has to be taken as the starting gun for the race toward that 1.8% target within 12-18 months—depending on the commencement period.

And since the Fed has removed itself from giving any date guidance for rate hikes, the second move higher will have to be purely data dependent. Unless the economy slips back into another recession, the Fed will be hiking rates on a regular basis throughout 2016. This will cause the U.S. dollar to surge even higher against the Yen and the Euro, which will place much greater downward pressure on the already anemic state of S&P 500 revenue and earnings. The resulting influence of a surging dollar and a rising cost of debt service should be devastating to the current equity bubble.

The bottom line is that Central Bankers both past and present have a vested interest in convincing investors that the strategies of zero percent interest rates and quantitative easing have been a success. But the sad truth is these policies have led to an additional $60 trillion of new debt piled onto the global economy since the end of the Great Recession; causing the re-emergence of colossal real estate, bond and equity bubbles worldwide. Mr. Bernanke may still be blind to these bubbles created by himself and current central bankers…but all investors need do to see them is open their eyes.

 

Bond Bubble Bust Won’t Cause Great Rotation Into Stocks
June 1st, 2015

For the first time in its country’s history, Portugal sold 6 month T-bills at a negative yield. The 300 million euros ($333 million) worth of bills due in November 2015 sold at an average yield of minus 0.002%. A negative yield means investors buying these securities will get back less money from the government than they paid when the debt matures.

To put this in perspective, the 10 year note in Portugal now yields just 2.38%, down from 18% a mere three years ago. Back in 2012, creditors grew wary of the countries referred to as PIIG’s (Portugal, Ireland, Italy and Greece) and their ability to pay back the massive amounts of outstanding debt. Consequently, creditors drove interest rates dramatically higher to reflect the added risk of potential defaults.

If a person had fallen into a deep slumber in the midst of the 2012 Eurozone debt crisis and awoke a week ago, they may make some reasonable assumptions as to why there was a collapse of Portuguese bond yields on the long end of the yield curve; and even displayed negative yields on the short end.

Perhaps Portugal had finally balanced their budget? Or even is now enjoying a budget surplus? To the contrary, that is not even close to the truth. Portugal has not balanced its budget…its budget deficit now sits at over 3% of GDP.

Or perhaps there was a massive restructuring of outstanding debt? Upon joining the Euro, Portuguese national debt was below the 60% limit set by the Maastricht Treaty criteria. By the start of the debt crisis in 2009, that level of public sector debt had edged up to 70% of GDP. However, the recession of 2009-12, saw a rapid increase in the level of debt. Despite recent efforts to reduce public spending and austerity measures pursued by the government, Portugal still has an immense and growing debt load, with a current National Debt to GDP ratio of over 130%.

Well then maybe there must be a dramatic deflationary cycle pushing those paltry nominal yields much higher in real terms?

Wrong again! Portugal posted a positive CPI of 0.4% year over year in April of 2015.

The truth is, the ECB would prefer bond vigilantes continue in that deep slumber, while they use artificial intervention to “do whatever it takes” to eviscerate markets and make sure sovereign debt yields never rise.

But eventually investors will wake up to the huge bubble in the bond market that must pop either through inflation, or insolvency. And when yields normalize, it will lead both the stock market and the economy into a depression.

However, the Charlatans in government and financial markets want you to believe the inevitable rising of yields in Portugal (and in the rest of Europe, the United States and Japan for that matter) will be a good economic sign. These manipulators of currencies and destroyers of savings want investors to believe they are privy to some ethereal information that only they are able to decipher. But if that were true, why then have the economic forecasts from central bankers been so incredibly inaccurate throughout history.

Likewise, central bankers also want you to believe that a rise in yields will prompt a great rotation out of bonds and into stocks--catapulting the stock markets to new highs. But higher rates in 2006 did not forebode an economic paradise, and it did not propel a 2008 great rotation out of Mortgage Backed Securities and Collateralized Debt Obligations into stocks. After all, did investors in 2008 run from collapsing real estate and mortgage related bonds into stocks when they became toxic…were they forced to put that money to work into equities right away?

Everyone who lived through the 2008 financial crisis knows that when the air came out of the mortgage bubble there was a lot of collateral damage. And in 2012 when the Portuguese bond market collapsed, investors weren’t immediately scrambling out of bonds in favor of stocks--they were aggressively shunning both during that 2010-2012 timeframe. The Ten-year Note went from 5%-18%, while the stock market was busy losing half of its value.

Central Banks around the globe have cranked up their bubble machines and are pointing them directly at the bond market. The Portuguese Central Bank has managed to engineer negative yields even though the nation has a positive rate of inflation and has become basically insolvent. In fact, the international bond bubble is vastly more pervasive and baneful than the NASDAQ and Real Estate bubbles combined. Therefore, when the bubble in bonds finally bursts, at least for a while, there will be very few places to hide outside of cash and owning hedges to plummeting equity and bond prices. And hopefully then we will all, with the perfect clarity of hindsight, acknowledge that allowing a small unelected cartel of market manipulators the power to distort markets to such a degree was a completely stupid idea.

 

Adjustable Government Data
May 26th, 2015

At the beginning of every quarter Wall Street places its overly optimistic GDP forecasts on parade. And by the end of the quarter, those same carnival barkers line up a myriad of excuses as to why the numbers fell short. Port strikes, a stronger dollar and snowier winters (caused by global warming?) are among their current favorites.

But the anemic data in the first quarter of 2015, followed by the not so much better data in the first month and a half of Q2, has rattled the optimism of not only the usual Wall Street cheerleaders, but even many at the Federal Reserve.

Historically, when the Fed saw no growth on the horizon, they would doctor up a monetary tonic in an attempt to soothe the economic malaise. But since interest rates are already at zero percent, it has left Fed officials desperate for another scheme to dig the economy out of the economic mud. So they have now found temporary relief in a simple phrase: It’s a phenomenon economists are calling “Residual Seasonality.”

What is residual seasonality?

Economists like to look at economic data in sequential quarters. Since economic activity varies greatly from the fourth quarter of a year to the first quarter of the next, the Bureau of Economic Analysis (BEA) makes adjustments to allow the quarters to be more comparable. For instance, the Holidays in the fourth quarter spur on consumer spending and deter corporate layoffs. Economists realize this and try to balance the quarterly numbers with adjustment to make up for this seasonality. They call these seasonal adjustments.

Feeding off this, The San Francisco Fed came out with a paper authored by economist Glenn Rudebusch, which seeks to resolve what he terms as; “The Puzzle of Weak First-Quarter GDP Growth”. And the conclusion is: there was no slowdown of economic growth in the first quarter…the BEA just didn’t seasonally adjustment enough. Quoting Mr. Rudebusch “The official estimate of real GDP growth for the first three months of 2015 was shockingly weak. However, such estimates in the past appear to have understated first-quarter growth fairly consistently, even though they are adjusted to try to account for seasonal patterns. Applying a second round of seasonal adjustment corrects this residual seasonality. After this correction, aggregate output grew much faster in the first quarter than reported”.

Their solution for this first quarter puzzle is residual seasonality. And the name of this new GDP calculation: GDP plus!

And as you can imagine--when the proper adjustments are made--researchers at the central bank’s San Francisco office said the economy in the first quarter was “substantially stronger” than the government reported last month. After adjusting the data, they found gross domestic product actually expanded at a 1.8 percent annualized rate, versus the 0.2 percent gain initially estimated by the government last month.

But, the BEA’s own data shows that first quarter GDP was higher than the second quarter, 4 out of the last 10 years and 2 out of the last 3 years. However, the government views this as Prima Facie evidence that all the first quarters’ growth from here to eternity needs to undergo a drastic spring makeover.

And no need to fear, if the data still looks weak after the double adjustment they can always triple adjust it. That’s the beauty of GDP plus…it’s based on simple mathematics--you can continue to add to the GDP number until you get the desired result. Even to the point in which a Chinese government official becomes uncomfortable.

In sharp contrast, The Atlanta Fed--who I imagine is the Black Sheep of the Federal Reserve family--has their own method of calculating GDP called GDPNow. GDPNow provides now-casts of GDP and its subcomponents on a regularly updated basis. The GDPNow model forecasts are nonjudgmental and non-subjective, meaning that the forecasts are taken directly from the underlying statistical model. GDPNow doesn’t look for pluses and excuses. And the Atlanta Fed’s GDPNow Model nailed that weak first quarter GDP number.

The objective GDPNow model forecasts real GDP growth for the second quarter of 2015 at just 0.7 percent; following up on what will become a negative number upon the official BEA revision.

But here is where it gets really interesting: with second quarter GDP also looking extremely weak, there is now a movement to bypass the GDP read all together. Recently, Wall Street carnival barkers and Keynesian economist are suggesting that GDP be replaced by employment and payroll numbers as the true barometer for economic growth. This is being suggested primarily because the surging number of part-time workers due to the Affordable Care Act has made the Non-Farm Payroll reports look much better of late.

And why should all the fun be limited to Fed-heads and economists? We see corporate America joining the party with their newly touted term “Constant dollars”. When the dollar was declining against most other currencies—as it has done for the majority of the time since the 1985 Plaza Accord--CFO’s didn’t say boo about the positive effects of a weakening currency upon Multi-national Corporations. But now that the strong dollar is working against them they also want to make adjustments for “residual currency translation”. I guess if you take out and add in whatever numbers you desire, you can make any data point portray whatever result you seek. Government first did this with CPI data with much success. And now that growth is AWOL they are tying it with GDP.

We have officially entered the final phase of every market bubble; it is called denial. Wall Street refuses to admit that despite 7 years of QE and ZIRP; the economy is simply not growing, the wealth gap between the lower and upper classes has surged and the middle class is going extinct. They are also trying to deceive themselves, and you, into believing stocks at these levels are fairly valued. Therefore, when they fail to get the economic data that fits with their delusional narrative…they will find a reason to just change it. The good news is the populace currently has access to the real numbers before they become favorably revised. The bad news is, official data will soon be “adjusted” right from the start.

 

Bond Bubble Will Explode Violently
May 18th, 2015

Central banks are incapable of saving economies or creating growth. The only thing a central bank can do is create inflation. These market manipulators set forth on a journey seven years ago to save the world by engaging in massive monetary manipulation, euphemistically called Quantitative Easing (QE), and a Zero interest rate policy known as (ZIRP).

As I could have told them before they started, all this easy money will fail to create viable growth. The economy, held back by massive debt levels, initially clocked in at 0.2% for the first quarter. This number is set to be revised down to negative territory due to a huge increase in the trade deficit during March. And the second half isn't setting up to be much better either.

But the Fed was successful in re-inflating the housing and equity bubbles and also creating another new massive bubble in the bond market.

Despite tepid growth, most at the Fed have become anxious to wave the "Mission Accomplished Banner" and to move towards interest rate "normalization". Ceremoniously, they have set goals for the economy to reach in order to begin that long journey: unemployment around 5% and inflation at 2%.

As the Fed's luck would have it, discouraged would-be workers have dropped out of the labor force and have found it more profitable to sit home than to work, which has allowed the unemployment rate to approach the Fed's target. The unemployment rate has finally returned to the 2008 bubble level of 5.4%. But when we look more closely, (at the chart below) employment to population ratio is nowhere near where it ought to be.

But those at the Fed stand determined to never let real data points get in the way of the narrative that printing money saved the economy. In fact, San Francisco Fed President, John Williams, was recently touting a new way to calculate GDP that he called GDP plus. It appears when you take out everything he defines as "noise", first quarter GDP would have come in at exactly 1.7%. Perhaps a better term would be GDP minus: GDP minus all the things we wish didn't happen in the economy this quarter.

Now the only thing hampering the Fed's path to rate normalization is the "too-low" rate of inflation--the inflation resulting from unprecedented money printing and years of ZIRP that caused massive stock, bond and real estate bubbles doesn't count in the government's inflation indices. Nevertheless, the official core CPI number used to measure inflation appears at the moment to be "just right."

And for a brief moment, if we dismiss those asset bubbles, ignore discouraged workers, cherry pick economic data points and squint a little--we can be deluded into believing the economy has reached Goldilocks Nirvana…or even Goldilocks Nirvana plus.

But before Goldilocks reaches for her porridge, she may want to pay closer attention to what the Bond Market is telling us.

Normally, interest rates are a product of credit and inflation risks. Until a few weeks ago, central banks got away with the notion they could monetize unlimited amounts of sovereign debt without creating inflation. That is until now; look at sovereign bond yields in the past month: the Italian 10 year went from 1.26 on April 14th, to 1.91%, Portugal--April 14th 1.71, to 2.49%, Spain April 14th 1.26, to 1.88%, France April 15th 0.35, to 0.99%, Germany April 16th 0.08, to 0.72%. And all this is causing the U.S. 10 Year Note to jump from 1.87% on April 16th, to 2.31%.

For the past seven years, investors didn't have to worry about credit risk because central banks were ready buyers regardless of a nation's insolvent condition; as long as inflation was thought to remain quiescent. But here is a news flash--investors won't own sovereign debt if real interest rates plunge much further into negative territory. And neither will they accept negative real and nominal yields on fixed income if they can instead own Precious Metals, Commodities, Real Estate, or any other hard asset.

There is also a lack of liquidity in bond markets because central banks have removed all the supply. Investors don't want to buy new debt with negligible yields, but also don't want to sell if central banks are providing a perpetual bid. Therefore, there is no trading outside of institutions front running the central banks' purchases-again, as long as there is no inflation.

But here is the rub; once inflation becomes a problem central banks will then become sellers instead of buyers of bonds and principal depreciation will quickly erase the paltry yield away from investors.

And here is where it gets interesting: the Headline CPI is down 0.1% YOY in March, but the core rate of CPI is up 1.8%--coming very close to triggering the Fed's "return to normalization" target. A steep decline in the price of oil that began in the summer of 2014 has dragged the overall CPI number down. But gas prices have risen over 30% since the January lows. And the effect of the energy price collapse on the headline number starts to diminish in July, and is completely erased by the end of the year.

Therefore, very soon the Fed should be confronted with all the data points it previously mapped out in order to start raising rates. But perhaps the central bank should be careful about what it wishes for. This is because seven years of interest rate suppression has created a powerful vacuum that could suck higher long-term interest rates in accelerated fashion.

On The Other Hand

Despite years of QE and ZIRP, the economy is still scraping along the bottom. If the Fed were to raise the cost of money above the one percent level, it will bring this bubble-addicted economy to its knees, as it provides the pin to the bubbles in real estate and equities. The growth rate in broad Money Supply (M3) has been falling from 9% in 2013, to just 3% today. Therefore, when short term interest rates rise it is also very likely that the yield curve will invert and cause money supply growth to turn sharply negative; just as it did during the Great Recession. This is precisely because the long-end of the yield curve has been artificially suppressed for so many years. Longer-dated maturities could discount even slower growth ahead, and the yield curve would quickly invert from its already compressed starting point.

As previously explained, if I'm wrong about the yield curve flattening after the Fed starts hiking rates, it will only be the result of the market losing complete confidence in the US tax base to service Treasury debt and for global central banks to keep inflation in check. This alternate scenario would occur if the Fed decided to hike rates just once and then sat on its hands for a long period of time. The Fed's prolonged "patience" in hiking rates further would soon lead to that intractable rise in US long-term rates and result in a complete disaster for markets and economies worldwide.

Either Way We're Sunk

Whether long-term interest rates rise or fall when the Fed begins its exit is still in doubt-it all depends on the slope of Fed Funds rate. The yield curve could quickly invert or rise intractably. However, the only sure outcome is chaos on a global scale because central banks have never been able to extricate the economy from the bubbles it created. Such is the inevitable result of the massive and historic intervention of central banks into the sovereign debt market. In other words, bubbles never pop with impunity and the international bond bubble is certainly not going to be the exception. Therefore, no matter what happens to interest rates in the future you can be sure of one thing...the suffering will be immense.

 

Obamacare Caused The Gas Tax Cut To Go Up In Flames
May 11th, 2015

Wall Street analysts unanimously cheered last fall when the price of oil fell from nearly $100 a barrel in June of 2014, to almost $45 a barrel by the end of January 2015. The theory was that the average American family, paying less at the pump, would plow this savings into other goods and services, giving GDP a much needed boost.

In the winter of 2014 optimism about a strong 2015 was abound. The average household was now poised to have an extra $750 a year that would soon be burning a hole in their pockets. Falling gas prices would free up billions of dollars for consumers to spend next year, with the spend-happy middle class seeing most of the benefit.

Lower prices at the pump was the equivalent of cutting taxes between $100 billion and $125 billion. Increased consumer spending as a result of lower gas prices were predicted to add as much as a half-percentage point to economic growth in 2015.

With first quarter GDP now running negative, it is clear this "gas tax" did not have the simulative effect analysts had hoped for.

What Happened To Our Gas Tax Windfall?

It appeared most analysts assumed if consumers liked their gas tax cut (much like Obama's promise to keep their health plan)…they could keep it. Unfortunately Obamacare may be the Grinch who stole the gas tax gift meant for consumers. An increase in what the average American pays in health care costs as a result of the Affordable Care Act (ACA) has swallowed all the savings from the fall in gas prices.

The first victims of Obamacare were small businesses, who quickly learned their once sufficient coverage did not match the arduous ACA mandates. The increase in health care costs passed on by employers caused Individual year-round employees at businesses with 50 to 99 workers to lose $935 in take home pay annually, while those at firms with 20 to 49 workers were out an average of $827.50. And workers with solo coverage now pay an average of $1,081 in annual premiums, according to a Kaiser Family Foundation/Health Research & Educational Trust report--up a whopping 8.1% from a year ago.

But small business and the self-insured are not the only ones suffering the Obamacare wrath. With Obamacare's onerous Cadillac tax, many who once enjoyed lavish health care plans, curtesy of their large employer, are now paying a lot more for premiums and out of pocket expenses.

Under this law, if an individual health-insurance policy costs more than $10,200, the employer has to pay a 40% excise tax for the amount the policy exceeds that threshold. For family policies, the corresponding threshold is $27,500. This tax goes into effect in 2018 but most employers aren't waiting for the tax to kick in. They have been busy trading in their employee's Cadillac for an AMC Gremlin. These high deductible plans are less expensive to the employer, allowing them to avoid the threshold and corresponding tax; but they are more expensive to the employee--burdening them with a lot of additional costs.

And it's only getting worse for employees of larger companies. Next year, nearly a third of large employers only plan on having the Gremlin on the lot. That is, they are only offering high-deductible plans. This is up from 22 percent in 2014 and 10 percent in 2010, according to a study by the National Business Group on Health.

Fittingly, this year, employees will pay 55% more for health insurance premiums and out-of-pocket medical bills than they did in 2010. This is taking a big bite out of consumer's disposable income. The average worker with employer-sponsored health insurance will pay about $2,664, or nearly 24% of the total cost of their plan premium in 2016. Five years ago, employees paid $1,835.

When you couple this with the high deductible plans, employees will pay an average of $2,487 in out-of-pocket costs, nearly double what employees paid in 2009. Not too long ago half of employees had deductibles below $500; now, only one-third do. Goodbye gas tax…hello higher health care costs.

Finally we have the previously uninsured, whom Obamacare was designed to help. Surely they are reaping the benefit of all this "affordable care". Unfortunately, those Obamacare recipients who count on a tax refund to balance their household books may have to look for another way to make those ends meet. Customers who received subsidized coverage based on their estimated income are now seeing tax bills for part or all of the subsidy because their actual income turned out to be higher.

The hard cutoff for subsidies occurs once incomes exceed 400% of the official U.S. poverty rate. Going over that amount by even $1.00 can result in a hefty IRS bill because all those subsidies go to Zero once you surpass that threshold. Health policy analyst and former New York Lt. Governor Betsy McCaughey wrote, "For about 1 in 4 tax filers, it's turning out to be a nightmare, with extra paperwork and penalties." It is anticipated that at least half of subsidy recipients owed more in taxes this year due to underestimating their income. And according to H&R Block, sixty-one percent of those filers saw their refunds reduced by an average of $729.

But Obama care isn't the only reason why the economy won't achieve "escape velocity". Cheerleaders on Wall Street don't want you to focus on the other drags to growth such as stagnant real incomes, the rise in the cost of rental housing and the debt-disabled, overregulated condition of the nation. They only want to talk up the positives; and then provide a myriad of banal excuses (e.g. weather) when the economy fails to live up to their over-hyped expectations. Q1 GDP will most likely produce a negative number for two years in a row and now interest rates on sovereign debt have spiked across the developed world. That doesn't bode well for a second quarter rebound in growth.

Still, the narrative on Wall Street is that Q2 will finally show a massive boost in consumer spending from lower oil prices. But the truth is there was no boost in retail sales when gas prices were coming down; and there is not going to be one now that gas prices have risen by 31% since mid-January. The decline in oil prices merely helped defray the spike in healthcare costs from the ACA. Therefore, those expecting a Q2 rebound driven by consumer spending from the erstwhile drop in oil prices should, unlike Ms. Pelosi, be careful to "read the bill now that they have passed it."

 

The Collapse of Cash
May 4th, 2015

Despite all of the central bank manipulations over the past seven years, it is finally becoming clear economies will not be able to achieve escape velocity. The U.S. central bank has the longest track record of treading down the path of monetary manipulations. And has achieved anemic average annual growth of 2.2% since 2010. Therefore, to further demonstrate the failure of money printing to engender economic growth, the dismal Q1 GDP read of just 0.2 % displays the failure of this policy once again. Wall Street Shills have been quick to once again blame snow in the winter for the Q1 miss. However, it is becoming evident that Q2 will not produce any such anticipated rebound.

Markit’s Flash U.S. Services PMI (Purchaser Managers Index) for April indicated that business activity rose at a slower pace than expected. The April reading came in at 54.2, which was below the consensus of 56.2 and below March’s level of 55.3. Adding to the bad news was the Conference Board's Consumer Confidence Index that hit 95.2 in April. Economists polled by Reuters expected a reading of 102.5. And, the Richmond Fed Manufacturing Index fell into the minus column for the second month in a row at -3 for the start of Q2.

Things don’t look much better across the globe. The Euro zone Purchasing Managers' Survey disappointed investors with the German PMI index falling to 54.2, from March's eight-month high of 55.4. France's PMI also showed a slower expansion than forecast in the services sector and a worse contraction in manufacturing than predicted. Manufacturing PMI in France decreased to 48.4 in April, from 48.8 in March.

Japanese manufacturing activity contracted in April for the first time in almost a year, as domestic orders and output fell. The Markit’s Japan Manufacturing Purchasing Managers Index (PMI) fell to a seasonally adjusted 49.7 in April, from a final 50.3 in March. The index fell below the 50 threshold that separates contraction from expansion for the first time since May of last year.

We are in our seventh year of record-low interest rates and banks have been flooded with reserves. However, the developed world appears to be debt disabled. That is, already saturated in debt, therefore unwilling and unable to service new debt due to a lack of real income growth.

So the problem for central banks and governments is how to get the money supply booming in an environment where consumers want to deleverage and save. Zero percent interest rates (ZIRP) are inflationary and negative real interest rates foment asset bubbles and encourage new debt accumulation. For decades central banks have used their control of the price of money to coerce boom cycles that eventually turn to bust. But for the past six years, their foray into ZIRP land hasn’t provided the boom cycle they were expecting. Sure, they have created massive bubbles in bonds and equities--but the economy has yet to enjoy the promised growth that is supposed to trickle down from creating these bubbles. They have set the markets up for a bust, yet the economy never enjoyed the boom.

This has left Keynesians scratching their respective heads and scheming new ways to encourage even more borrowing and spending. The Keynesians who rule the economy now control the price of money but are having difficulty controlling its supply and producing rapid inflation rates.

Bank deposits that pay nothing and ultra-low borrowing costs haven’t proved effective in boosting money supply and velocity growth. The growth rate of M3 has fallen from 9% in 2012, to under 4% today. And monetary velocity has steadily declined since the Great Recession began. Therefore, unfortunately, the next baneful government scheme is to push interest rates much further into negative territory in real terms; and also in nominal terms as well!

You would think this is absolutely absurd but it is already happening. The European Central Bank, has a deposit rate of minus 0.2 percent and the Swiss National Bank, has a deposit rate of minus 0.75 percent. On April 21st the cost for banks to borrow from each other in euros (the euro interbank offered rate, or Euribor) tipped negative for the first time. And as of April 17th, bonds comprising 31% of the value of the Bloomberg Eurozone Sovereign Bond Index, were trading with negative yields.

Could Negative Interest Rates Arrive In America?

They already have. Beginning on May 1st, JP Morgan Chase has announced they will charge certain customers a “balance sheet utilization fee” of 1% a year on deposits in excess of the money they need for operations. That amounts to a negative interest rate on deposits. Banks formerly competed for your money--now they want to charge you to park it with them.

With interest on deposits at next to nothing, or now slightly negative, the only reason for consumers to keep money in the bank is convenience. The more money you lose money on your deposits in the form of a “utilization fee”, the more attractive your mattress becomes. But, as long as paper money and your mattress are available, the Fed will not be able to fully implement its negative rate policy in its quest to create inflation. After all, there would be a global run on the banking system if rates were to fall into negative territory by more than just a few percentage points.

So how can central banks and governments ensure rapid money supply growth and velocity if consumers have the option to hoard cash? Some of the “best minds” in Keynesian thought, like Kenneth Rogoff, have a solution to this. They are floating the idea that paper money should be made illegal and the evidence shows governments are listening. If you outlaw hard cash, and make all money digital, there is no limit to how much borrowers can get paid to borrow and how much savers get charged to save. This would make it unprofitable to hoard cash, and compel people to consume and borrow electronic currency as fast as possible. Money in the bank would become the “hot potato”: as soon as it hits your bank account the race would be on to move it to the next person’s account. Whoever gets stuck with the money when the music ends pays a fee; that would be some increase in velocity! And vastly negative real interest rates would force the amount of leverage in the economy to explode.

This idea sounds fairly Orwellian–allowing central banks to control every aspect of monetary exchange and giving the Federal Government an electronic gateway to every financial transaction. But when you think about it, the idea of a fiat currency and the Federal Reserve were radical ideas before they became common place. Indeed, this is exactly why the authors of our constitution tried to ensure gold and silver would have the final and only say in the supply and value of money.

Just as gold once stood in the way of governments' desire to expand the money supply, physical cash is now deemed as a fetter to the complete control of savings and wealth by the state. History is replete with examples of just how far governments will go to usurp control of people under the guise of the greater good. Sadly, the future will bring the collapse of cash through its illicit status, which will in turn assist in the collapse of the purchasing power of the middle class. Wise investors would take advantage of the opportunity to park their savings in real money (physical gold and silver) while they still have a chance.

 

Let’s Blame the Savers
April 27th, 2015

Just like in the world of fashion, economic terminologies come in and out of vogue. One such economic term trending recently is Secular Stagnation. First proposed by Keynesian economist Alvin Hansen back in the 1930s, Secular Stagnation was coined to explain America’s dismal economic performance—in which sluggish growth and employment levels were well below potential.

The term is now back in style thanks to the likes of the contemporary heroes of Keynesian economics, like Larry Summers and Paul Krugman; and is based on the notion that a chronic savings glut has resulted in the economy operating well below potential. The notion that the developed world is trapped in some type of stagnation is something I can agree with.

However, the reasoning offered for this stagnation completely dismisses the role of central banks and assumes low growth and interest rates are instead being driven by those pesky savers. This theory is not only philosophically and economically bankrupt, it also dismisses all of the factual evidence about the actual decline in worldwide savings rates.

What Krugman and Summers fail to realize is; when interest rates are high, people are compelled to save more. And on the other hand, when interest rates are low they tend to save less. Supporting this theory, in the 1970s when interest rates neared 20%, the US savings rate hit an all-time high of 14.6%; today it averages closer to 5%.

Not surprisingly, Japan, the poster child for secular stagnation, has seen a shocking drop in household savings. Savings rates that averaged as much as 20% in the 1980’s, hit a negative 1.3% in March of 2014. It’s no coincidence that this negative savings rater concurred with its 0.3% 10-Year Note yield and highly-negative real interest rates.

Savings in the European Union has also fallen along with lower interest rates manufactured by the ECB. Household savings was at 13.3% in 2009, but fell to 10.5% by the first quarter of 2014. The truth is despite Summers and Krugman’s desire to lay the “blame” with savers, there is no proof of a world-wide savings glut. These Keynesians never seek to explain who or what would have caused global consumers to undergo such a mass hypnosis into the propensity to increase savings.

This is because no such increase in savings rates exists. In fact, 28 percent of current U.S. workers have less than $1,000 in savings that could be applied toward their retirement, according to a new Employee Benefit Research Institute and Greenwald and Associates survey. And, 57 percent of consumers say they have less than $25,000 in total retirement savings. Indeed, the so-called “savings” referred to by these market manipulators is really just central bank credit masquerading as savings. And this investment capital should only have become manifest through productivity growth and deferred consumption—not by central bank fiat.

The Real Cause of Secular Stagnation

Over the past seven years the Federal Reserve printed $3.7 trillion with the hopes of spurring economic growth. But ask yourself, who did this money actually go to?

At the onset of the financial crisis Ben Bernanke didn’t run around America like Ed McCann--knocking on doors and handing people checks to pay off their underwater mortgages. On the contrary, the first tranche of money in the form of TARP and the AIG bailout went to banks in order to allow them to remain solvent.

Then, three rounds of QE bought distressed assets on the books of banks with hopes this would allow them to make new, less questionable, loans. But, who were the banks supposed to lend to? Consumers were already loaded with debt because they didn’t get a Fed bailout.

Adding to this condition of excess reserves piling up in the private banking system were new and more onerous regulations. Dodd/Frank legislation encouraged banks to park new money with the U.S. Treasury. And the leftover money more easily found its way into the stock market than it did in the pockets of consumers. Thus, creating the massive bubbles that now exist in bonds and equites and also greatly exacerbating the trenchant wealth gap between the rich and the poor.

But, ironically Krugman and Summers acknowledge these Fed-induced asset bubbles and see them as our only hope. In fact, Summers argued in a speech delivered to the IMF that today’s world needs bubbles just to achieve anything close to full employment. New York Times columnist Paul Krugman doubled down on that specious reasoning in his blog stating; “Bubbles may be necessary to make up for insufficient demand, high unemployment, and sluggish growth.”

Instead of allowing the economy to work through a short-term painful deleveraging in order to clear mal-investments, pay down debt and pave the way to real sustainable growth, Messrs. Summers and Krugman would rather cheerlead the economy through a series of never-ending booms and busts that is causing the global middle class to become a passing fad. It appears Keynesians, that dominate global politics and central banks, have completely lost faith in economies to rebound and for markets to clear. They have acquiesced to a command and control economy built on phony central bank interest rates and credit.

The truth is real savings and real investment do not cause secular stagnation, but are rather the very foundations of productivity and growth. However, the develop world’s current condition of secular stagnation is brought on by central bank debt monetization; which leads to asset bubbles, debt saturations and the desolation of middle classes. In reality, the economy is mostly suffering from the stagnating brains of those who control governments and banks. And it is this blatant form of secular stagnation that will soon bring down the entire global economy.

 

The Spread between Stock Prices and GDP is Blowing Out
April 20th, 2015

On a fundamental basis stock prices are reflective of both economic and earnings growth. When growth is strong, stock prices should increase in value. And when economic activity decelerates or turns negative, stock prices should go down. Of course nothing is that simple—especially today, when all markets are so highly manipulated by governments and central banks. Beginning in 2008 the markets followed the Fed on a magical journey down the rabbit hole into a wonderland where bad news is good news; and economic fundamentals and stock prices no longer move in tandem.

Welcome to the worldwide equity bubble brought to us courtesy of central banks, which has caused the complete decoupling of stock prices from underlying economic activity. This delusion has been fomented by the specious notion that QE and ZIRP will eventually cause economies to catch up to record-high stock valuations.

Perhaps the best example of this fiction is the nation of China, where the ride on the command and control economy has left the communist country perched atop two massive asset bubbles. One in real estate, whose foundation is empty cities, and one in the Shanghai Index, whose value is based on companies that have, at best, questionable accounting practices. But why let a lot of manipulated facts get in the way of a really exciting asset-bubble story. For an exploit in pure froth, China doesn’t disappoint.

Let’s take a look at the recent deceleration of China’ GDP growth compared to the frothy bubble in the Shanghai Composite over the past year:

China’s Shanghai Index:

It’s clear the Shanghai valuation has completely fallen off the economic tracks--as the stock market has been accelerating into decelerating growth. In early March, Beijing cut its gross domestic product (GDP) growth target to "around 7 percent" for 2015, the lowest level in 11 years. Official data also showed China's exports unexpectedly plummeted 14.6 percent year-on-year in March. But the bad news doesn’t end there; growth in factory output slowed to 6.4 percent in the first quarter from nearly 10 percent in December. And that officially reported 7 percent GDP growth in Q1 of this year is the lowest growth rate since 2009.

Despite this, the Shanghai Index is at new highs--up 30% YTD and over 106% YOY. This because investors, hesitant to build additional empty cities, are finding new hollowed investments in equities - creating a massive bubble in the stock market.

Adding to the fun, Shanghai traders now have more than 1 trillion yuan ($161 billion) of borrowed cash fueling this high-flying stock market. The outstanding balance of margin debt on the Shanghai Stock Exchange is at an all-time record high and accounts for nearly a 400 percent jump from just 12 months prior. Perhaps that is why Chinese regulators recently placed curbs on the shadow banking system’s ability to purchase equities on margin.

Although China may sit as the best example of equities decoupling from economic fundamentals, it’s far from the only one. Japan’s NIKKEI Index has skyrocketed up 40% year-over-year, and is up almost 14% year-to-date; despite recent data that confirms the nation is fast turning into one big retirement home.

Japan’s NIKKEI Index:

In the U.S., where growth has been lack-luster, the total market cap for stocks is hovering around 127 percent of GDP, far above the 110 percent level seen just prior to the housing and credit bubble collapse and a full 75 percentage points above its multi-decade average. And with NYSE margin debt for February 2015 at $465 billion, it is also at an all-time record high. Why not borrow money to speculate on stocks when the cost of borrowing is at a record low?

Then there is Europe. Since QE began stocks have been surging. In France, the CAC 40 is up 20% this year, while real GDP was up 0.1 percent in Q4; and projected to be up just 0.9 percent for all of 2015. The German DAX up 25% YTD and 31% YOY; yet industrial production was down 1.6% YOY in February.

And despite Mario Draghi’s bubble-denial syndrome, the bubble in European bonds has now hit the manic stage; as 30% of European Sovereign debt is now trading with a negative yield. The world-wide bond bubble has now dovetailed perfectly into a massive global equity bubble.

While world-wide markets are cheering central banks QE--sending stock markets sky rocketing--our Fed is quickly running out of credibility and tools to fight another economic downturn. Zero percent interest rates for 7 years and a $3.7 trillion QE bail-out from the Great Recession have not done anything to improve economic growth. Central banks have merely re-inflated old bubbles and then created a new one in global sovereign debt.

But what happens when investors reach the epiphany that all of the central banks’ interest rate manipulations and money printing didn't work? The U.S. Federal Reserve isn’t able to lower interest rates any further. Furthermore, our central bank is growing exceedingly anxious to unfurl its own “mission accomplished” banner on rescuing the economy and to begin the journey on rate normalization with the first rate hike in June.

But if the economy were to enter into a recession at this point how would the stock market and economy respond? Seven years of ZIRP and QE didn’t help the U.S. economy achieve “escape velocity”, so why would the holding in abeyance of the Fed’s interest rate liftoff this summer, or even another round of QE, automatically send stock prices higher?

Ever since the end of the Great Recession in June of 2009, investors have full-heartily bought into the belief that central banks will eventually cause economic growth to catch up with equity valuations. To date investors have been willing to excuse sub-par economic growth, such as March’s abysmal Non-Farm Payroll report, on the weather. The Empire State Manufacturing Survey for April showed a month-on-month negative reading of 1.19, giving credence to the belief that economic growth has currently completely stalled.

An objective look at the above charts and data clearly depicts that equity values have become completely divorced from economic reality. The catalyst for the next major collapse in stocks will come from an impending recession that central banks and governments will be viewed as powerless to prevent. If April’s better weather doesn’t come along with a spring economic recovery, investors will have finally run out of excuses and will have to face the truth that after seven years of market manipulations the government has failed to engender sustainable growth—both Q1 and Q2 GDP and earnings growth could be hugging the flat line for the first time since the second quarter of 2009. Therefore, without an immediate improvement in Q2 data, the erstwhile view of only a temporary disconnect between economic fundamentals and equity prices will become one of indefinite duration. And this should finally cause the massive correction in equity values that is so very long overdue.

 

3 Daggers for This Equity Bubble
April 13th, 2015

The recent stock market volatility has caused the major averages to lose nearly all their gains for 2015. However, it is clear stock prices are still extremely overvalued by virtually every metric, especially when viewed in the absence of GDP and earnings growth.

For starters, the Cyclically Adjusted PE Ratio on the S&P 500 is currently 27, whereas the normal level for this longer-term valuation metric is just 15. Also, the ratio of Total Market Cap to GDP is currently at 125%. This reading, which measures the value of all stock prices in relation to the economy, is the second highest in history outside of the tech bubble and is far above the 110% level witnessed in 2007. And with a median PE ratio of all NYSE stocks at a record-high 22, there can’t be any doubt that stock prices are at extreme valuations.

But these lofty valuations sit atop negative earnings growth and a faltering economy. The Atlanta Fed’s GDP model currently shows Q1 2015 economic growth will come in at a paltry 0.2% annualized rate. And S&P Capital IQ predicts Q1 earnings will fall 2.9%, while also projecting Q2 earnings growth will contract 1.8%.

So how can stock prices remain at record high valuations; given the fact such levels seem egregiously ridiculous within the context of no growth? The answer is simply that central banks have given investors no other alternatives. Banks pay you zip on your deposits and sovereign debt offers little return--even when going out 10 years on the yield curve.

Central banks have forced investors to play musical chairs with their money; but this dangerous game has millions of players and just a handful of chairs. When the music finally stops investors will find that bids for stocks have become very rare.

There are three very specific conditions that will warn investors when a spike is about to be driven through this massive equity bubble—and, if heeded, will give you a chance to pounce on one of those few remaining bids for stocks at these incredible levels.

The first is a U.S. recession. To be clear, domestic growth in Q1 will already be close enough to zero to get us halfway to a recession. The carnival barkers on Wall Street have jumped on the weather excuse once again and have bought the markets of few more weeks. However, once April economic data is announced, it must clearly display to investors that first quarter’s flat GDP print was simply caused by another cold winter. If it does not, the negative earnings growth in Q1 will then be extrapolated to Q2 and will convey to investors that the Fed was unsuccessful in providing sustainable growth after 7 years of ZIRP. Now that QE is no longer levitating stocks (and the Fed is actually threatening to raise interest rates), the markets will finally succumb to the massive weight of record-high valuations that have been erroneously built on top of anticipated rapid growth that never materialized. If April’s data on Durable Goods, Industrial Production, Factory Orders or Retail Sales is reported with a minus sign, investors should run for the exit.

The second indicator that the equity bubble is about to explode will be if the Fed actually starts raising rates. Of course, some pundits will be quick to point out that just one 25bps rate hike won’t be enough to derail the equity bubble because rates will still be very low. However, the Fed will be embarking on a rate hike campaign into a market cycle of deflation and slowing growth. Normally, the Fed raises rates to combat inflation, which has started to send long-term rates much higher. But, this time around the Fed will be hiking rates just to prove it can get off the zero bound range it has been stuck on since 2008. Or, because the unemployment rate dropped below the Fed’s arbitrary, Phillips-curve line in the sand, where inflation is supposed to magically materialize. This means the Ten-year Note, which has already dropped below 2% due to deflationary forces, would most likely fall even lower. Since the Effective Fed Funds Rate is currently at .12%, it will only take a handful of 25bps rate hikes before the yield curve flattens out and banks find it unprofitable to make new loans. Once this occurs, the money supply contracts and the markets and economy go into a tailspin. Unless the Fed makes it abundantly clear that its first rate hike is not part of any protracted campaign, look for investors to quickly anticipate an inverted yield curve and to start panicking out of stocks.

Finally, the third spike for this market bubble will be if U.S. Benchmark interest rates were to rise above the 3% level. This could occur if the Fed is finally successful in creating inflation. Or, more likely, when investors lose confidence in the U.S. to easily service the debt. Total Non-financial debt has surged $9.5 trillion (30%) since the Great Recession of 2007. Any significant increase in borrowing costs would quickly derail the fragile consumer who is already suffering from a lack of real income growth. And, increased borrowing costs for the U.S. government would lead to much higher budget deficits. A Ten-year Note that eclipses 3% would quickly topple the fragile real estate market and also begin to offer significant competition for stocks. The last time U.S. rates spiked from 1.5%, to above 3% was April 2013-January 2014. And this was the real cause for GDP growth to fall to -2.1% in Q1…not the weather.

Until one of these conditions are met the markets may continue to surge further into record-bubble territory. However, investors should pay close attention to April’s economic data, the Fed’s strategy surrounding its first rate hike, and also keep a close eye on the long end of the yield curve. That is, if they want to avoid getting consumed by the third massive collapse in equity prices since 2000.

 

Yellen Runs Out Of Patience, But Not Excuses
March 23rd, 2015

The Fed removed the word Patience from its statement made following the FOMC meeting that concluded on Wednesday. But, taking out that one word proved to be mostly irrelevant. The removal of the patient language was more than offset by the Fed’s lowering of its GDP growth estimates and its projection for when and how high it will raise rates based on its previously incorrect assessments of inflation and growth. Ms. Yellen said in the FOMC press conference that removing “Patient” did not mean she would become impatient with raising rates. It is clear that the dollar's strength and the cascading economic data reported since the start of 2015 caused the Fed to push out its timing for its first rate hike and the overall level for which it will finally reach equilibrium.

This was a dovish statement despite the removal of the word “Patient”. It is now apparent that the Fed will not raise interest rates unless both the dollar falls in value against the euro and yen; within the context of building U.S. economic strength. However, both those conditions cannot be true. A stronger economy would lead to a stronger dollar; and that will cause earnings growth to continue to plummet, cause a stock market correction and put the Fed’s inflation goal further out of reach. This should stay the Fed’s hand. Likewise, a falling dollar would only become manifest under continued weakening economic data, which would cause the Fed to remain on hold because it can’t raise interest rates while the economy is barely growing; and is currently flirting with recession. The bottom line is the Fed will find it very difficult to raise rates unilaterally and will probably have to wait at least until the ECB and BOJ stop QE. This is why gold soared after the FOMC statement, along with the major averages.

The Carnival Barkers that dominate the financial media applauded Ms. Yellen’s performance at her press conference; saying the Fed had learned its lessons from the past (think 1937) and would not cause another depression within a depression. However, keeping ZIRP in place for another few months, at the very least, after being at zero percent for nearly 7 years isn’t at all learning from the past. The central bank is directly responsible for creating serial asset bubbles during the last three decades and allowed for massive debt accumulation to now reach the point where every developed nation is insolvent and totally addicted to their central banks purchasing virtually every issued sovereign bond.

The bottom line is the Fed is scared to death about pricking the equity and massive bond bubbles. Ms. Yellen appears to have run out of patience with only one thing…the word patience. But sadly, it appears she will not run out of excuses for keeping borrowing costs at zero.

Beware of the Inverted Yield Curve!
March 16th, 2015

In the movies, an edgy musical score is an effective tool that warns the audience something really bad is about to happen. Like the shrill screech in Psycho, certain sound effects forebode impending doom. In like manner, economics also has a similar warning sign of imminent market chaos. This omen is called the inverted yield curve. And it’s no coincidence that the last seven recessions have been preceded by this ominous predictor of economic and stock market disaster.

The yield curve graph depicts the slope of sovereign bond yields across all maturities. When investors desire to purchase longer-dated maturities, they typically demand a higher yield to compensate for inflation risks that tend to increase over time. Therefore, under normal circumstances, longer-term bonds yield more than their short-term counterparts. Typically, the yield on 30-year Treasury bonds is three percentage points (300 basis points) above the yield on three-month Treasury bills. When the yield curve steepens from that usual spread it means long-term bond holders believe the rate of inflation will increase sharply in the future.

At the other end of the spectrum we have the inverted yield curve. This occurs when the Fed Funds Rate and short-term U.S. Treasuries offer higher yields than longer-dated issues. The signal here is that investors anticipate an environment of sharply slowing economic growth, deflation and economic turmoil.

How This Played Out During The Past Two Recessions?

By the late spring of 2000, the rate on the 10 year note was lower than the Fed funds rate; thus officially inverting the yield curve. The Federal Reserve raised the Fed funds rate 25 basis points on March 21st from 5.75, to 6.0%. Afterwards, the Fed ended its rate hike campaign in May of that year with a 50 basis point rate increase to 6.5%, while the Ten-year Note traded below 6.0% by June. After this, the S&P 500, which was not a part of the tech bubble, peaked in July of 2000 and dropped 40% by September of 2002.

Likewise, in June 2006 the Fed ended its multi-year cycle of rate increases, taking the Funds Rate up 25 basis points to 5.25%, while the 10-year Note yielded around 5.0% during that same timeframe. The yield curve officially inverted for the second time that decade—investors once again heard the ominous music playing. The backward yield curve first caused the massive housing bubble to rollover in the summer of 2006. And, since the yield curve remained inverted for over one year, the equity market quickly followed the collapsing real estate market. The S&P 500 plummeted 50% from July of 2007, to March 2009.

Today the 10 year note is trading around 2.25% and the Fed Funds rate is in the 0-25 basis point range. During the Fed’s previous rate hike campaign, it had to move short-term rates up 400+ basis points before the yield curve became inverted. However, this time around the Fed will only have to increase the Fed Funds Rate half that amount before the yield curve will become inverted. And it may take even less than that, as the economy is already experiencing anemic growth and disinflation—which will put downward pressure on long-term rates. In addition, interest rates on foreign sovereign debt are well below those in the United States, which will push domestic rates down even further.

Therefore, this time around the yield curve will invert at a much lower level than at any other time in history. What’s more, the Fed has historically raised rates in order to combat a rising rate of inflation, a weakening U.S. dollar and rapid GDP growth. Now, it will be raising rates in the midst of low inflation, a soaring Greenback and anemic economic growth. And, the Fed won’t have to make many rate hikes before the yield curve inverts.

So Why Will The Fed Raise Rates?

The Fed has drawn a Maginot line with its use of the unemployment rate as the main indication of when to raise rates. The Fed is relying on an indicator for when to raise rates that is painting an inaccurate picture of growth and inflation. The U-3 unemployment rate, which is now sitting at 5.5%, isn’t taking into account the unusual amount of part-time and discouraged workers. That U-6 unemployment rate, which includes those partially and fully separated from the workforce, is currently 11%. That figure is two full percentage points higher than where it was the last time the U-3 rate was at this level, which was during the epicenter of the financial crisis.

But the Fed’s Keynesian illogic dictates that a low unemployment rate is the very cause of all that is inflationary, despite alternative measures of labor slack. Therefore, in Pavlovian fashion, it will feel compelled to start raising rates in the next few months.

Most importantly, it will be raising short-term rates when the long end of the yield curve has been artificially manipulated to a record low level. Our hapless central bank may be venturing down the short and dangerous path to an inverted yield curve. But at the same time, economic growth and inflation are decelerating.

Foreign central banks will also soon have to abandon their reckless policies of QE to infinity due to its futile effect on GDP growth. Likewise, since sovereign yields are near zero percent in Japan and Europe, it will take just a few basis points in rate hikes to send the entire developed world into an inverted yield curve situation for the first time in global economic history. This is what lies ahead for global investors as central banks begin to move away from the massive distortion of asset prices for the last 7 years. Unfortunately, in the aftermath of this next deflationary collapse, global governments will embark on an unprecedented economic experiment that will involve the further erosion of free markets as part of their effort to reflate asset prices.

In the movies, when a character is unaware of the ominous warning signs that the director has provided the audience, it usually leads to their imminent demise. Ms. Yellen and company may be unaware how important an inverted yield curve is to the banking system and money supply growth. But investors should not let the ignorance of central banks lead to the demise of their wealth.

 

What Color is This Economy?
March 9th, 2015

Last Friday a photograph of a dress, whose exact colors were in doubt and became the subject of much debate, absolutely dominated the Internet. Not only is this a perfect example of the inane distractions that the general public is fascinated with, but it is also a topic that should be elevated into a higher level of discussion. That is, how people can look at the same thing, and yet interpret it in different ways? The current picture of economic growth in the United States is undergoing a similar debate.

During the second and third quarters of 2014, Wall Street popped champagne corks because the average of the two periods displayed 4.8% economic growth. The better than expected GDP read, coupled with a steady decline in the unemployment rate, led many to believe our seven years of economic malaise was over. The economy appeared colored in growth…happy days were here again!

Unfortunately, those celebrations proved premature. Fourth quarter GDP has now been revised downward to an annualized rate of 2.2%, not the 2.6% analyst had been expecting. And full year GDP growth came in at an underwhelming 2.4%. Turning to data in Q1 of this year, the Chicago PMI came in at 45.8, indicating contraction in the manufacturing sector in the Midwest for the first time since April 2013, and the number of Americans seeking first-time unemployment benefits rose last week back above the 300k mark.

But the bad news doesn’t end there, U.S. Existing Home Sales fell sharply to their lowest level in nine months in January, and despite bullish calls for consumer spending to be bolstered by falling energy prices, consumer outlays fell in both December and January, the first two-month decline since 2009.

So What Color is Our Economy?

Former Chairman of the Federal Reserve, Alan Greenspan, doesn’t think the color of the economy is all rosy. He told CNBC’s closing Bell that effective demand is extraordinarily weak. Referring to the Depression inside the Great Depression that occurred in 1937 he said, "The way I measure it, it's probably tantamount to what we saw in the later stages of the Great Depression."

Among other things, Greenspan blames entitlements for crowding out savings, a critical aspect to investing, and crowding out capital investment. Greenspan continued, "Capital investment is key to productivity growth. That has slowed down quite dramatically and productivity has followed right along."

Former Treasury Secretary Larry Summers sees the economy in shades similar to Greenspan. And he has a name for this color, “secular stagnation”. Summers contends that the inflation-adjusted Fed Funds Rate should be as low as negative 2-3%, “forever.”

Despite the bleak hue seen by some, many of those who currently work at the Fed see the economy colored in blue skies forever, and are confident we will see 3% growth this year. In fact, some members on the FOMC see the economic picture as being so bright that they believe the Fed should dull it with immediate rate hikes.

St. Louis Fed President James Bullard, who's generally hawkish, called for rate hikes as part of "the normalization process," as he expects the unemployment rate to fall below 5% in the second half of this year and overall economic growth at 3% for 2015.

He claims, "These labor markets are improving so rapidly…if you haven't even come off zero and the unemployment rate has come down below 5% that seems like a little bit extreme to me."

Likewise, Federal Reserve Vice Chairman Stanley Fischer said recently, “If the labor market continues to strengthen, and if we see some signs of inflation beginning to increase, then the natural thing is to get the interest rates up.”

But perhaps Bullard and Fischer should review their color charts; the last time we had annual GDP growth over 3% was in 2005. We have spent the last nine years growing well below the 3% level–despite the Fed’s unprecedented accommodation. In case they forgot, we had the following growth rates for the past five years: 2010 – 2.5%; 2011 – 1.6%; 2012- 2.3%; 2013 – 2.2%; 2014 – 2.4%. Why would the economy suddenly start growing at 3% if QE has now ended and interest rates are projected to start rising? Do they expect companies to start building new factories because the cost of capital is increasing, when they didn’t build those factories when it was next to nothing? Or do these color blind pundits think collapsing asset prices will finally spur on consumer demand that has been absent for nearly a decade.

While those at the Fed are busy tinkering with their color wheel, they are missing the contractionary and deflationary data points hanging all around them. They have spent the last seven years “mixing paint”, but the economy has shown no signs of sustainable and robust growth.

The only thing we have to show for years’ worth of global central banks’ absolute domination of free markets are worldwide asset bubbles in real estate, equities and sovereign debt.

And now true to form, the Fed’s reading of the economy is 180 degrees away from its actual condition. Since our central planners have managed to artificially bring the belly of the yield curve down to around 2%, it won’t take many increases in the Fed Funds Rate before banks find it unprofitable to make loans—and the economy shuts down just as it did in 2000 and 2007. Therefore, once the Fed raises interest rates just a few times and flattens the yield curve, the real color of this economy’s “dress” will become clear to everyone…and it is sackcloth and ashes.

 

Party Like It’s 2015
March 2nd, 2015

In 1982 the artist formally known as Prince released a popular party anthem called “1999”. The song was a premonition that 1999 would be a year we would all aspire to “party like”. It was obvious that Prince was making reference to the excitement associated with ringing in a new century. However, unbeknownst to him, the accommodative policies of the Federal Reserve would lead to a festal bubble in NASDAQ stocks, making his call to party in 1999 that much more appropriate.

After that hangover lapsed, our central bank—in full cooperation with the Wall Street casino--was once again donning party hats by the mid-2000’s. The Fed’s cheap money, along with the private banks’ proclivity to create credit, produced similar merriment in the housing market. The fallout after this party ended was much more severe than the previous monetary orgy.

Today, even as most Americans are still suffering the ill effects brought forth by all the aforementioned partying, the festivities on Wall Street’s trading floors have reached its apogee. Although GDP growth has remained below trend for years and household incomes have stagnated, the corrupt carnival barkers that dominate the financial services industry have caused investors to party like its 1999 and 2007…combined.

Last year venture capital investments reached a level that was last seen during the dotcom bubble, as they poured a staggering $48.3 billion into startup companies. One of those companies, Pinterest Inc., recently announced they were looking to raise $500 million in a new round of funding, which will double the company’s valuation to a hefty $11 billion. That’s a frothy valuation for an on-line scrapbook. But there is no room for the process of honest price discovery in an environment where money is free and failure has been annulled. And, if you are ever invited to one of these gluttonous venture capitalist galas, and are looking for a ride, check out Uber Technologies, an internet car service company valued at a whopping $41 billion dollars.

Today’s festivities span well beyond the 1999 internet startup theme. Those who missed their invite to the NASDAQ bubble and the real estate flipping bash, will be happy to learn subprime lending is back to its profligate peaks. Loans to consumers with low credit scores have reached the highest level since the start of the financial crisis. In fact, almost four out of every ten loans for autos, credit cards and personal borrowings in the U.S. went to subprime customers during the first 11 months of 2014. That amounted to more than 50 million consumer loans and credit cards totaling more than $189 billion, the highest levels since 2007.

But as Wall Street resumes its gaiety, Main Street is still mired in despair. According to a newly released report from Bankrate, 24 percent of Americans have more credit card debt than emergency savings. And 13 percent of consumers don't have any credit card debt; but, they don't have any savings either.

The jobs picture, which is paraded by Wall Street and government as the one bright spot in an otherwise lackluster recovery, just isn’t as rosy as it appears at first glance. According to the Federal Reserve Bank of Atlanta, "The economy has been generating full-time general-service jobs at a much slower pace than in the past." In fact, the economy has 2.5 million more part-time workers and 2.2 million fewer full-time workers than it did at the start of the Great Recession in December of 2007.

Despite what the MSM would have you believe, the economy is more fragile today than at any other time in the past. The virtually free money and QEs provided by many global central banks have caused economies to pile on an additional $60 trillion of debt on top of the already unsustainable and insolvent conditions that existed in 2007.

Sadly, the mindset of governments and central banks remain unchanged from the collapse of the previous two bubbles. Unprecedented money printing and artificially-produced low interest rates have created a perpetual happy hour. And it’s placed all of us at the precipice of a collapse in equities and real estate prices once again.

Naysayers will point to the six-year stock rally as evidence that all is well. And are also quick to point out that record-low bond yields illustrate that investors have complete confidence in sovereign nations to service and pay off their debt. But these are not the results of the free market price discovery process at work. Rather, it is merely the ability of central banks to use the availability of free money to artificially and massively inflate asset prices.

Another reason for today’s complacency is the widespread belief that banks are now properly capitalized—unlike the condition experienced at the start of the Great Recession. U.S. banks, once loaded with insolvent mortgage securities, are now thought to “safely” hold over $4 trillion worth of Treasury, Agency and Mortgage Backed Securities. And, thanks to Basel III and the Dodd Frank legislation, these banks have $2 trillion worth of Treasuries that carry a zero-risk weighting in their capital ratios.

Therefore, these banks only appear to be well capitalized. Once the sovereign debt bubble bursts and investors dump their bond fund holdings, interest rates will soar. Banks will then become capital constrained and will once again be forced to hold illiquid assets that cannot be sold without destroying their balance sheets. In addition, rising interest rates will put a severe strain on the global economy, which is now saturated with a record amount of debt in relation to total output.

Unless you believe the global economy has entered into a multi-decade recession like Japan, interest rates have nowhere to go but up; dramatically. The problem is that debt levels are at all-time highs. Once the cost of money rises this part-time working, no savings, asset-bubble driven and debt-laden economy will collapse. And, the next time the wheels fall off Wall Street’s party bus, the crash will be more severe than 1999 and 2007…combined

 

Great Recession Redux
February 23rd, 2015

We are fast approaching the time when it will become obvious to all that mortally-wounded economies cannot be resuscitated by a massive increase in credit from central banks. Nations that suffer from tremendous capital imbalances, debt capacities and asset bubbles cannot be healed by printing money. Quantitative easing and zero percent interest rates have the ability to provide GDP growth that is merely illusory and ephemeral. This is because it can temporarily levitate equity, real estate and bond prices, which causes an artificial boom in employment and consumption. But the “benefits” of making the cost of money free has its limits, and it also comes with dire consequences.

Further hope in economic growth generated from central banks is quickly fading because the transmission mechanism is now broken. Central banks can print money; but if new assets aren’t purchased by private banks there is less of an increase in broader money supply growth. Now that most central banks have set borrowing costs at rock bottom levels there isn’t much room to go lower. And it is becoming clear that governments are really good at creating asset bubbles, but woefully inadequate at creating sustainable growth.

For example, the Bank of Japan was fairly successful at creating inflation (YOY CPI up 2.4%), but after more than two years of Abenomics and its attack on the yen, GDP is lower today than in 2012. The growth dynamic isn’t much different in China, where GDP growth in 2010 was 5% higher than it is today, according to official government numbers, as the PBOC tries to slowly let the air out of an overwhelming fixed asset bubble.

But now all hopes for central banks to save the world rests on Mario Draghi and the ECB. Two years after promising to do “whatever it takes” to bring down skyrocketing bond yields, the ECB will officially start buying bonds in March. The problem is that Mr. Draghi’s well telegraphed move has only served to allow private banks to front run his bid. Therefore, sovereign bond yields are already near zero percent and any artificial benefit derived from lower borrowing costs has already been accounted for. And now these banks, which are saturated with EU debt, are now just waiting until March to say to Mr. Draghi, “sold to you.” But these same banks won’t be in any rush to make new loans with the ECB’s credit or buy additional sovereign debt because the assets in question offer virtually zero profit motive.

The United States has been basking in the afterglow of the Fed’s ability to temporarily re-inflate home prices and the pockets of Wall Street bankers. But sorry to say, once again growth on Main Street appears to be chronically illusive. U.S. Q4 2014 GDP growth was less than half of what it was in the prior quarter. And so much for all the drivel about finally achieving, “escape velocity” last year. The 2.4% GDP growth for all of 2014 was still less than the 2.5% growth seen during 2010—the first year out of the Great Recession.

Central banks have destroyed any vestiges of the free market with the primary goal of creating inflation. But with the growth benefits derived from free money (if any) now in the rear view mirror, what do we have to look forward to? Investors have the pleasure of witnessing the massive reversal of bond yields, as the failure of central banks and governments to create viable GDP growth is realized. For instance, the Japanese 10-year Note yield has rallied to 0.46%, from the low of just 0.2% on January 19th of this year. And yields have begun to rise in Europe and the U.S. as well.

The turnaround in global sovereign bond yields is not due to a rise in inflation, nor is it because of an increase in growth. Rather, it is because QE's efficacy has run its course. Therefore, we are left with sovereign yields that must now discount the inflation risk represented by the tremendous increase of central banks’ balance sheets, along with the massive increase in IOUs piled up since the Great Recession ended. Most importantly, without the manifestation of this growth promised by central bank money printing, there just isn’t any way for sovereign nations to maintain the illusion of solvency. Indeed, since the start of the financial crisis at the end of 2007, total global debt has risen by nearly $60 trillion, which is 286% of GDP, up from 269% seven years ago.

As confidence in central banks to save the world fades, interest rates have started to rise. Rising interest rates is Quantitative Easing in reverse. The increasing debt service payments combined with crumbling asset bubbles will cause spurious global GDP to collapse. On top of this, the Federal Reserve is threatening to raise interest rates into an environment of slowing GDP growth around the world. With the total market cap of U.S. stocks at an incredible 124% of GDP and a world-wide historic bubble in government debt, investors across the globe need to get ready to relive the Great Recession all over again.

 

Austerity is Now Extinct
February 16th, 2015

Greece’s newly elected leftist Prime Minister, Alexis Tsipras, is bringing deficit spending back into vogue. The charismatic prime minister laid out plans to dismantle Greece's "cruel" austerity program, ruling out any extension of its international bailout and setting himself on a collision course with the European Union. Unabashedly candid, he has burst on the scene as the veritable anti-austerity rock star; serenading fans with a return to big spending, including a raise in the minimum wage and pensions.

However, one can argue that the last five years of Greek austerity has started to pay off. The nation has swung from a hefty deficit, which drove the 10-year Note to 40% in 2012, to now displaying a small primary surplus equal to 2.7% of GDP. The country's deficit had been a whopping 10.7% of GDP back in 2009. Unfortunately, positive debt metrics have provided little solace to the average Greek voter. They believe austerity has come with too large a price, as the unemployment rate has risen to 26% and half of all young people are out of work. The soaring interest rates of 2012, which manifested from their fiscally irresponsible ways are now a distant memory. Low growth and high unemployment have caused the well intentioned plans of frugality to go extinct.

This brazen call to end austerity and return to profligate spending is spreading in Europe like wild fire. In Spain, tens of thousands of people protested against welfare cuts in rallies led by the left-wing movement Podemos--which is now leading the polls in Spain's elections this year.

Meanwhile Italy, which like Greece suffers from a stagnant economy, astronomical youth unemployment, and has a debt load that is 132% of its GDP, is hoping Greece is leading the way towards the exintction of austerity. If Italy were to team up with Greece and other debt-strapped eurozone countries such as Portugal and Spain, it could pressure the E.U. to ease austerity measures and adopt more fiscally expansive policies. These debtor nations could threaten to default and leave the E.U. and the euro; thus creating massive bank runs and economic chaos across Europe.

This anti-austerity sentiment appears to be gaining momentum even in the core nations of Europe. France’s President Francois Holland is suffering under high unemployment and has asked for a time-out on austerity. Even the president of the European Commission recently questioned the usefulness of austerity, noting its results so far have only been shrinking growth and social suffering.

Austerity in Europe is on life support, but the insatiable desire to spend is not limited to just Europe. President Obama released his latest budget that is choc-full of spending goodies for Americans to feast on. Unlike last year, when Obama was seeking a fiscal bargain with Republicans, this year’s proposal contains no spending compromises. Gone is the request for chained CPI, an offer to reduce the benefit increases for Social Security and other federal social programs. The spending restraints that existed during 2010 have vanished; such as the sequester cap on federal spending. These fiscal restraints have been supplanted by a host of freebie proposals including “free” pre-school and college.

Seduced by low interest rates, governments all over the globe are yearning to return to their former big spending ways. Using the cover derived from lower deficit to GDP ratios—caused by record-low rates--politicians are emboldened to return to their first love…deficit spending. For example, the interest payment on the national debt in the U.S. is lower today than it was during 2008, despite the fact that the national debt is $9 trillion higher. However, this renewed prerogative to spend money ignores some important facts, the biggest being; what will happen when interest rates return to normal levels?

When interest rates rise above theses currently manipulated low levels, not only will payments for debt service soar, but the asset bubbles created by central banks over the past seven years will burst. The problem being, much of the phony GDP growth that has occurred in the developed world since the Great Recession ended came from the building and servicing of these same asset bubbles. Therefore, the combination of crumbling GDP and rising interest payments will cause deficits as a percentage of GDP to skyrocket to an even worse level than what occurred during the Great Recession.

The nominal level of debt in the world has soared by over 40% since 2008. We are now set up for colossal and unprecedented deficits in the developed world once rates rise and faith in central banks fails. The additional spending proposed by politicians, which has been emboldened by phony interest rates and GDP growth, will only exacerbate the situation. After the inevitable collapse occurs, we will hopefully be forced to take austerity off the endangered species list for good.

 

Yellen: Looking For Inflation In All The Wrong Places
February 9th, 2015

In 1958, economist W.H. Phillips wrote a paper that argued an inverse relationship existed between wage inflation and unemployment. The crux of his theory was when unemployment is high wage growth is absent; but when the unemployment rate is low wages rise rapidly. Philips established his theory under the framework of a curve and it was aptly referred to as “The Phillips Curve”. However, many economists wrongly adopted the Phillips Curve by relating it to general price inflation, rather than to just wage inflation. Sadly for Phillips Curve enthusiasts, the high inflation and high employment rates of the 1970’s turned this metric on its head.

Stagflation in the U.S. throughout the 1970’s proved high inflation and high unemployment can—and often do--exist concurrently, thus rendering the Phillips Curve obsolete. This same phenomenon where rising inflation coincides with a rising unemployment rate has also been witnessed throughout the globe. Fittingly, the notion that more people working was the cause of inflation should have found its place in the Wall of Shame of economic theories, sandwiched in between other items falling out of vogue at the time, such as toe socks and the pet rock.

However, the Keynesian economists who held this curve in such high esteem in the 1960’s, were somehow unable to let it go. Therefore, a new metric was created rooted in the Phillips Curve, but conveniently much more ambiguous. They called this metric the Nonaccelerating Inflation Rate of Unemployment (NAIRU). The idea behind NAIRU is inflation and unemployment really only become correlated once unemployment falls below a certain calculated rate. But you have to understand that the Fed’s number for NAIRU is more elastic and flexible than Gumby. And when it does fall below that predetermined rate, as it did from 1996-2000, and inflation (as the Fed measures it) is still absent, the Fed must come up with an excuse for its inaction.

Just to be clear, there is no relationship between unemployment and the overall rate of inflation. As Milton Friedman taught us, inflation is solely a monetary event. It is my view that inflation is caused by a persistent fall in the purchasing power of a currency. The market becomes convinced that substantial currency dilution will occur and the value of paper money falls. Even if everyone able to work became gainfully employed it would not cause inflation. It may lead to rising nominal wages but the increase in products and services provided by these newly employed persons would absorb the wage growth without causing prices to rise. A growing labor force and increasing productivity are the very keys to economic prosperity.

But, the reason it is important to understand the Phillips Curve and more importantly NAIRU, is because this metric is perhaps the most important data point Janet Yellen looks at when making decisions on Fed Policy. When unemployment is higher than NAIRU, as it is now, Yellen sounds like a dove. But when unemployment falls below, as it did in 1996 to 2000, Yellen has shown she's more ready to tighten policy than other central bankers.

Ms. Yellen has an unfounded fear that too many workers will hyper inflate our deflating worldwide economy. Just to understand how unfounded these beliefs are in reality, take a look at these two charts.

U.S. inflation as indicated by the CPI since 2011.

U.S. unemployment rate during the same timeframe.

As you can see, inflation and unemployment are both declining in tandem. I defy any Keynesian adherent to the Phillips Curve or NAIRU to glean the correlation between a falling unemployment rate and the rate of inflation.

It was the Fed’s initial belief back in 2010, when the unemployment was just south of 10 percent, that a change in monetary policy would be necessary once the unemployment rate reached 6.5%. However, since inflation and the economy have not picked up, they have since moved the new target to around 5.4%. With unemployment currently at 5.6%, we are getting dangerously close to Ms. Yellen’s line in the NAIRU sand.

The problem is, while Janet Yellen is busy tinkering with the Phillips Curve--in a pernicious attempt to determine how many Americans she will allow to find work--she is missing the crumbling economic fundamentals all around her. The flattening yield curve, plummeting commodity prices, and weakening U.S. and international economic data; all show that the asset bubbles created by central banks are popping. Once again, the Fed is applying faulty models to the wrong economic fundamentals.

However, if unemployment continues to fall Ms. Yellen will be forced by her own passionately held doctrines to raise interest rates into a deflationary cycle. I welcome this move and the overdue and inevitable consequences that it brings; but also understand the Fed will unwittingly be doing the equivalent of parking a car on the train tracks. Ms. Yellen will even have to ignore the fact that the falling unemployment rate is happening for the wrong reason, as it coincides with a falling labor force participation rate.

Yet again the Fed will be missing what is right in front of them. As usual, it is fighting yesterday’s war with the wrong weapons. This pervasive and protracted incompetence is not just confined to the U.S. central bank. The central banks of Europe, Japan and China also now join the Fed in owning the markets for real estate, equities, bonds and (as a direct consequence) their entire economies. This is why the immense power to determine the money supply and level of interest rates should never have been given to a group of unelected bureaucrats. And is why faith in the money printers to solve our economic problems is soon coming to an end.

 

Say Goodbye to the “Strong Dollar Policy”
February 1st, 2015

It is absurd to believe that the inhabitants of the Eccles building in D.C. promote a strong dollar policy. Printing $3.8 trillion dollars and keeping interest rates at zero percent for going on the seventh year can hardly be confused with a hard-currency regime. Merely pretending to cheer the dollar higher appears to be the Fed’s method of operation.

But since World War II every administration likes to pledge their support for a “strong dollar policy”. However, the truth is this policy has only truly been practiced in the United States on very rare occasions. The courageous Fed Head, Paul Volcker, raised interest rates to the dizzying level of 20% in order to squeeze inflation out of the economy in the early 1980’s. During his tenure the intrinsic value of the dollar increased and the economy thrived. This is because, contrary to what the Keynesians who currently run our economy believe, a strong dollar is great for America; while a weaker dollar is most efficient at destroying the purchasing power of savers.

A weak currency doesn’t boost GDP or balance a trade deficit—a philosophy that governments and central banks now embrace with alacrity. Take Japan, which still has a 660 billion yen trade deficit two years after Shinzo Abe unleashed his all-out assault on the yen, which is down a staggering 40% against the dollar since January 2013. This, after a 50-year average trade surplus of 382 billion yen prior to his reign. And, in its 25th month of massive currency depreciation, Japan still finds itself in an official recession.

However, despite these facts Keynesian logic favors a currency debasement derby to the bottom. This is because they maintain that a weak currency stimulates exports, boosts manufacturing and leads to lower rates of unemployment. So with the dollar rising over 15% against the Euro and the Yen since July of 2014, it is no wonder we see a renewed fear of the stronger dollar, as it plays into their number one fear of deflation. We got the first hint of this from the U.S. Treasury Sec., as he explained that the current dollar strength is more the result of yen and euro manipulations, and less about the intrinsic dollar strength. Treasury Secretary Jack Lew said this in Davos Switzerland last week:

"The strong dollar, as all my predecessors have joined me in saying, is a good thing. It's good for America. If it's the result of a strong economy, it's good for the U.S., it's good for the world. If there are policies that are unfair, if there are interventions that are designed to gain an unfair advantage, that's a different story."

We see multi-national companies playing right into this theme. These companies are now using the strong dollar to replace last year’s harsh winter as their excuse for not making the numbers. The plethora of companies that missed earnings this season are all blaming it on currency translation--leading to the new buzz phrase of 2015…Constant Currency. Constant Currency is when last year’s earnings are re-translated to this year’s rates to strip out the effects of currency dynamics.

First, we have the construction and mining equipment giant Caterpillar (CAT), who reported a lower profit that came in well below expectations. This was due primarily to the recent drop in the price of oil and lower prices for copper, coal and iron ore. But of course they had to mention “The strong dollar didn't help either…it seems like when it rains it pours, and this is one of those days." Then, of course, the Caterpillar CEO urged the Fed to hold off on any rate hikes this year.

Procter & Gamble CFO Jon Moeller told CNBC that the strong dollar was the major factor in the company's disappointing earnings report last quarter. And we heard similar stories from 3M, Pfizer, United Tech and Amazon; just to name a few.

This appears to be a legitimate excuse, until you ask yourself--is the problem that the strong dollar is hurting their earnings, or is it that they no longer have a weakening dollar making it easier to beat the estimates. After all, I didn’t hear these same companies offer this excuse when the weakening dollar was helping their profitability? Currency translations work both ways.

The truth is politicians and multinationals alike enjoy a weakening dollar because they don’t have to work as hard. A weak dollar allows politicians to do what they do best--spend money without having to raise taxes. And a weak currency allows multinationals to appear more profitable, as they enjoy gains when stronger currencies are translated back to a weakening dollar. After all, how many times did we hear the term Constant Currency during the 2002-2008 timeframe for example, when the dollar was plummeting in value?

Keynesians cling to the belief that a weak currency is the corner stone for building a healthy economy. But I believe this fatuous notion is a ruse that stems from the necessity to find a justifiable excuse to give central banks carte blanche to monetize debt. For without an activist central bank aggressively printing money to purchase sovereign debt, interest expenses would soon spiral out of control—a falling currency is just an ancillary side effect of supplanting the free market for government issued debt.

Therefore, it is my prediction that Yellen will not be able to raise rates and will soon have to adopt a very bearish stance towards the dollar. After all, a hawkish interest rate policy is untenable for a Fed that is now paralyzed with the fear of deflation, especially while the rest of the world is frantically printing money. Our central bank will not have the courage to allow the dollar’s rise to continue. And, it is inevitable that Yellen and her comrades at the Fed will soon follow the lead of our Treasury Secretary in talking the dollar down. That may be music to the ears of multi-national corporations and our government; but will be the death knell for the middle class.

 

Why QE in Europe Will Fail
January 26th, 2015

The fear of deflation has become the cornerstone of Keynesian economic thought. A lack of inflation has been used to explain periods of economic weakness from the Great Depression of the 1930’s, to the Great Recession 2008-2009. And now, that philosophy has been adopted as gospel by those that control the Federal Reserve and virtually every central bank on the planet.

In reality deflation is cathartic, and a necessary condition to heal the economy. If deflation were allowed to naturally run its course, as it did in the brief Depression of 1920–21, depressions would be sharp but fairly short in duration. And the economy would find itself on firm footing fairly quickly. However, Keynesians view deflation as the source of a destructive cycle in which; asset prices plunge, companies cut jobs, spending plummets, and a permanent recession sets in. Therefore, the prevailing current view maintains that deflation is something that needs immediate intervention of massive monetary stimulus--you can say they have become deflation phobic.

This is why I find it fascinating that Keynesians, who proliferate in central banks and in the financial media, are relentlessly cheerleading the recent spate of deflationary data. And, just to be clear, deflation has not been limited to the New England Patriots’ footballs--it is everywhere you look.

However, it is the height of hypocrisy that Keynesians use the specter of deflation to frighten us into believing we need to endlessly dilute the value of our currencies and take the rate on our savings to zero percent. But then, at the same time, take every data point that points to falling prices as another reason to be bullish on markets and the economy. Their mantras are: Lower commodity prices--a boost to the consumer, plunging interest rates--an increase in mortgage refinancing, I actually heard a commentator suggest crumbling copper prices were a boon to minting pennies--he obviously didn’t realize pennies have been minted mostly with zinc since 1983.

How can Keynesians celebrate deflation, while at the same time use it to scare us into accepting ZIRP forever? The easy answer would be, they are cheerleaders for the stock market…and I believe they are. But a more compelling reason is these individuals have convinced themselves that a group of 12 academics can arrive at better conclusions than the free market. So enamored are they by the collective wisdom of our men and women who occupy the Federal Reserve, that they can’t bring themselves to imagine there may be some unforeseen negative consequences to their actions. And, because for a moment it appeared as though the Fed would have a graceful exit from QE, their blind faith in micromanagement of markets appeared to be warranted.

Keynesians are unable to acknowledge that printing and borrowing money has simply been a failure in bringing sustainable and vibrant growth back to economies.

Unfortunately, we are just beginning to experience the pain associated from believing central banks can obliterate the free market pricing of stocks, bonds, commodities and currencies for seven years with impunity. Most importantly, there is an inherent danger in basing investment decision on the capriciousness of a handful of individuals, as opposed to economic fundamentals and markets.

For example, Mario Draghi is doing his best imitation of the Fed and the Bank of Japan in promising to buy at least 1.1 trillion euros worth of public and private debt over the course of the next year and a half.

However, much like in the U.S. and Japan, Europeans will find that monetizing debt will do little in the way of engendering growth; but will be remarkably successful in destroying the purchasing power of the middle class.

The ECB’s bid to monetization massive amounts of Eurozone sovereign debt won’t rescue the economy or do much in the way of creating inflation. This is because sovereign bond yields are already close to zero percent, and even have negative yields in some cases. Once the ECB buys debt from private banks they will likely sit on most of that new central bank credit. Why would private banks buy new government bonds that offer no interest and have tremendous downside risks to the premiums? And why take the risk of making new loans to unqualified borrowers when the interest rate they can charge in nearly zero percent?

In fact, the private banks that already front ran the ECB’s bid could very well just unwind their positions to Mr. Draghi and then sit on that cash. And the hopes of “saving” the European economy from the disastrous fallout of deflation will go down in history as yet another failure of central banks to manipulate markets.

Central bankers tend to be duplicitous and incompetent plutocrats. Investors would be far better off placing their faith in markets and real money instead of fiat currencies and empty promises. Of course, this misplaced faith will eventually lead to the biggest shock of all…the soon to arrive collapse of paper currencies and the insolvent sovereign debt backed by central banks.

 

Where Would Interest Rates Be If the Fed Didn’t Exist?
January 19th, 2015

On January 7th CNBC’s Rick Santelli and Steve Leisman engaged in a heated debate that posed an interesting question; is the free market at work keeping interest rates low, or is it the central banks’ put? This made me consider the real question to ask which is: Where would rates be if central banks didn’t exist?

What would happen if the Fed liquidated its balance sheet and sold its $4.5 trillion worth of Mortgage Backed Securities and Treasuries and closed up shop? Some claim, after an initial spike from all that selling, rates would subsequently tumble due to a deflationary cycle that would result from the end of central bank money printing. These people also maintain that rates are currently historically low because of the overwhelming deflationary forces that exist in the economy. Yes, we now see deflation pervading across the globe and that does tend to push down borrowing costs, but I am not convinced rates would remain this low for very long and here’s why.

The level of sovereign bond yields is both a function of real interest rates AND sovereign credit risk. While there is now a deflationary environment causing yields to fall to record lows, the market is still aware if push came to shove central banks would step in and create a perpetual bid for government debt. However, without a central bank in place, global GDP (which has been fueled by asset bubbles) would quickly get eviscerated.

Therefore, faltering GDP in the U.S. would cause bond holders to panic over the Treasury’s ability to pay back the over $18 trillion in debt that it owes—which is now already over 5.5 times the annual revenue collected. To put things in perspective, 5.5 times annual revenue would be similar to a family who brings in just $50,000 a year, and holds a $275,000 mortgage. But as bad as that condition is it would get even worse because faltering GDP--resulting from rapidly rising debt service payments--would send the current half trillion dollar annual deficits soaring back above one trillion dollars in short order.

Markets have an innate understanding that central banks can always make good on the principal and interest payments on sovereign debt. If you don’t believe me, maybe you will believe Alan Greenspan, who said as much on Meet the Press after the U.S. debt was downgraded by Standard and Poor’s in 2011. Clarifying the down grade as more of a hit to America’s “self-esteem”, the former Chairman of the Federal Reserve went on to say, “This is not an issue of credit rating, the United States can pay any debt it has because we can always print money to do that. So, there is zero probability of default." The truth is central banks stand as the ultimate co-signer of sovereign debt; a co-signer with a printing press. Credit ratings on sovereign debt have become more of a formality, they don’t actually mean anything anymore.

Consider this, Moody’s downgraded Japan’s debt by one notch to A1, from Aa3 in early December of 2014, and bond yields fell almost immediately. Japan’s Five-year yield fell to a record low just two days after the downgrade. Was this the market screaming that Moody’s got the call wrong? On the contrary, the drop in rates was solely driven by the Bank of Japan’s decision to expand its record bond-buying program, thus tightening supply and driving down rates. Think about it, with a debt as a percentage of tax revenue well over 1,000 percent, I have a hard time believing the free market would extend any country, or business for that matter, credit for 10 years at just one quarter of one percent.

The real mental exercise here is to determine what interest rates the free market would assign to sovereign debt if there were no printing presses? The best insight we can gleam to answer this question is to look at what happened to rates in Greece and Southern Europe during 2010-2012. When Greece and these other countries joined the Euro, they forfeited their respective printing presses to the ECB. After the fall out from the 2008 financial crisis, the ECB was initially reluctant to bail out countries with new money. Instead, they suggested Greece and other Southern European countries cut spending to counter mounting deficits brought about by overspending and low tax receipts. Greece’s revenue to GDP actually stood remarkably better than Japan’s, at about 475%. However, without the ability to print its own currency and the ECB’s initial reluctance to rescue Greece, the market’s reaction was profound. The Greek Ten-year Note, which averaged around 5% prior to the crisis, soared to just under 40% by March of 2012. Then, in July of 2012, ECB Chairman Mario Draghi vowed to do “whatever it takes” (read—buy unlimited amounts of Greek debt) to push yields back down. And down yields went, thanks to the ECB’s promise.

Because of the record amount of government debt in the developed world that exists today, there is a significant risk that not only would interest rates rise, but they could actually spiral out of control until an explicit restructuring and default occurred.

But the real conundrum is that current bond holders believe the Fed can monetize trillions of dollars of Treasury holdings without creating inflation and destroying the purchasing power of that debt. This spurious belief has been bolstered by the Fed’s previous QE programs that did not immediately lead to intractable inflation. However, history has clearly shown that a nation cannot habitually monetize massive amounts of debt without suffering runaway inflation. It would be silly to think this time is different. Therefore, having a central bank ready and willing to monetize a significant percentage of a nation’s debt shouldn’t provide any solace to bond holders at all. Soon investors in government debt will come to understand that a default is in store either through restructuring or inflation. And the answer to our question is that interest rates are headed much higher in the near future.

 

Enjoy the Ride on the Inflation/Deflation Rollercoaster
January 12th, 2015

Politicians and central bankers are desperately trying to convince investors that the economy has returned to what they deem as a “pre-crisis normality”. But the truth is the global economy has never been in a more fragile condition. In an example of just how precarious the Fed-engineered asset bubbles have become, all of the 2014 U.S. equity market gains were wiped out by just a few really bad trading days in October.

That’s correct, the Dow Jones, S&P 500 and the NADAQ averages were all negative after the first 10 months of last year. Investors were better off sitting on the sidelines in cash, waiting for the better entry point that appeared in mid-October. The so described strength of markets and the economy is completely illusory.

Investors need to strategically allocate their portfolios for volatility like we've never seen before, because government manipulations of formerly-free markets have caused equities to repeatedly lose half their value. That’s what happened in 2000 and in 2008-’09. We are due for just such another crash in the very near future. The investing rollercoaster ride that results from the building and busting of asset bubbles is becoming more extreme as central bank intervention grows ever more intrusive.

We have now reached the point where central banks can never stop buying bonds because they cannot risk the normalization of interest rates. The best example of this is Japan. Allowing interest rates to mean revert would now cause nearly all of Japanese government revenue to be used for debt service. Once a market becomes aware that all of a nation’s revenue must be used to pay interest on current outstanding debt, it becomes a mathematical certainty that it must default on the principal. This condition has always led to a currency, bond, equity and economic crises.

Throughout economic history this has only really occurred in isolation, and/or in small banana republics. However, presently most major economies face the same fate concurrently. Japan, China, Europe and the United States cannot allow rates to rise...ever.

It seems logical to conclude that eventually the money printers will become successful. After all, if buying banks’ assets doesn’t boost the money supply central banks could simply resort to writing checks directly to the public. By circumventing the private banking system it would guarantee to create the inflation that money printers so desire. And then, once inflation runs out of control and asset bubbles grow to unimaginable heights, interest rates MUST become unglued because investors will then lose complete confidence in all fiat currencies. Insolvency can be the only result of interest rate normalization and that is why central banks will fight it until the end.

Nevertheless, on the journey to central banks’ ultimate solution to create runaway inflation, it seems deflation has once again become the main issue. This happens every time the Fed has tried to stop its QE programs. That deflation is now pervading across the entire globe.

The perma-bull bobble heads in the financial media are extolling plunging oil prices as the consumers’ panacea. But the drop in oil also happens to coincide with cascading base metal prices and global bond yields that are crashing through the floor. Perhaps this is because nearly every economy on the planet is either flirting with, or in a recession. Sure, deflation is great for the consumer in the long run. But the collapse of asset bubbles, although healthy and necessary, never feels great on the way down. Crumbling equity markets and falling home prices, along with rising unemployment rates and recessions aren’t going to be offset by a few extra bucks in your pocket at the pump. The WTI crude oil price at $33 per barrel didn’t immediately bail out the consumer in March of 2009, and it won’t save them this go around either.

In fact, the only vibrant growth that can be found anymore in the world is in the Bank of Japan’s balance sheet--and in government debt levels--not in global GDP. The true message of falling oil prices is that global economic growth is headed towards the zero bound range and deflation will be the prevalent condition in the short term. Why else would the German 5-year note offer investors a negative yield? The current state of record low and negative bond yields are a sign of economic chaos, not a return to normality.

Investors would be very foolish to contend the U.S. can remain unscathed from this global deflation and recession. The market selloff that began in early 2015 is the result of slowing economic data, which is beginning to unwind the massive yen carry trade.

But deflation has become public enemy number one in the eyes of all central bankers. Therefore, it would be even more foolish to believe that the Federal Reserve will raise interest rates into this incipient deflation and recessionary environment. To the contrary, the printing presses for QE IV are already warming up and the big shock of 2015 will be the rebound of investments that profit from a weakening U.S. dollar.

The Fed believes interest rate normalization can occur within the context of robust economic growth. However, a pivot away from the inflationary monetary policy of the last 6 years will only start the rollercoaster down the cliff towards a deflationary depression.

 

Will Cheap Oil Bail Out the Consumer?
December 29th, 2014

Analysts on every financial news network are screaming about how the lower oil and gas prices will spur on the U.S. consumer and lead to a stronger economy. It is true that total retail sales rose 0.7 percent in November, beating analysts’ expectations of 0.4 percent. And the Thomson-Reuters University of Michigan survey of consumers saw its December 2014 “preliminary index of consumer sentiment” soaring to 93.8--well above last month’s 88.8 reading. Yet, despite this, global markets are throwing off many deflationary signals that should not be ignored.

The first important market signal is the dramatic decline in oil prices. Since peaking at just over $100 a barrel this summer, prices have since fallen by 45 percent. In fact, the last time we have seen a decline nearing this magnitude was during the financial crisis of 2008. If this one data point existed in a vacuum, it may be easy enough to attribute it to just an increase in the oil supply.

If happening in isolation, a surge in the supply of oil would lead to less spending at the pump and be a boost to the consumer. However, that is not what is occurring today. First off, years’ worth of QE and ZIRP have caused massive economic imbalances to occur. Capital spending by the energy industry accounted for 33% of all capital spending in the last few years. States where fracking is prevalent have accounted for all the job growth in the nation. This would never be feasible if oil prices weren’t drive into bubble territory in the first place.

After all, the Fed’s manipulation of interest rates has left investors chasing all kinds of yield traps; such as encouraging investments in Master Limited Partnerships in the oil fracking industry. The cost to extract shale oil and transport it to a refinery capable of processing it is very high. Therefore, the price per barrel needs to be higher than $65 per barrel just to approach feasibility.

Most importantly, although the U.S. has been able to bring more oil on-line, the rapid decline in oil today has occurred for the same reason it did during the Great Recession. Namely, deflation and a global economic slump. Most of the world outside the United States is either in or near a recession. Japan is now officially in yet another recession. Germany and France have only managed to narrowly avoid a recession. But Italy has suffered 11 quarters of contraction in the last 13. In fact, growth is nearly 10% smaller than it was before the financial crisis began. Europe’s southern region is leaving the entire EU (18) block of nations teetering on recession. Then of course we have the BRIC nations-- Brazil, Russia, India and China, all with economies either in free fall or decelerating rapidly.

Focusing more specifically on Russia, where the decrease in the price of oil has left the country in dire straits and the ruble in free fall, investors have to wonder about the possibility for a debt crisis a la 1998. The Russian Central Bank was recently forced to raise interest rates by 6.5 percentage points, to 17 percent. This in an attempt to stabilize the currency. The sharp decline in the ruble makes international debt payments much more expensive in ruble terms. A credit crunch is looming in 2015 when Russian companies and banks are scheduled to repay $120 billion in debt. U.S. banks are far from immune, having claims totaling $35.2 billion against Russian entities, according to data from the Bank for International Settlements. Regulatory filings by the top four U.S. commercial banks show they have around $24 billion in exposure to the country.

All this is reminiscent of 1998, when Russia defaulted on its debt and created market dislocations. This lead to the implosion of the hedge fund Long Term Capital Management, which nearly brought markets to the brink before the Federal Reserve stepped in and managed a bail out.

Many are taking a Russian default off the table, as they now have a much improved debt to GDP level. While that may appear to be the case, we should not take solace in this data point because it is misleading. Russia has supplanted much of its public debt with quasi-sovereign corporate debt, whose debt levels have been soaring. The oil-rich nation has seen revenue plummet due to the decreasing oil price. Add in soaring interest rates and the conclusion is easy to reach that Russian GDP will shrink; making the debt to GDP figure far less favorable.

But oil is far from the only indicator that is telling a deflationary story. Industrial commodities are tumbling along with bond yields. In fact, the yield on the US ten year alone has dropped 27% this year alone. And sovereign debt yields are at record lows across the planet. Dr. Copper, a barometer for worldwide economic health, has fallen ill, as prices have dropped 15 percent this year. In addition, the Baltic Dry Index, a global indicator for the cost to move goods by sea, is down 63 percent this year. These are not signs of a booming worldwide economy.

Consumer confidence is indeed at an eight-year high--the highest tally since January 2007—due to falling oil prices. But polling the consumer in January of 2007 wouldn’t have been a good prognosticator of smooth times ahead. The truth is that oil prices, industrial metals, bond yields and risk assets in general are all falling due to a deflationary cycle and global economic duress.

It’s amusing to witness nearly every bobble head in the financial media extolling the virtues of this current collapse in oil prices. WTI crude oil peaked at $147 per barrel in the summer of 2008; and then the stock market and economy spiraled into freefall shortly thereafter. Would it have been prudent for market strategist to claim that the plunge in oil and home prices in 2008 was a harbinger for a robust consumer to appear in short order? Were these same market gurus warning investors of a collapse in consumer spending when oil prices soared from $33 per barrel in the spring of 2009, to over $100 per barrel in July of this year?

Maybe the U.S. consumer knows something the market indicators don’t—and you can throw the Fed and Wall Street into that mix as well. But more than likely, economic chaos on a global scale is just around the corner.

 

Patience is a Virtue: Unless you are a Central Banker
December 22nd, 2014

With the utterance of one word, “patience” in reference to the Fed’s anticipated lift off date from its zero bound interest rate target, Janet Yellen sent the Dow Jones soaring over 700 points in two days. It is clearly evident that our central bank is finding endless excuses not to raise interest rates in an effort to keep the equity and bond bubble rolling along. But this entrenched addiction to free money has now set the economy up for a catastrophe. The Fed’s $3.7 trillion dollars in QE and six years of ZIRP have created massive economic imbalances. When interest rate normalization eventually occurs, it will lead to wide spread insolvency.

The following is just one example…just follow the bouncing ball. The mere threat from our Fed to raise interest rates in about six months from today is causing the US dollar to soar against the Yen. The rising dollar, which is soaring in relation to the Japanese currency only because it will become confetti sooner than greenbacks, is in turn is causing Wall Street speculators to dump oil. Plummeting oil prices are leading to the implosion of the oil fracking industry in the U.S. and the junk debt that supports it. This will wipe out investors in high-yield bonds that have mistakenly dumped over a half a trillion dollars into the space since 2010.

This is just one of those “unintended consequences” that will occur once interest rates start to rise and expose the misallocation of capital induced by the Fed’s imprudent policies. I guess we need not worry about the hundreds of trillions of dollars’ worth of interest rate derivatives causing any problems when rates eventually rise either; because I’m sure the Fed has all that under control too. That will be just another one of those “small oversights”, like the collapse of the housing market and economy back in 2008, that the Fed just didn’t see coming.

The truth is the Fed is aware that paying anything close to a historically normal interest rate on Treasuries would make it extremely difficult for our government to service the debt. In fact, interest payments would then consume about 40% of our government’s federal revenue. For Japan, the number is more ominous, as interest payments would consume more than 75% of government revenue if rates merely return to the average of the last thirty years. It isn’t any wonder why the Bank of Japan has completely usurped the private market for JGBs and has taken the 10-year Note down to a staggering record low of 0.36%.

Central banks will continue to suppress interest rates and seek to keep ever-increasing amounts of debt out of the public domain until investors reject fiat currencies and the sovereign debt that backs them. The more “patience” central banks exhibit the greater these economic distortions will become. Economic reality may still be a few years away; but God help us when that day arrives.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

 

The Passive Management Bubble
December 15th, 2014

We have happened upon that time in the investment cycle when investors vastly eschew active management of their assets in favor of a more passive management style. In fact, I read recently 461 Hedge Funds, a hallmark of active investment management, shut their doors in the first half of this year alone. If liquidations continue at that rate, they'll outpace the 1,023-closure record from 2009. All signs now indicate that active management has fallen out of vogue.

And why wouldn’t it? Index funds have done very well these past few years; whereas active managers have underperformed the major averages. The problem is when everyone piles into or out of the same investment philosophy, it usually signals it’s time to change course. Therefore, I predict the tides will soon change and active management will make a huge comeback.

Passive investing, such as Index mutual funds, is an easily understood investing style that allows you to access broad segments of the market. Indexing has been called investing on autopilot. This is a strategy that tends to work well, until it doesn’t. Take the mid to late 90’s, when it appeared the stock market would always go up. Everyone from your hairdresser to the cab driver was a stock genius. New websites such as the Motley Fool preached that you didn’t need an investment advisor--just buy a broad basket of stocks (especially in the technology sector) and you would get rich. And, if got out before March 10, 2000, you were all set.

However, if you failed to get out then, we all know what happened--your portfolio quickly crashed and caused the loss of $5 trillion in the market value of companies from March 2000 to October 2002. During this time, only managers who offered a long/short and dynamic asset allocation strategy produced positive returns.

Another feature of the passive investment approach argues that you don’t have to actively manage your investments as long as you stay diversified. This is referred to as the Modern Portfolio Theory (MPT). MPT is a mathematical formulation that creates diversification in investing, with the aim of selecting an assortment of investment assets that have a collectively lower risk than any individual asset. This is possible, so the theory goes, because different types of assets often change in value in opposite ways. For example, the stock market often moves in the different direction from yields in the bond market. Therefore, a pool of both types of assets can nearly always (in theory) offer lower overall risk than holding just one asset class exclusively.

But this doesn’t always work. Consider the 1970’s, a time when stock prices fell, while bond yields soared. Investors who remember the protracted bear market of 1970-1982, know that during this time both stocks and bond prices went down in tandem.

During the 1960’s, investors were persuaded to enter into a basket of large-cap stocks called the Nifty Fifty. If they were diversified, as the MPT suggested, they would have also been in bonds yielding around 4%-5%. The Nifty Fifty coupled with your 4%-5% bond would have worked pretty well during this time period, until it didn’t. Holding this diversified portfolio would have left you in a house of pain during the mid and late 1970’s, as the S&P 500 dropped around 50% and the Ten-year Treasury note went from 4%, to over 15% by 1981. The stagflation in the 1970’s caused both stocks and bonds to fall in tandem.

So where are we now? I have stated for a while that it is my belief the United States—along with the rest of the developed world--are facing an entirely new paradigm. Namely, that such onerous and record debt levels have now reached a point where government revenue will become woefully insufficient once interest rates normalize. Therefore, the developed world must choose the manner in which they will default on the debt. Central banks will be forced to either monetize mountains of debt, or allow a deflationary depression to wipe out the economy.

With bond yields already at historic lows, brought about artificially by massive central bank manipulation of bond prices, the next time a recession occurs it is much more likely we will have a debt crisis due to a lack of revenue available to service government debt.

The European bond crisis was all about such a fiscal disaster, not the prevailing rate of inflation at that time. Investors did not flock into the “safety” of bonds during their financial crisis of 2008. Instead, the Greek 10-year Note, which averaged around 5% just prior to the crisis, soared to near 40% by March 2012. However, the rate of inflation averaged just 1.5% during that same time frame. Bond yields soared because owners of sovereign debt became assured that Greece would either have to pay investors back in worthless currency or renege on the principal and interest of its debt. As it turns out, Greece used both methods of default.

A true fiscal crisis always leads to sovereign default—either through inflation, a debt restructuring or both. Another recession similar to the Debt Crisis of 2008 will most likely bring down both stock and bond prices. Only this collapse in bond prices may not be caused by inflation right away, but instead will be the result of a severe revenue dearth due to a collapsing economy. A diversified portfolio of Index and bond funds will not provide much security in this case.

The easy monetary policies of global central banks have not only brought about serial asset bubbles, but these market manipulators have also created a new bubble…one where most investors have been lulled to sleep with a false feeling of comfort. What they believe to be a diversified portfolio may instead prove to be a group of highly-correlated asset classes.

These investors are also convinced that they have become buy and hold geniuses, duped by central banks into believing the passive management style of investing can never fail. But if stock and bond prices plunge together in the next recession, investors will then flock back into the active management style of investing, as they realize the need to have a manager that can not only move between asset classes (including precious metals), but also has the flexibility to profit from a decline in the market

 

Why Wall Street and Governments Hate Gold
December 8th, 2014

Gold is hated more than ever by both governments and the financial services community. This is because it has now become imperative to keep the illusion of confidence in sovereign debt and paper currencies. To that end, a gentleman by the name of Willem Buiter, Citigroup’s chief economist, shot into the media spotlight by writing a note on the day before Thanksgiving stating his belief that gold is in a six thousand year-old bubble.

Citi’s chief economist penned this “brilliant” commentary in the days just prior to the Swiss referendum on increasing the percentage of gold reserves held by its central bank. In a clear attempt to influence the gold vote, Mr. Buiter also stated on November 26th that, "The Swiss vote is ridiculous and no self-respecting central bank should ever be putting a large chunk in a single commodity."

This hatred for gold spurs from his belief that gold has no intrinsic value. But how can one individual have the hubris to believe he can erase thousands of years of human experience and knowledge that has maintained gold’s intrinsic value stems from the fact it is the perfect store of wealth?

Mr. Buiter went on to exclaim that, “Gold has become a fiat commodity or a fiat commodity currency, just as the U.S. dollar, the euro and the yen." He continued, “The main differences between them [fiat currencies] are that gold is very costly to produce, while the production of additional paper money has an extremely low marginal cost." So, here we have this paragon of the Wall Street and banking community saying that gold is no different from fiat currencies.

Since his body of work clearly shows he is aware of the definition of the word fiat, the only conclusion one can reach is that Mr. Buiter is being brazenly disingenuous. The word fiat means by decree or edict—from the Latin “let it be done.” In reference to currencies it means that governments and banks can create money at virtually no cost and at will. Gold is the exact opposite of a fiat currency. Mr. Buiter admits this in the very same commentary by stating gold is costly to produce.

Our collective human conscious has for millennia deemed gold to be valuable because it is; portable, divisible, beautiful, extremely rare and virtually indestructible. How many things on this planet fit those criteria? The answer is nothing else except precious metals; fiat currencies fail miserably when it comes to the rare and virtually indestructible part. This is what gives gold intrinsic value and what makes it so vastly different than fiat currencies.

In the near future, I believe Citi’s chief economist will be embarrassed by his remarks, especially when comparing gold to pet rocks. He also claims that gold, since it is just another fiat currency, can reach zero value just as paper money can lose all its worth.

But contrary to what this gentlemen thinks, the value of gold is about to soar because central banks and governments have become trapped. These market manipulators need to keep asset bubbles inflated in order to keep the wealth effect in place and sustain whatever anemic economic growth they have been able to achieve. Most importantly, they need to keep sovereign debt out of public hands in order to keep debt service payments remain low. This means governments have no escape from their massive and unprecedented money printing campaigns. Therefore, the value of fiat currencies is set to plummet when compared to precious metals

These haters of gold are becoming more bold and desperate in their attempt to maintain confidence in government issued debt and currencies as asset bubbles have reached dizzying heights and debt levels have exploded into record territory.

Inflation has become the goal of every central bank on earth. This makes the mean reversion of interest rates inevitable, which will lead to a global sovereign debt crisis. To illustrate this point, the U.S. national debt officially eclipsed $18 trillion this week! This equates to a trillion dollars + per year just on interest payments once the Treasury is forced to pay a more normal rate on all that debt. Economic chaos and soaring inflation will then follow, which should send U.S. Investors flocking to gold en masse.

Buiter’s concludes his inane commentary by stating that gold, “has had positive value for nigh-on 6000 years.” “That must make it the longest-lasting bubble in human history.” But history has proven the real bubbles have manifested in sovereign-issued debt and currencies; never in gold. Since the rate of debt accumulation and government money creation is exponentially greater than at any other time in human history, I can state with confidence the “bubble” in gold has only just begun.

 

The World Has Become Obdurate
November 26th, 2014

There is a perfect word that describes the current condition of governments and consumers around the world today. The word is obdurate, and it means to be stubbornly persistent in wrongdoing.

The word comes to mind when witnessing the renewed enthusiasm of central banks to re-inflate old asset bubbles and to endlessly debase their currencies with the misguided belief that inflation will engender sustainable economic growth. In the case of the Fed, it has so far to date made at least three QE efforts and six years of ZIRP to achieve this goal. But what it has actually achieved is to create asset bubbles and render the nation insolvent. Governments have failed to grow economies in any viable manner. But today’s central bankers have become the very embodiment of the word obdurate, as they stubbornly persist in the effort to pursue inflation as a panacea, despite all available evidence that it will fail to achieve their desired results.

Leading the way on this front is Japan, perhaps the paragon of obdurate thought and action. Abysmal GDP numbers produced by Japan’s economy has brought the nation back into an official recession for the second time in past two years. This should have served as a wakeup call, proving Abenomics and its three Keynesian arrows failed to hit their target. However, Abe and his cohorts at the BOJ are not about to let the facts get in the way of their borrowing and printing fairy tale. On the contrary, Prime Minister Abe has stated he is now more convinced than ever to aggressively pursue the dangerous course of deficit spending and currency debasement; and clearly will not stop until Japan is in full-blown currency crisis.

Amusingly, Paul Krugman has emerged as Abe's chief champion and apologist, proposing Europe follow in Abe’s footsteps. He suggests that, "Europe needs something like Abenomics only Abenomics, I think, is falling short, so they need something really aggressive in Europe." As if the problem with Abenomics is only in its failure to be bold and audacious enough!

Spanning the globe, we have China, whose local government debt levels have soared to almost $3 trillion (up 70%) in less than three years. Yet, despite the fact that its municipal debt is spiraling out of control, the People’s Bank of China recently cut interest rates—perhaps to encourage the building of additional empty cities.

Following through with this specious reasoning, the Keynesians might suggest that Japan can exit its recession by starting a pretend war with China--blowing up some of its empty cities so China has a great excuse to rebuild them, thus making the communist nation’s predetermined GDP easier to achieve. I am sure this will be mentioned in Paul Krugman’s next op-ed.

Unfortunately, America is far from immune to this world-wide obdurate behavior. Let’s start first with the U.S. investor, whom the Fed has once again left starving for yield. They are back to pursuing high-yielding investment vehicles whose risks they overlook with alacrity. Rabid speculation now abounds in Treasuries, municipal bonds, leveraged loans, student debt, collateralized loan obligations, et al.

Take Master Limited Partnerships (MLPs) in the oil service industry for instance. With bond yields at historic lows, MLPs have been averaging 6.7 percent. That’s an extremely tempting yield. However, what investors fail to realize is these investments are tied more to the commodity price than they were led to believe. If oil stays below $80 a barrel for a protracted period of time, many of these MLP’s will stop paying that sizeable dividend and will therefore substantially decrease in market value.

Investors struggling for income to offset near-zero interest rates have also piled into high-yield (junk) bonds. The value of these bonds in the Bank of America Merrill Lynch Global High Yield Index has soared to more than $2 trillion. It took 12 years for the gauge, which began at the end of 1997, to get to $1 trillion. And only 4 years to add that additional $1 trillion.

On average since 1993, U.S. companies that lack investment-grade ratings defaulted on 4.4 percent of bonds, according to Moody’s Investors Service. The current default rate is projected to jump about 100 basis points in the next few months. However, at the height of the credit crisis in 2009, almost 15 percent of high-yield bonds defaulted. Investors are woefully unprepared for such losses once economic reality returns to markets.

The most concerning obdurate behavior of all is evident in U.S. borrowers and the predatory lenders who enable them. This mutually irresponsible conduct brought the economy to the brink back in 2008. Loose-lending practitioners, a la the mortgage market circa 2007, have reemerged on Wall Street. But this time they have surfaced in the subprime auto loan sector. Opportunists in financial institutions have once again organized shady lenders, who are making near usurious loans at an interest rate of 20 percent and at 115 percent of the vehicle’s value, to consumers who are essentially one paycheck away from default.

The subprime lending market shrunk from more than $125 billion, at the bubble peak in 2007, to only about $60 billion by 2009. But re-fueled by the Fed’s ZIRP policy, it has now come roaring back to $120 billion. And by the end of this year it is projected to be at all-time highs. The sad truth is that the resurgence of auto sales, much like the record pace of new home sales before the Great Recession, is being built on the back of unpayable debt.

Fittingly, Fannie and Freddie aren’t about to stand by and let auto lenders have all the post-crisis fun. In an attempt to get back in the aggressive lending game, these Government Sponsored Enterprises (GSEs) have drawn up new rules aimed at loosening lending standards. In order to make mortgages easier to obtain for those who can’t afford to pay the loans back, these GSEs, which are still in conservatorship from past transgressions, will once again require just a 3 percent down payment on new mortgages. The new guidelines come with some inherent risks, but rest assured, Fannie Mae executives are confident they can responsibly administer the lower equity requirement to ensure it is an effective tool for increasing access to credit. This is tantamount to a raging alcoholic, who has only been sober for a few years, being confident he can handle his new position as a wine taster.

Once again we have central bankers and governments hell-bent on creating inflation and turning a blind eye to the asset bubbles they create. Once again we have yield-starved investors looking to over extend themselves with credit. And once again we have eliminated any semblance of prudent lending standards in order to accommodate a massive accumulation of record debt.

Government and consumer behaviors have become obdurate--a stubborn persistence in wrongdoing. But it is insufficient to claim that we have merely continued on with past errors. More accurately, we have become much better at doing everything we did wrong in the past.

 

Why Gold is Headed Much Higher
November 24th, 2014

What really drives the price of gold? Some say it's a fear gauge. Others prefer to look at the demand coming from the Indian wedding season. But the silliest of all conclusions to reach is that the dollar price of gold should be determined solely by its value vis-à-vis another fiat currency.

The truth is the primary driver of gold is the intrinsic value of the dollar itself, not its value on the Dollar Index (DXY). The intrinsic value of the dollar can be determined by the level of real interest rates. Real interest rates are calculated by subtracting the rate of inflation from a country’s "risk free" sovereign yield. Right now the level of real interest rates in the U.S. is a negative 1.55%.

A key factor is to then determine the future direction of real interest rates. The more positive real rates become, the less incentivized investors are to hold gold. And the opposite is also true. The more negative real rates become, the more necessary it is to own an asset that is proven to keep pace with inflation. The Fed has threatened to begin lift off from its zero interest rate policy in the middle of next year. However, the Fed has made it clear that it will only raise nominal yields if inflation is rising as well. Therefore, there is no reason to believe real interest rates will rise anytime in the near future.

The intrinsic value of the dollar is not rising; and most likely will not increase for the foreseeable future. The dollar is only rising against other currencies because the value of those currencies are being pummeled by their central banks to a greater extent than our Fed. The weightings in the DXY favor the performance of the dollar against the euro and the yen. Therefore, just because the nations of Europe and Japan are determined to completely wreck their currencies does not mean that the intrinsic value of the dollar is improving or that the dollar price of gold must go down. In fact, holders of the euro and yen should be more compelled to own gold than ever before.

The sophomoric view held on Wall Street is that gold must go down if the dollar is rising on the Dollar Index. Their specious argument is that it's more expensive to buy gold because of the dollar's strength, and therefore demand for the commodity must decrease. However, this argument completely overlooks the increased motivation to buy gold emanating from the continued attack on the yen's intrinsic value by the bank of Japan. For example, real interest rates in Japan are a negative 3% and are promised by the Bank of Japan to keep falling. Japanese citizens should be scrambling to own gold in this scenario even if it will take more yen to buy an ounce of gold. And from all evidence available demand for the physical metal remains strong.

Supply demand metrics for gold are currently favorable. Central bank demand increased to 335 tons so far this year, up from 324 tons in 2013. Investment demand is up 6% YOY, while supply was down 7% YOY in Q3. Nevertheless, gold is down about $100 an ounce YOY, and gold mining shares have plummeted by about 30% during the same time period. This is due to short selling of gold futures by banks that wish to see the gold price lower. In the short-term financial institutions may be able to manipulate gold prices lower, as they bring to fruition their self-fulfilling prophesies.

However, in the long run there exists three great risks to markets and the global economy in general that will be very supportive for gold: A collapse of the yen that becomes intractable; spiking interest rates in the United States due to the Fed’s unwillingness to get ahead of the inflation curve; or, more likely, a significant weakening in U.S. economic data that puts serious doubt in the sustainability of the recovery and corporate earnings growth.

At least one of these events is guaranteed to occur because the free market price discovery mechanism has become completely abrogated and has been replaced by government manipulation of all asset prices. When these massive bubbles break it won’t be so easy to put them back together again because central banks and sovereign balance sheets are already at a breaking point. Therefore, the recovery won’t be as easy to engineer like it was back in 2009.

Equity prices have been propelled to record highs by the money-printing frenzy of central banks. And the Fed Funds Rate is near zero percent, instead of a more normal 5%. The total debt in the United States is near an all-time record 320% of GDP. U.S debt is up $7 trillion (14%) and global debt has increased over $30 trillion (40%) since 2008. Most importantly, the record amount of debt has been coupled with interest rates that have been artificially manipulated to record lows around the world for the past six years and counting.

This is why I know it will all end very badly once interest rates normalize. Regardless of bank manipulations and the BOJ’s kamikaze mission to commit Hara-kiri with its currency, gold will be an increasingly-necessary asset to own. Especially after this current illusion of prosperity comes crashing down. You can learn more about the coming economic chaos by getting a free trial subscription to my Mid-week Reality Check podcast located at www.pentoport.com.

 

Japan’s Last Stand
November 17th, 2014

There is a popular American military term called a “last stand”, which is meant to describe a situation where a combat force attempts to hold a defensive position in the face of overwhelming odds. The defensive force usually sustains very heavy casualties or is completely destroyed, as happened at Custer's Last Stand. General Custer, misreading his enemy’s size and ability, fought his final and fatal battle of Little Bighorn; leading to complete annihilation of both himself and his troops.

The Japanese government is now partaking in a truly incredulous measure to expand its QE program in a desperate attempt to de-value its currency and re-inflate asset bubbles around the world. In other words, Japan is constructing its own version of a “last stand”.

In a final attempt to grow the economy and increase inflation, Japan announced a plan to escalate its QE pace to $700 billion per year. In addition to this, Japan’s state pension fund (the GPIF), intends to dump massive amounts of Japanese government bonds (JCB’s) and to double its investment in domestic and international stocks. All this in a foolish attempt to increase inflation, which Japan mistakenly believes will spur on economic growth. But these failed policies have now caused Japan to enter into an official recession once again, as GDP fell 1.6% in Q3 after falling 7.1% in the previous quarter.

Japan is now guaranteed to be successful in the total destruction of its currency, the complete destruction of its economy and the collapse of the markets it is attempting to manipulate around the world. To fully understand its misguided reasoning, we have to explore how Japan got here in the first place.

Coming out of WW II, Japan enjoyed a three-decade period referred to as its “Economic Miracle”. This “miracle” was instigated by a booming post-war export economy helped by prudent fiscal policies, which was meant to encourage household savings. Japan’s standard of living soared among the highest in the world. Japan sailed into the 1980’s on the wave of robust economic growth. However, if we have learned one thing after all these years, it’s Government’s insatiable need to meddle with the free market, even when they don’t need to. Accordingly, the 1985 Plaza Accord was sought to weaken the U.S. dollar and German Deutsche Mark against the yen. The Bank of Japan, in an attempt to offset the rising yen, drastically reduced interest rates. The BOJ’s loose monetary policy in the mid-to-late 1980s led to aggressive speculation in domestic stocks and real estate, pushing the prices of these assets to astonishing levels. From 1985 to 1989, Japan’s Nikkei stock index tripled to 39,000 and accounted for more than one third of the world’s stock market capitalization.

By the late 1980s, Japan had transitioned from a “miracle” economy to its infamous bubble economy, in which stock and real estate prices soared to stratospheric heights driven by a speculative mania. Japan’s Nikkei stock market hit an all-time high in 1989, then crashed, leading to a severe financial crisis and long period of economic stagnation that Japan is still entrenched in. It has now become known as Japan’s “Lost Decades.”

Shortly after the bubble burst, Japan embarked on a series of stimulus packages totaling more than $100 trillion yen--leaving an economy that was once built on savings to eventually be saddled with a debt to GDP ratio that now exceeds 240%--the highest in the industrialized world. Making matters worse, the BOJ has more recently engaged in an enormous campaign to completely vanquish deflation, despite the fact that the money supply has been in a steady uptrend for decades. At the end of 2012, we were introduced to Abenomics, which is Premier Shinzo Abe’s plan to put government spending and central-bank money printing on steroids. His strategy is crushing real household incomes (down 6%) and caused GDP to contract 7.1% in Q2.

With the rumored delay of its sales tax, Japan is clearly making no legitimate attempt to pay down its onerous debt levels. Therefore, one has to assume this huge addition to their QE is an attempt to reduce debt through devaluation and achieve growth by creating asset bubbles larger than the ones previously responsible for Japan’s multiple lost decades. This will not return Japan back to the days of its “economic miracle”, where the economy grew on a foundation of savings, investment and production.

The sad reality is that Japan is quickly surpassing the bubble economy achieved during the late 1980’s. Its equity and bond markets have become more disconnected from reality than at any other time in its history. The nation now faces a complete collapse of the yen and all assets denominated in that currency.

This is clearly Japan’s last stand and there is no real exit strategy except to explicitly default on its debt. But an economic collapse and a sovereign debt default on the world’s third largest economy will contain massive economic ramifications on a global scale. Japan should be the first nation to face such a collapse. Unfortunately; China, Europe and the U.S. will also soon face the consequences that arise when a nation’s insolvent condition is coupled with the complete abrogation of free markets by government intervention.

 

Yellen Hands Off Printing Press to Japan
November 10th, 2014

There is a saying: “The rich just keep getting richer”. And by all accounts, since the 2008 financial crisis, they have. Unfortunately, for the struggling poor and middle class, wealthy asset holders have been the only beneficiary of six years of Federal Reserve easy-money policies. Under the tutelage of Ben Bernanke, the Fed introduced QE in March of 2009 with the hope it would save the economy from economic collapse. The goal was to create a new vibrant market for borrowing to replace the former vibrant market for borrowing that had just blown up, taking the economy with it. I am sure Ben Bernanke began this ruse with good intentions and the misplaced belief that real economic prosperity could be manufactured from creating new money.

But as they say, hind sight is 20-20, and here we sit six years and 3.5 trillion dollars later with the realization this money printing scheme did not work as planned. Don’t just take my word for it. According to Wall Street Journal, Former Fed Chairman Alan Greenspan said the QE program had failed to achieve its primary goals. As a means of boosting consumer demand, the asset purchase program, he said, "has not worked," though it did a good job of increasing asset prices.

Bond king Bill Gross agrees, noting that the roughly $7 trillion pumped into the financial system since the financial crisis by the world's three biggest central banks has succeeded mostly in lifting asset prices rather than workers' wages: "Prices go up, but not the right prices."

And Hedge fund manager Paul Singer recently noted “The inflation that has infected asset prices is not to be ignored just because the middle-class spending bucket is not rising in price at the same rates as high-end real estate, stocks, bonds, art and other things that benefit from quantitative easing.”

Why QE Hasn’t Worked

The U.S. Government has done a splendid job of continuing its borrowing spree, as Federal debt has increased from $9.2 to $17.9 trillion. But if we learned any lessons from these last few years, it should be that government borrowing and spending in the form of transfer payments (such as food stamps) doesn’t grow an economy.

The Fed hoped that printing $3.5 trillion would encourage private companies to borrow money and grow their business by investing in property, plant and equipment. Unfortunately, growth doesn’t happen in a vacuum. With the consumer tapped out, business was more realistic about demand. The idea that low interest rates and available credit would spur growth similar to what we saw in the 1990’s with the technology boom did not manifest. Therefore, instead of borrowing at low rates to grow their businesses, many companies just took on cheap debt and bought back stock--growing their EPS but not the economy. This kept the “beat the expectation” crowd on Wall Street happy but did nothing to encourage sustainable growth.

Central banks have failed to realize that lasting economic growth only comes from real savings and investment, which leads to an increase in labor hours and productivity. The government’s borrowing and printing scheme left the banking system intact, but did nothing to help the average consumer. While the Fed was frantically printing money to re-inflate asset prices, the majority of American’s incomes have decreased, as real after tax income has actually fallen by -5.9%. In fact, in this recent election, we learned 65% of Americans are still primarily concerned with the economy, and nearly the same amount believe they are worse off since the great recession began. This is despite manipulated data from the Federal Government meant to persuade them otherwise.

With the prospect of viable economic growth pushed further out of reach and the Federal Reserve out of the QE game, deflationary forces should prevail and equity prices should be falling. But, if there is one thing Central Banks are famous for, it’s not learning from past mistakes. Fittingly, taking a page from the hyperinflationary playbook, Japan has gone on a kamikaze mission to destroy its currency; announcing an escalation of its bond purchase rate to $750 billion per year. In addition to this, Japan’s state pension fund (the GPIF), intends to dump massive amounts of Japanese government bonds (JCB’s) and double it allocation to equities, raising its investment in domestic and international stocks to 24% each. The BOJ is also planning on tripling its annual purchase of ETFs and other equity securities. Japan has taken the baton from Yellen and will run with it until the nation achieves runaway inflation and its currency is completely destroyed.

Central bankers across the globe have succeeded in hallowing out the middle classes, but have failed miserably in achieving viable growth. This game will continue until the inevitable currency collapse unfolds and investors lose faith in government-manipulated asset prices. The tsunami resulting from currency, sovereign debt and equity market destruction will soon begin rolling in Japan. The problem is that Japan isn’t some isolated banana republic—it is the world’s third largest economy. When its currency collapses it will wipeout worldwide markets and economies as well. And then, hopefully, investors will insist on putting their faith and wealth in money that can’t be destroyed by a handful of unelected and unaccountable government hacks.

 

Ebola is the New Weather Excuse
October 27th, 2014

The perennially-optimistic crowd on Wall Street never lets the truth get in the way of a good story. So whenever the stock market doesn’t move their way, they come up with a myriad of excuses to explain the fall. The members of what my good friend Peter Grandich likes to call, “The Don’t Worry Be Happy Crowd” appear at their favorite hangout “Tout-TV”, and try to deflect attention away from the truth.

What these cheerleaders are unwilling to admit is that the Federal Reserve’s myriad of QEs and manipulations of interest rates have been pumping air into the stock market. Therefore, every exit attempt from its manipulations has, and will, begin a painful (yet necessary) deflation of this bubble.

Instead, they fall over themselves to deliver some alternative explanation for the deflation of asset bubbles after the Fed stops pumping in air. The heavily-relied-upon excuse after the first quarter’s negative GDP print and 6% drop in the stock market was the weather. Likewise, it was no surprise that this October’s vicious market selloff wasn’t blamed on the Fed’s imminent exit from QE. On the contrary, the view being promulgated was that the market was selling off due to Ebola fears.

The infectious disease that is ravaging Western Africa is nothing to joke about, as it has caused the death of thousands of people. However, in the United States to date, less Americans have died of Ebola than have been married Kim Kardashian. But those who cheer the Feds every move would have us believe Ebola, not the end of QE, was the primary cause of the market’s woes. After all, the Keynesian view of the world is that government spending and central bank money printing are the very embodiment of all that is good, and Ebola is bad, it kills people—so let’s blame it.

And so the cheerleaders deftly weave this entertaining narrative; oil prices are plummeting because nobody is going to fly a commercial aircraft from fear of contracting Ebola. Americans will stop going to the mall, won’t buy another car and will not leave their house. For a fleeting moment, Ebola had purportedly brought the U.S. economy and market to its knees.

Yet, the market bottomed on October 16th about one minute after the “hawkish” St. Louis Federal Reserve President James Bullard, hinted central-bank bond buying may get extended. Bullard apparently didn’t get the Ebola talking points. The S&P 500, which had tumbled that morning, managed to reverse course back to unchanged after his statement, despite no new Ebola news. In fact, Mr. Bullard’s statement sent the S&P up nearly 5% during the ensuing four trading days. And just like that, the markets fear of Ebola vanished--perhaps Bullard should have been named the new Ebola Czar.

The truth is it’s not snow or a third world infectious disease that is driving this market. It is QE and the Fed’s ability (for the time being) to keep interest rates near zero.

The Fed started its bond purchase program known as QE1 in late 2008. Then, ramped up QE in March of 2009 when the economy was on the brink of destruction and the S&P 500 stood around 666. But the stock market didn’t turn around until QE 1 was put in full force.

Then, when the first round of QE purchases were completed in March of 2010, the S&P fell by over 13% during the next few months. During roughly the same time period, the 10-year note yield fell from 3.85% to 2.38%, commodity prices tumbled around 10% and the M3 money supply dropped from a positive 2%, to a negative 6% annual rate of change.

Similarly, once QE2 ended in June of 2011, the S&P fell by 17% within three months. The 10-year note yield dove from 3.2%, to 1.8%, and again coincided with a plummet in commodity prices and M3 money supply.

Now these events may have coincided with some other non-correlating events such as; the Icelandic volcano eruption that temporarily closed European airports, the occupy Wall Street movement and the end of Oprah’s 25 year run on ABC – but none of those events caused these deflationary forces to ensue; it was the end of QE. In fact, for the past six years the stock market has been unhinged from fundamentals and has traded predominantly on central banks’ monetary policies.

However, the “happy crowd” is ignoring the dynamics of inflation and deflation. The Fed’s exit from QE is a deflationary event, just as massive money printing is an inflationary event—plain and simple. Since asset prices are currently so high into the stratosphere, it takes an overwhelming amount of QE to override the gravitational force of deflation. When the stimulus is withdrawn, inflated asset prices begin to deflate back to normalized levels.

Deflation is a healthy and healing process; as asset prices and debt levels deflate from artificial levels. But, this also coincides with a temporary decrease in GDP growth. This is the true message investors should glean from commodity, stock and bond markets. Deflation and recession is also what the 2% Ten-year Note is telling you.

Of course, the perpetually bullish will argue the drop in energy prices and borrowing costs will be great news for the consumer and imminently boost the stock market and the economy. They said the same thing when the WTI oil price began its drop from $147 per barrel in the summer of 2008, to $33 six months later. But don’t be fooled by those who are incessantly upbeat. Deflation, although a healthy occurrence in the long run, will not just bring down inflated commodity prices, but will take equities and real estate down along for the ride.

If we allow deflation to run its course, we can emerge as a much stronger economy. But, the Federal Reserve will not sit idle as air streams out of the asset bubbles it has worked so very hard to create. When asset prices stop rising, our central bank will come to the rescue with another round of stimulus, as the market cheerleaders cheer them on yet again.

 

A Funny Thing Happened on the Way to Raising Rates
October 20th, 2014

It wasn’t too long ago that the stock market was busy celebrating a “great” September jobs report. There were 248k net new jobs created and the unemployment rate dropped to 5.9 percent. Janet Yellen, Ben Bernanke and the rest of Washington D.C.’s central planners deemed it a great time to take a Keynesian victory lap, basking in the delusion that they now have proved you actually can print and borrow your way to prosperity.

And, because of their success, the Fed would be able to raise interest rates without any damage to the economy.

But while crossing the finish line they discovered they were on the wrong track. U.S. stocks have dropped for the third consecutive week and have erased all the gains for the year. The market’s anxiety stems from the global economic slowdown (that includes the United States). Industrial commodity prices, most notably oil, are tumbling and sovereign debt yields are plunging—asset prices around the world have begun to collapse.

Ever since the late 1980’s, the Fed has viewed itself as the savior for the stock market; this is affectionately referred to on Wall Street as the Fed put. Like a fireman standing ready to put out a major fire brewing in the economy’s kitchen, the central bank has stood ready to bail out any of the markets bad behaviors—most of which were first derived from the Fed’s provision of artificially-low interest rates to begin with.

But, today’s Fed isn’t merely waiting for a fire to start, it is using a flame thrower to light the stove. It has stopped relying strictly on overnight repos to manage short-term rates and providing liquidity on the margin; but instead has now put the responsibility of the worldwide economy squarely on its shoulders.

This is why former Fed Governor Laurence Meyer recently complained that too-low inflation, “is getting to be a real issue again,” With inflation at 1.5 percent according to the Fed’s preferred index, Meyer believes FOMC policy makers aren’t likely to raise interest rates, even if the economy approaches full employment—what Keynesians believe causes inflation.

And taking this a step further, John Williams, president of the San Francisco Fed, said in a recent interview with Reuters that the first line of defense at the central bank would be to telegraph that U.S. rates would stay near zero for longer than mid-2015. Then, if inflation isn’t really hollowing out the middle class fast enough, Mr. Williams suggests the Fed should be open to another round of asset purchases. Even so called Fed Hawks, like St. Louis President James Bullard, are now suggesting that the current quantitative easing program should be extended.

It has become clear that the Fed is no longer just tinkering on the edges of the economy, it is now micromanaging every economic data point and, most importantly, each tick of the stock market.

This over-engaged Fed has created an overwhelming sense of investor complacency—an entitlement that asset prices will always go up and bond yields will always stay low.

All central bank intervention comes with a price. The upside of lowering interest rates is that it lowers debt service costs. The down side is it encourages more gluttonous debt consumption. That is why the U.S. National debt has risen from $9.2 trillion, to $17.9 trillion, since the beginning of the great recession. This is also why total Global debt has soared by over $40 trillion, since the start of the Great Recession. Stated differently, total global debt has leaped from 176 percent of GDP in 2008, to 212 percent by the end of last year. The truth is there has been no deleveraging at all since the financial crisis; but rather a dramatic re-leveraging of the global economy.

Rising rates are not the current problem. Despite the fact that the biggest buyer (the Fed) is nearly out of the picture, yields are falling because deflation is pervading across the globe. However, the ending of our central bank’s massive QE programs is acting like a defacto tightening of rates.

The fact is that debt levels have increased to such a lofty level that zero percent interest rates are not enough to keep the current stock market bubble afloat. If you don’t agree with this, take a look over in Europe. Central Bank head Mario Draghi is having difficulty getting a genuine QE program going and there has been no increase in the ECB’s balance sheet. Despite the negative nominal interest rate environment in Europe all stock indices are down on the year; with the German DAX down 11% in 2014.

U.S. markets fell around 15% after QEs 1 and 2 ended. That’s because asset bubbles have risen to the extent that they now rely on perpetual central bank money creation to survive. Investors need to be reminded that the stock market did not bottom from the panic selloff experienced during the height of the great recession until QE1 was expanded to $1.55 trillion in March of 2009. Each time QE ended the stock market fell apart. Only this time the end of QE III finds the market more than 40% higher than it was at the end of QE II. In addition, the end of this round of money printing coincides with the majority of developed and emerging market economies at or near a recession. And, the Fed isn’t just ending QE but is planning to raise interest rates in the next few months.

Bond yields and industrial commodities have already tumbled in price; and now real estate and stock prices have also begun to plummet. I believe that stocks have entered into a significant bear market.

Without having the ability to further lower interest rates, it will take another massive and protracted QE program to pull equities out of this tailspin. To keep the bubble growing we will see a promise from the Fed that QE won’t end until inflation has become permanently entrenched in the economy.

It looks like yet another Fed prediction has failed to materialize and another of its strategies has been thwarted. The sad truth is that the Fed’s plan to raise interest rates next year will not come to fruition. In sharp contrast, the new plan will be called QE infinity.

 

Q3 Earnings Horror Show
October 14th, 2014

The International Monetary Fund (IMF) has downgraded its global growth forecast for both this year and next, highlighting among other things, the threat of weakening demand in the Eurozone and a slide into deflation. This comes after consumer price growth in the euro zone slipped again in September, coming in at just 0.3 percent.

There’s absolutely no sign of growth in the Euro region. France is stagnant, Italy is back in recession, and even the German economy, once the pillar of the Eurozone, shrank in the second quarter. German industrial output fell by 4 percent in August, with the worse-than-expected drop coming a day after the country's industrial orders had their largest monthly decline since the global financial crisis in 2009.

The United Kingdom isn’t fairing any better, as manufacturing output for August grew just 0.1 per cent, down from 0.3 per cent in July.

And then of course we have Japan, whose industrial production shrank 1.5 percent month-on-month in August and spending among Japanese households fell a steeper-than-expected 4.7 percent.

Life in the emerging markets isn’t faring much better. Adding to the world-wide misery is Russia. Russia is suffering from its involvement in the Ukraine, resulting with both U.S. and European Union imposed sanctions. Investors are now frantically pulling money out of the country. Demand for dollars and euros is growing among Russian companies locked out of western debt markets as they contend with $54.7 billion of debt repayments in the next three months; leaving the rubble under severe pressure. All this is exacerbated by the plunge in oil prices to their lowest level in more than two years--threatening to tilt the $2 trillion Russian economy further towards recession.

Moving to the other side of the globe, we have Latin American economies that are also in, or teetering on recession. Brazil’s economy, post-world cup, is on life support, its one hope being that President Rousseff, the Marxist and former guerilla, doesn’t win the election. A win for her seems likely, even though Brazil’s economy is officially in recession. The second quarter’s GDP took a huge downturn, contracting 0.6 percent from the first quarter.

Chile’s manufacturing output fell 4.9 percent in August, as policy makers cut their growth forecast for the 4th consecutive quarter. And, it may finally be time to cry for Argentina, as tougher controls on trade and the currency market are exacerbating economic imbalances that were already dizzied from the nation’s July default. Economists now predict the first full-year recession in Latin America's No. 3 economy in over a decade.

And then of course we have China, the former darling of global growth. Its industrial production growth slowed sharply in August to its lowest level for more than five years. In addition to this, house prices have fallen for five consecutive months. This could be a result of China's large debt-to-GDP ratio, which stands at 217 percent. The Chinese government continues to add to their debt load by fruitlessly attempting to stimulate the economy through endless construction projects. But all they have produced are more unoccupied cities, instead of balanced and sustainable growth.

The fact is that economies all over the world are in, or near a recession. However, Wall Street’s greed and hubris is trying to convince investors to believe U.S. growth will be immune from the global malaise and leave the earnings of multinational corporations unaffected.

But why would the growth rate of earnings and the US economy be better than virtually every other country on the planet? Linear-thinking economists are extrapolating the Q2 GDP rebound from the negative first quarter as a sustainable trend. But a temporary bounce from a sharply negative 1st quarter should not be viewed as a permanent growth trajectory. The entire planet is suffering from anemic growth due to a tremendous debt albatross. That includes the United States.

To think Q3’s earnings won’t be disappointing, investors have to believe that; weak and faltering global growth, a surging U.S. dollar, the Fed ending a $1.7 trillion QE III program, and the specter of rising interest rates in 2015, will be great news for multinational corporate earnings.

The United States is part of a global economy and does not operate on an economic island. Now that the Fed’s QE programs are ending, global deflation is starting to take over. Equities, bond yields, commodities and home prices are all starting to roll over. Look for these factors to negatively impact S&P 500 earnings in significant fashion this quarter.

 

Dollar’s Ride is About to End
October 6th, 2014

Under the stewardship of Shinzo Abe, the nation of Japan has become a global leader in debt, currency devaluation and inflation. Unfortunately for the Japanese, Abenomics is also leading Japan into a hyperinflationary depression, as the first of his three arrows has shot right through the yen and put a gaping hole in the wallets of every Japanese citizen.

The Bank of Japan (BOJ) has placed all its chips on the bet that inflation will cure all the nation’s economic problems. Making deflation public enemy number one is rather convenient when your country's public debt to GDP is the highest in the world. In order to end deflation, the central bank has purchased 70% of all newly-issued Japanese Government Bonds. All this money printing is intended to get prices rising, and it has been very successful. Japan's consumer prices rose 3.1 percent in August from a year earlier. Prices for fuel, light and water rose 6.4 percent on the year. But as real wages continue to fall, the bull’s eye appears to be directed on destroying the Japanese middle class.

In the nonsensical world of Abenomics--where inflation is viewed to be the progenitor of growth--the 3.1% CPI reading is deemed to be insufficient. This is because the core rate of 1.1 percent was far shy of the 2% read they are aiming for. So, as expected, there are calls coming from the lobotomized economic experts in Japan for yet more money printing from the BOJ.

Japan’s “experiment” with Abenomics would be much more interesting if we didn’t already know how it all ends. This so called experiment of massive debt monetization has already been tried in countries such as Weimar Germany and, more recently, in Zimbabwe; with disastrous results. The misguided policy of using inflation to create growth is predictably causing asset bubbles in JGBs and stocks. The BOJ is tirelessly printing money to monetize nearly all of the Japanese government’s enormous debt load and also to buy stocks. This has ballooned its equity portfolio alone to be an estimated 7 trillion yen ($63.6 billion). However, all this has done nothing to boost real GDP, balance trade or boost real wages. In fact, Industrial production shrank 1.5 percent month-on-month in August and spending among Japanese households fell a steeper-than-expected 4.7 percent.

The Japanese economy has reached the point of no return. The BOJ will continue to print yen until the citizens of Japan, unable to take any more pain from intractable inflation, insist on a change of course. The real solution for Japan will be to explicitly default on its monstrous debt.

The major beneficiary of Abenomics has been the value of the U.S. dollar. But this will not be the case for very much longer. There currently appears to be a trenchant divergence between the monetary policies of the BOJ, and that of the Fed. The market has become convinced that the Fed will soon be raising interest rates, while the BOJ continues to reckless print money. This has caused a large increase in the value of dollar vis-à-vis the Yen.

The dollar is going higher because of the misperception that the U.S. economy is strengthening. Markets are also convinced that the Fed will have a graceful exit from QE and a smooth transition to interest rate mean reversion. But this could not be further from the truth. The US economy is still highly susceptible to even slight interest rate hikes. This is why Q1 GDP was a negative 2.1 percent. The 10-year note went from 1.6% in May, to 3% by the end of 2013. Keynesians blamed snow for the negative first quarter, but the truth is that our over-indebted economy falls apart once debt service costs increase—even from such low levels.

As the Fed exits QE and prepares the market for rate hikes, we see the Case-Shiller home price index fell 0.5% in July, the biggest drop since November 2011 and the third month in a row of such declines. The Russell 2000 is down 12% from its March highs, and half of the NASDAQ is in a bear market. Commodity prices are crumbling as the economic data is weakens. Pending home sales, the ISM Manufacturing Index, Construction Spending and Factory Orders all recently came in worse than expected.

QE’s purpose was to boost real estate, equity and bond prices. After six years of successfully re-inflating assets, the Fed has duped itself and the markets into believing it can exit monetary manipulations with impunity. Therefore, get ready for the resumption of plummeting asset prices like we experienced in 2008.

But remember, central banks’ number one fear is deflation. The Fed under Chairperson Janet Yellen is certainly not the exception, and she will do whatever is necessary to curtail the dollar’s strength. This is why the Fed will not be aggressively hiking rates in 2015; and could even start another round of QE in the near future.

Much like the BOJ, our central bank firmly believes that inflation can somehow lead to prosperity. After asset bubbles crumble and the Fed re-engages, the true anemic state of the dollar will be revealed.

Most importantly, it is crucial to understand that the intrinsic value of the dollar is not rising. Real interest rates in the United States are still very much negative and the money supply is growing far faster than real GDP. Therefore, the dollar is only rising if measured against those countries whose central banks are actively trying to depreciate their currencies. And the U.S. Fed is about to rejoin in that effort.

Japanese citizens—if they have any discretionary investment income left—should be aggressively selling their paper money and buying gold. And it won’t be long before all holders of fiat currencies are forced to do the same.

 

Yo – This Market is Set For a Major Correction
September 29th, 2014

Wall Street came to a halt recently, as Chinese e-commerce giant Alibaba made its Initial Public Offering debut. The media became myopically focused over this so-called “historic event” and by its celebrity founder Jack Ma. By the time the closing bell had rung, the hype and fanfare propelled Alibaba up 36 percent on its first day of trading and caused the world’s largest IPO to display a market cap worth $231 billion. The investing public seems to have forgotten the dangers associated with disregarding valuation metrics—Alibaba is trading at a Price to Book value ratio north of 27!

This hysteria is scarily reminiscent of the late 1990’s, where an over-hyped stock market soared to new heights fueled by an accommodative Federal Reserve. Today, just as in 1999, a vastly superfluous money supply is finding its way into the pockets of any flimsy business model, with stock valuations that far outstrip the book value or potential profits.

During the peak of the late 90’s tech bubble, the Price/Earnings ratio of the Nasdaq 100 was far in excess of 200. This confirmed investors were willing to pay very high prices for stocks, due to their delusional expectations of earnings growth. The problem, which is now easily acknowledged by using hindsight, was these companies never had the potential to reach the valuations ascribed to them—all they had was eyeballs. But a central-bank manipulated increase in the money supply does strange things to investors, it ails them with a condition Alan Greenspan referred to as “irrational exuberance.”

Today we see that same type of irrational exuberance, as investors fall over themselves to buy stock of a Chinese internet company, despite the fact the communist government of China retains total control over that country’s internet. If China’s Premier Li Keqiang decides to pull the plug on the company, it will become worthless overnight. However, while Alibaba does have revenue and earnings, the gross overvaluation of the enterprise echoes the tech bubble with frightening similarity.

But Alibaba is not even the best example of this current Fed-induced social media frenzy. The paragon of “irrational exuberance” would have to be the social media app called YO. What is the intellectual property behind this life-changing technology you ask? Brace yourselves; it just sends friends the thought provoking message “Yo,” Yo was developed in eight hours and was launched on April Fool’s Day of 2014. As idiotic as this idea may sound, it has a valuation of $10 million. The actual meaning behind the word “Yo” is subject to interpretation. And not even its founder, Mr. Arbel, whom I imagine is “Yoing” all the way to the bank, is willing to provide Webster’s with a definition. Some presume its code for “hey”, which I am sure will be the next app to raise millions of dollars very soon as well. But, more than likely the significance of this word really is, “Yo, this market is a bubble; get out now!”

But it’s not just irrational investments, such as Yo, and overhyped IPO’s, that are signaling a top to this market. There are technical indicators in the market that are also setting off loud warning bells. The breadth of the market is troubling to say the least, with nearly 50 percent of stocks in the NASDAQ down more than 20 percent from their peak in the last 12 months. Additionally, more than 40 percent have fallen that much in the Russell 2000 Index. In fact, the Russell 2000 index of smaller companies is now down over 4 percent on the year, and has in technical terms reached a “death cross”. A death cross occurs when a stock or index's 50-day moving average trend line dips below its 200-day moving average; and is a sign momentum is fading.

It’s clear as the Federal Reserve reins in its economic stimulus plans that the appetite for risk is narrowing. QE III totals $1.7 trillion worth of Treasury and Mortgage Backed Security purchases and this program ends in October. And the Fed’s massive money printing scheme, which resulted in record-low interest rates for the last 6 years, has manifested in stock, real estate and bond bubbles occurring all at the same time.

After a Fed-induced five-year rally in stocks, which added almost $16 trillion to equity values, it’s been three years since investors saw a 10 percent decline in the S&P 500. But we are starting to see the early anecdotal and technical signs that this market has gotten too frothy and a significant pullback is imminent. With the total market cap of stocks as a percentage of the economy at 117%, its highest point since the dot.com bust and far above its level reached in 2007, the toboggan ride down can’t be too far off. Perhaps those who haven’t gotten out in time will yell this as their portfolios plunge, “Yo, I should have known better.”

 

Doves Don't Know History
September 22nd, 2014

A wise saying goes like this; "Those who do not remember history are condemned to repeat it." So ask yourself; what is the fate of those who seem to have absolutely no recollection of events that happened just a few years ago?

We are nearing the end of 2014, and to the debt markets, it is almost as if the 2008 economic collapse never happened. It appears that borrowers and lenders are suffering from a severe case of collective amnesia. Yes, consumer debt levels took a slight breather in 2009-10. But today, total consumer credit in the U.S. has risen by 22 percent over the past three years, and at this point 56 percent of all Americans have a subprime credit rating.

By the end of 2014, total U.S. credit card debt is expected to rise by $54.8 billion and average household credit card debt will surpass the $7,000 mark, reaching levels not witnessed since the end of 2010. Adding to these disturbing figures is student loan debt that is at a nationwide all-time record of $1.2 trillion, which is an 84 percent jump since the Great Recession of 2008. Almost 19 percent of student loan borrowers owe more than $50,000, according to a report published recently by the Federal Reserve. Only 6 percent of borrowers had that much debt in 2001. Student loan debt now outstrips credit card and auto loan debt in America. And speaking of auto loan debt, during the first quarter of this year, the size of the average vehicle loan soared to a new all-time record high of $27,612. Five years ago, that number was just $24,174.

The financial crisis of 2008 was born out of a romance between the US consumers' insatiable desire to spend and financial institutions' voracious desire to issue debt, which compelled them to lend money regardless of the other party's ability to make payments. In 2008, this dysfunctional relationship ended badly and both parties swore each other off. But, with the Fed in the background playing the violin, recent data shows today, these two lovebirds can't stay away from each other.

Unfortunately, todays mounting debt isn't limited to the US consumer, Bank of America is forecasting about $110 billion of collateralized loan obligations for 2014, as volume is on pace for a record year. CLO's are used to finance small and medium size businesses. And CLO issuance in total, is on pace to surpass the record $93 billion raised in the U.S. during 2007.

Adding fuel to the debt fire is the aggressively growing Junk bond market. Junk bond yields have fallen to the 5-6 percent range. This has caused fund managers, still insisting on a 10%+ return, to buy on leverage in order to increase the yield on their capital investment. Citigroup, displaying a pre-2008 mindset, has even calculated that leveraging junk bonds at 2.3X is a better trade than leveraging US Treasuries at 8.1X.

All these data points prove that we, as a nation of borrowers, have learned nothing from 2008. In fact, things have gotten worse as our own Federal Government, lulled by record low interest rates, has massively stepped up its own passion for debt, taking Federal Debt levels up from $9.2 trillion, at the start of 2008, to $17.8 trillion today. But the tease is that with record low interest rates, they are actually paying less today to service that debt then they were 6 years ago.

This is in part because the Treasury insists on financing debt at the shortest duration possible. In fact, about 80 percent of the government's $12.8 trillion publicly traded debt is financed with shorter-term Bills and Notes. And thanks to the Fed's ZIRP and Treasury's short-term thinking, the average interest rate on the government's marketable debt was less than 2 percent last year. Compare that to the 6.6 percent level in January of 2000, when interest rates were still below their forty-year average.

It's clear that simply reinforcing bad behavior of the past has left few to learn from previous transgressions. The past six years of record low interest rates, should have given borrowers a reprieve; an opportunity to refinance debt and get their financial house in order. Instead, it has predictably lured, first the public, and now private sector borrowers, to pile on more debt. Indeed, the aggregate level of U.S. debt now stands at a record $57 trillion! That figure is up nearly $7 trillion from the Great Recession.

Therefore, those investors who believe the Fed can seamlessly transition from 6 years of ZIRP and $3.7 trillion in QE should re-read the above data. An aggressive Fed will immediately cause our overleveraged and asset bubble-driven economy to collapse. It's just a shame the Dole of Doves at the Fed never learned from previous mistakes-even those made just a few years ago.

This is why the Federal Reserve will not be raising rates anytime soon. And why Ms. Yellen kept the language in last week's FOMC statement regarding, "considerable time" between the end of QE and the first rate hike.

Those investors piling into the U.S. dollar based on a hawkish Fed are making a big mistake. Our central bank wants to create an environment of perpetual inflation. And will not end its policy of providing negative real interest rates until thoroughly successful.

Since the Greenspan era, history has taught us that our dovish Fed exists to accommodate government borrowing. This truth is becoming more immutable as debt levels inexorably increase. Unfortunately, this codependent relationship has now caused the latest iteration of a stock market bubble to become the most dangerous of them all.

 

Why Goldman Sachs is Wrong on Gold
September 15th, 2014

Wall Street powerhouse Goldman Sachs has recently reiterated its negative view on gold, which it has held for the past year. However, it is now doubling down on this view and advising clients to actually go short the metal. Jeff Currie, head of commodity research at Goldman noted "Our target is really driven by the view that we think that the Fed will ultimately be the dominate force here and put more downward pressure [on prices]".

While I am in agreement with Goldman that the Fed will be the dominant force behind the price of gold, I believe the central bank will soon be back into the QE business, rather than raising interest rates and crushing the dollar price of gold.

Here’s why:

Since Nixon closed the gold window in 1971, gold has made an impressive move upward from its fixed price of $32 an ounce, to where it sits now around $1,250. But few seem to grasp what actually causes gold to move higher. An increase in the gold prices occurs when the market becomes convinced that a currency will lose its purchasing power due to central bank-induced money supply growth and real interest rates that have been forced into negative territory. And nothing convinces a market more of a rising gold price than when debt and deficits explode.

But while the parabolic move higher in gold from 2009 to 2011 did contain a period of low nominal interest rates, real rates did not fall. And, the surging gold price was not accompanied by a growing money supply either. In fact, the growth rate of M3 plummeted during 2009 thru 2010—it wasn’t until 2011 that the money supply rebounded. So what would explain the steady move in gold from $800 to $1,900 per ounce during that time period? The gold price simply got ahead of itself because the market feared that out of control deficits would force the Federal Reserve into an unending cycle of debt monetization, which would engender a protracted period of negative real interest rates, booming money supply growth and inflation.

However, those fears were temporarily ameliorated by the reduction of Federal Budget deficits starting in 2011. This is because the Fed was, ironically, able to temporarily re-engineer asset bubbles, while sending borrowing costs lower, causing revenues to increase and expenditures to decrease. Annual deficits fell from $1.3 trillion in 2011, to $500 billion today. Adding to the gold market’s recent woes is the specious belief held by U.S. dollar bulls that the Fed will be aggressively raising interest rates while the rest of the world is cutting rates. This is the explanation to why gold and gold mining shares have suffered mightily during the past three years.

Today, the equity and bond markets have positioned themselves for the best outcomes of all possible scenarios. These markets are assured that the Fed can painlessly exit QE in October and real interest rates will rise with no ill effects on the economy. The pervasive belief being that US bonds, stocks and dollars will be the sole beacons of economic hope in an otherwise slumping worldwide economy; and, having complete faith that budget deficits will continue to shrink.

I don’t buy any of it, and here are the reasons:

Last week we learned that mortgage applications plunged to a 14 year low. This is because home prices are still so unaffordable that just a slight tick higher in interest rates is enough to stall both potential home buyers and borrowers looking to refinance their loans. This confirms that after six years of unprecedented Fed manipulation of markets, our economy has become hypersensitive to the slightest interest rate blip. It also supports my contention that the rise in rates which occurred during the second half of 2013, was much more influential on the first quarter’s negative 2.1 percent GDP print than what can be attributed to snow. Our economy is not anywhere near strong enough to sustain growth during a rising interest rate environment. And is why the Fed won’t venture very far into this game.

Furthermore, economies in Europe and Japan are in recession, while the once mighty emerging market economies are flailing. As their respective Central Banks frantically print money, the US dollar is soaring due to the belief that the US economy will remain unscathed from a global economic slowdown. But, the belief that the U.S. economy will stand alone on a pristine island, while Europe and Japan sinks into the sea, is just as preposterous and unprofitable as the belief held back in 2008 that economies around the world would remain untouched by the U.S. housing meltdown.

The markets also seemed to shrug off last week’s disappointing jobs report as an anomaly. Perhaps a colder-than-normal August is a good scapegoat. But this week, Janet Yellen gave us an interesting glimpse into the Fed’s view of the jobs picture with her “Labor Market Dash Board”. It showed that only three out of nine metrics regarding the labor market are better than they were prior to the start of the Great Recession. Investors should think again if they believe the Yellen Fed will be aggressively raising rates and boosting the value of the dollar given the labor market’s already-fragile condition.

Most importantly, the tide of shrinking budget deficits is about to turn. For instance, since 2011, we have seen a significant reduction in defense spending (down 5.5% during 2014 alone), due to the drawdown of troops in Iraq and Afghanistan. And although we have yet to learn the full costs associated with Obama’s plan to destroy ISIS--we can safely assume it will be very expensive.

Adding to this, is the drastically underestimated cost of Obamacare. Insurance risk pools failed to get the proper demographic mix, and the Cadillac tax--delayed until 2018--has companies scheming to redesign existing plans in order to avoid these taxes. Add to this the unexpected costs of illegals flooding the border, demographics moving far out of favor, and an increase in interest rates that will drive up debt service costs, and you can see why deficits will rise. But nothing adds to the deficit like a recession. Our asset-bubble addicted economy faces another reduction in GDP growth very shortly. This factor alone will send deficits north of $1 trillion in short order.

Faced with a worldwide economic slump, central banks remain the only game in town. And today’s central banks, determined to smooth out every hiccup in the economy, only have one answer--print money. When all you have is a printing press, every problem looks like a monetary crisis.

The Fed will not be raising rates anytime soon. To the contrary, Ms. Yellen will soon be forced back into the money printing business in an attempt to; force higher money supply growth, push real interest rates further into negative territory, keep the dollar from rising, and to make sure debt service payments remain under control.

Therefore, very soon we will once again have a perfect storm in which gold will rise. The next phase in the gold bull market will include all four conditions that existed in the massive bull run that started in 2009; negative real interest rates, rapid money supply growth, a falling dollar and skyrocketing deficits. Investors that have the foresight to realize this opportunity today stand to benefit greatly in the near future.

 

Why This Equity Rally is About to End Badly
September 8th, 2014

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.

 

The Fed's Ice Bucket Challenge
September 1st, 2014

Unless you have been living under a rock for the past month, you have more than likely heard of the ALS Ice bucket challenge. But, just in case you have been living under that rock--the challenge dares nominated participants to be filmed having a bucket of ice water poured on their heads and challenging others to do the same. The stipulation is that the nominated people have 24 hours to comply, or forfeit by way of a charitable donation to ALS. It is an ingenious marketing campaign that has thankfully raised awareness and millions of dollars for ALS.

However, we all know that while many made a monetary contribution, others just dumped a bucket of water on their head under the guise of helping the cause, simply because everyone else was doing it. In social media circles, this is known a slactivism. A pejorative term that describes "feel-good" measures, in support of an issue or social cause, that have little or no practical effect other than to make the person doing it take satisfaction from the feeling they have made things better.

And in a similar, but far more dangerous fashion, the Fed is engaging in its own form of "slactonomics". It forces new dollars into the economy in order to stoke inflation, with the hope that rising asset prices will give the illusion of a booming economy. Therefore, the Fed's specific Ice bucket challenge is: Put your cash in stocks, bonds and real estate assets; or watch your money earn no interest while it loses its purchasing power against those same assets. And, just like the herd mentality of humans causes us to dump ice water on our heads, the lemmings in the market are loading up on stocks despite the fact that equity valuations have become far removed from the underlying anemic fundamentals of the economy.

But here is the catch--the Fed thinks it can escape its huge marketing campaign that involved years of market manipulation with impunity. But, it has made an egregious miscalculation.

Wall Street has completely bought into the fantasy that the Fed can end its $3.5 trillion dollar QE programs and also normalize interest rates after having them near zero percent for over six years without hurting GDP growth or having a negative effect on equity market prices.

However, one of the unintended consequences from normalizing interest rates is the effect on the U.S. dollar. The dollar is already rapidly rising as the Fed winds down QE3; just imagine how high it would rise if interest rates were to rise here in America.

Beginning in early 2009, asset prices in the U.S. increased in tandem with that of the developed world, as most global central banks depreciated the intrinsic value of their currencies in concert. However, we now see the dollar rise and asset prices in the U.S. begin to fall (S&P Case-Shiller Home Price Index now down two months in a row) as the Fed winds down its latest $1.7 trillion dollar QE program and sets the table for a lift off from a zero percent Fed Funds rate in the first half of 2015. In fact, the dollar index has already increased from 79 in May, to over 82.6, which is a 52 week high.

The real estate market is starting to factor in the end of QE and the rise of the dollar, but equity prices seem to be still in a state of denial. The Fed's Ice bucket challenge seems to have frozen investors' brains into believing the exit from QE will be a smooth one for equities and the FX market.

While it is true that a strong and stable currency is the cornerstone of a healthy economy, it is also true that the journey from a massively manipulated currency to one that is subject to free-market forces is never a smooth ride. The Fed cannot tighten monetary policy unilaterally without causing massive disruptions in currency valuations.

The BOJ continues to monetize 7 Trillion yen per month of Japanese assets and the ECB is expected to begin its own substantial QE program very soon. If the U.S. attempts to raise rates while the developed world is printing money to keep rates low, the dollar will skyrocket against our major trading partners.

A surging dollar will crush commodity, real estate and equity prices, as it causes the reporting earnings of U.S. based multi-national corporations to plunge.

This is just one example of the volatile and disruptive ramifications associated with the normalization of interest rates; many of which appear to be out of the Fed's risk calculations. In a very short time from now asset prices should undergo a sharp correction in an amount north of 20 percent because of the end of QE and the tremendous volatility in the U.S. dollar.

But, the Fed's number one fear is deflation. Ms. Yellen and Co. will do everything in their power to make sure inflationary expectations are permanently anchored into the U.S. economy.

Therefore, the Keynesian mind-warped Fed will interpret the surging dollar and plunging stock prices as a catastrophic threat of deflation-even though the rebalancing of capital and asset prices are the only viable solutions to our economy. And is why, in the final analysis, the Fed will not venture very far into its tightening cycle-if it even attempts a serious effort to raise rates at all.

Investors should then use this upcoming correction in asset prices and cyclical period of deflation to position their portfolios in hedged positions that profit from an inexorable increase in the rate of inflation.

 

Why Global Bond Yields Are Tumbling
August 25th, 2014

Market pundits appear to be mostly dumbfounded as global bond yields continue to set record lows. For some examples; the 10 year German bund fell below 1%., the Italian 10 year note has dropped below 2.60%, Spanish bonds fell to 2.40 % and Japan is offering a shocking one half of one percent to borrow funds for ten years. Even Greece, whose bonds were on ECB life support just two years ago, has a 10 year note yielding below 6%. Worldwide bond yields are at all-time lows, leaving market commentators scrambling to come up with a creative array of explanations for this phenomenon. Tensions in Ukraine and escalating violence in the Middle East are some favorites. But at least in Europe and Japan, most are willing to attribute record-low bond yields to the real cause…that is no growth and deflation.

Curiously, here in the United States--despite bonds yields heading towards 52 weeks lows around 2.31%--those perpetually-bullish market strategists are extremely optimistic about growth in the second half. Just as they have been each year since the Great Recession ended in 2009.

Few commentators in the U.S. are willing to admit the truth that plunging bond yields are signaling the same thing here that they are in the rest of the globe, which is the inability of massive central bank money printing to engender real growth. These pundits have a myriad of other excuses to explain our low borrowing costs. But my favorite red herring is to completely lay the cause for our plunging yields on the low yields that exist in Europe and Japan. They claim it is the yield spread alone that is causing a monetary deluge into U.S. debt.

It is true the benchmark U.S. yield has been running more than 1.30 percentage points above the yield on 10-year German Bunds since the beginning of July. This premium is the biggest since June 1999, which was before the euro was introduced. Leaving many to summarily conclude that our yields must fall commensurately to that of Japan and Europe; despite their contention that the U.S. growth and inflation rates will be drastically different than that of those same countries.

But falling yields in the US are not solely due to an arbitrage between Treasuries and European/Japanese debt. To the contrary, it is because the fundamentals of low growth and cyclical deflation are the same in both countries. If the U.S. had differing fundamentals, like rapidly-rising inflation, then the yield spread would be rising instead of narrowing. That’s because foreign investors would need to be compensated for the increasing differential in real interest rates (much lower in the U.S. than in Europe). Therefore, this condition of falling real rates in the U.S. would cause the Euro to rise vis-à-vis the dollar and erode all incentives to own Treasuries near the same yield as European debt.

The truth is, the investors who make up the bond market are smarter than most who comment on it. They understand, bond prices are a result of Credit, Currency and Inflation risks. Since the credit risks of Europe and the U.S. are fairly commensurate, we have to assume a worldwide decline in yield reflects the market’s perception of inflation risk, or lack thereof. This is because the U.S. is ending its biggest QE program to date ($1.7 trillion worth of Fed asset purchases), which will bring about a short-lived respite from the inflation experienced over the last few years.

In 2011, I said the world was heading into a new paradigm – central banks around the globe were walking their economies on a very thin tight rope between inflation and deflation. Onerous debt levels had reached the point where the central banks would be forced into a difficult decision; either massively monetize the nation’s debt or allow a deflationary depression to wipe out the economy.

In this environment, governments are compelled to seek a condition of perpetual inflation in order to maintain the illusion of prosperity and solvency. However, once the central bank shuts off the money spigot, deflation then returns with a vengeance. As a result of winding down the massive money printing from the Fed, we are now seeing the very early signs of deflation. Yet, the usual talking heads are too busy cheering from the sideline to watch the game. And they see every deflationary signal the market is throwing them as another reason to get their pompoms out.

Falling commodity prices (down 8% on the CRB Index since June) are great for consumers and businesses in the long term. A period of deflation would be greatly welcomed in the long term, inasmuch as it represents a needed healing process from the Fed-induced inflation. However, it is not conducive to rapid growth in the short run because this deflation will be the result of collapsing asset bubbles.

The facts are that Japanese GDP is falling sharply, European growth is nil, and U.S. GDP for the first half of 2014 is under 1%. For those who love to continually applaud every central bank intervention, the failure of our Fed to produce sustainable growth seems not to be an option. So every data point is spun to support the narrative of an economic recovery. Unwilling to admit the Fed’s massive monetary experiment may fail, they sit in perpetual denial about our true economic condition and spin an elaborate web of excuses.

What they fail to realize is that QE never created viable growth, it just inflated asset prices. Likewise, the winding down of QE will not manifest growth, it will just temporarily deflate those bubbles that represent the greatest distortion of asset prices in the history of global economics.

 

The Keynesian Counterfactual is Japan
August 18th, 2014

We heard the "surprising" news last week that the Japanese economy shrank at an alarming 6.8 percent annualized rate in the three months through June, its biggest quarterly contraction since the 2011 earth quake and tsunami. Proving Japan’s greatest national disaster, Abenomics, has failed and the Japanese economy has fallen victim to the scam called Keynesian economics. Defined as the belief that a country can tax, spend, devalue and inflate its way to prosperity.

Since the popping of the BOJ- induced bubble in 1989, Japan has been the most faithful adherent of Keynesian principals. At the onset of the crisis they immediately began on their misguided path with large doses of deficit spending. Instead of allowing the economy to rid itself of bad investments and heal, they continued to prop-up failed business models--creating Zombie banks and an equally Zombie-like economy.

As one lost decade turned into two, in the year 2000, they coupled their fruitless spending efforts with massive amounts of money printing. And despite two decades of low growth, the nation stubbornly held on to the popular Keynesian excuse of “if only”…If only our stimulus was larger, if only we weakened our currency more, if only we kept interest rates lower for longer; economic nirvana would be achieved. Keynesians love to use this counterfactual argument because they believe it cannot be proven wrong--that is until now!

In 2012, Prime Minister Shinzo Abe had a master plan to pull the world's third-biggest economy out of its stagnation. His plan was to deploy, in massive and unprecedented fashion, the strategies of central bank credit creation, currency destruction and debt accumulation. The Japanese doubled down on the great Keynesian experiment, as if Paul Krugman himself was running the economy, they placed the economy on Keynesian steroids. Now, we are beginning to see what an economy looks like when the Keynesian playbook is utilized to its fullest extent.

With a first half economic contraction in the books, many economists are now warning that Japan is poised for yet another recession. Back In June, I warned the reported 6.1 percent GDP growth in Q1 will prove to be temporary because businesses frontloaded capital spending in a move to avoid April’s well-anticipated and substantial increase in the consumption tax from 5% to 8%. And because of the asinine belief that growth comes from inflation, Japan’s lethargic economy--whose inactivity had previously been blamed on falling prices--slowed dramatically right after prices went up. Household consumption plummeted at an annualized pace of 19.2 percent from the previous quarter, while private investment sank 9.7 percent. And because of the Japanese battle against deflation, real wages dropped 3.8% year on year in May. Those mismanaging the Japanese economy believe consumption will surge if they can achieve a substantial increase in the CPI. The misguided logic being the Japanese consumer will only spend if they are running in perpetual fear of rising prices.

One of the cornerstones of Abenomics was destroying your currency with the hopes of boosting exports. Ironically, last week the central bank warned over a worsening export and factory output picture. In fact, June showed the worst trade deficit ever in Japan, and a 57 percent rise in the trade deficit for the first half of the year.

And today with a near 250% debt to GDP ratio, it’s difficult to argue Japan didn’t engage in enough deficit spending. Over the past three years, interest rates on the JGB 10-year note went from 1.5% to .52%. Under its own brand of quantitative easing policy put in place last April, the BOJ now buys 70 percent of all new government bonds issued in markets, as well as other more risky assets. With the JGB market on virtual life support courtesy of the BOJ, it is impossible to argue rates aren’t low enough or that the BOJ hasn’t monetized enough. They spent, they printed, they taxed; but the Japanese economy is out of gas, and the Keynesians who own this plan are now out of excuses.

The truth is Japan is a perfect example to the counterfactual argument that anemic U.S. growth is the result of a Keynesian plan that was launched half-heartedly.

The United States should heed Japan’s economic woes as a warning sign, and a reason to change course while we still have a chance. With U.S. debt to GDP at 105 percent and household debt at over 80 percent, the aggregate amount of our nation’s debt is at an all-time high. But unlike Japan we have the overwhelming privilege and responsibility of holding the world’s reserve currency.

Obliging other nations to trade and hold U.S. dollars is not written anywhere in the bible. These nations have, for the time being, decided to maintain a holding that is equal to 50 percent of our publicly traded Treasury debt. Losing their confidence in our credit and currency would be devastating to our economy. Japan has no such worries about keeping foreign investors happy because they finance 90 percent of their debt internally.

We have become a country that habitually over-consumes and under-produces. Debt levels have skyrocketed while our demographic and labor force participation conditions are quickly approaching critical mass.

We have to abandon these failed Keynesian policies while there is still time. We must boost our employment to population ratio, deregulate the economy, simplify the tax code, balance the budget, cut expenditures, end the Fed’s runaway printing press and allow the free market to set interest rates and asset prices. Only by doing this do we stand a chance of not falling further into Japan’s stagflationary nightmare. But if we persist in following the Keynesian counterfactual, our fate will be worse than that of Japan, as the deluge of debt being dumped by our foreign creditors causes the dollar to be dethroned, interest rates to soar and inflation to skyrocket.

 

Hopelessly Devoted to Inflation
August 8th, 2014

In the middle of July the stock market finally awoke from its QE-induced coma and realized the Federal Reserve's tapering, which has been going on for the last six months, was for real. Like a child, who becomes accustomed to a parent that threatens punishment but never follows through, the market had been in denial to the Feds withdrawal of monetary stimulus. But now, thankfully, the ending of Fed asset purchases will be the pin that pops this QE-inflated market and economy. But please do not confuse the end of QE with the Fed actually fighting inflation and selling trillions of dollars' worth in Treasuries and mortgage backed securities (MBS)…because that will never happen.

The Fed has increased its balance sheet by an unprecedented $3.5t since 2008. They accomplished this by purchasing Treasuries and MBS from banks in exchange for Fed credit. A credit from the Federal Reserve is a nuanced way of saying "new money". This new money is transferred as a credit to the banks with the idea that the Fed can and will reverse this transaction at its discretion. Like an army releases reserves, the Fed (with the help of private banks) has marched many of these new dollars into the economy to "save us" from deflation. Once the job is done, the Fed intends to call these dollars back and shrink its balance sheet back to pre-crisis levels. This all sounds great in theory, but as we will soon see, the practical applications of shrinking the Fed's massive Balance Sheet has become impossible without creating a monetary depression.

For the past few years, the central bank's credit and inflation has been predominantly deployed in bonds, real estate and equity assets. However, recently this new money has leaked into the government's manipulated CPI calculation. Therefore, our government can no longer promulgate the lie that inflation is some elusive goal that it cannot achieve. And, the argument that stronger economic growth is around the corner in a context of low inflation has been fully debunked. That is why the market sold off last week. In a word, it is inflation. The Employment Cost Index (ECI) component in the GDP data put the Keynesians on "high wage inflation alert".

But, most will be blindsided by the temporary period of deflation that will result from the end of the Fed's massive asset purchases, as the monetary spigot for the primary beneficiary of the Fed's credit--namely stocks and bonds-gets turned off.

Similar to the housing market in the mid-2000's, we are about to relearn the lesson that many equity investors (especially those on margin) can only afford to hold on to an asset when prices are rising.

However, on the other end of this cyclical period of deflation, lies a period of inflation that will make the '70s seem like an era of hard money. The reason for this is in order to fight inflation the Fed will have to bring home trillions of those "money troops" it sent into the economy. Calling the money back is going to be far more difficult than it was deploying it.

When the Fed buys Treasury debt, most of the interest payments made go back into the government's coffers. In fact, by law the Treasury has claim to all income derived from the Federal Reserve; less expenses. So the Treasury pays the Federal Reserve an interest payment and in return receives most of that payment back. This is a pretty good deal for the Treasury, considering the Fed's profit is in the neighborhood of $91 billion a year. This means the Treasury not only didn't have to find a real buyer for the newly issued debt but it also did not have to worry about paying interest on that debt.

But, it gets even better--as the bonds mature, the Fed has been rolling over the principal. Therefore, it is as if the $2.4 trillion of newly issued Treasury bonds sold to the Fed since 2008 don't even exist. The Treasury gets reimbursed on its interest payments and never even had to worry about what the cost would be for the private market to purchase that debt. To further sweeten the pot, the Fed has pushed rates down to unprecedented lows, leading to relatively-modest debt service payments on all of its record-breaking $17.6 trillion of outstanding debt.

However, if the Fed wants to genuinely fight inflation, it will have to eventually raise interest rates. Ending QE will only provide temporary relief from a weakening currency. To accomplish this in sustainable fashion it will have to shrink its balance sheet back to around the same level it was prior to the Great Recession.

How does the Fed shrink its Balance Sheet? As we discussed, when the Fed purchases a bond from a bank it creates a credit that can be taken back at the Fed's discretion. Taking the credits back on a short-term basis is called a reverse repo-the Fed sells the assets back to the banking system and takes back the cash for a very limited period of time.

But, it just cannot conduct reverse repos to the tune of trillions of dollars without putting extreme pressure on the market for private short-term loans. This means the government is not only going to have to permanently sell the over $2 trillion in bonds into the market, it will have to start paying real interest on that debt as well. And, the private market will also have to finance all the new annual deficits, which will no longer have the luxury of a trillion dollar plus annual QE program from our central bank.

The net effect of all this would be surging interest rates and a complete economic collapse. This is why I do not expect the Fed's balance sheet to significantly contract for many years, if at all. And predict inflation will become a huge and growing problem--especially after the central bank launches another massive QE program in 2015 to re-inflate falling stock prices.

Our government is in a horrific trap because of the record amount of debt it has issued and allowed the central bank to monetize. This is why every time the Fed tries to fight asset bubbles and bring inflation under control it will result in the creation of a monetary depression. And is also why nearly every central bank on the planet has decided the only real long-term objective is to fight against deflation and ensure inflation will always prevail.

 

The Fed-Induced EPS Fairy Tale
August 4th, 2014

The stock market has advanced sharply over the past five years no matter what geopolitical situation has blown up or how tenuous the economic foundation may be. This is because Investors have simply been forced to throw money at the market with a reckless disregard of logic due to the lack of interest provided through the holding of cash.

But if one looks objectively and the true market fundamentals, it is clear to see that the stock market has blown into yet another bubble, except its total magnitude has been masked by the central bank's engineering of corporate earnings growth.

Unfortunately, the sobering truth is stock values are highly extended at this time. And, it is silly to ask the question if these values are justified because of strong earnings growth or because of the Fed's easy money policies--because you can't separate corporate profitability from the record-low interest rate environment provided by the Fed.

The Price to Earnings ratio of the S&P 500 as of this writing is at 19.5. That is about 4 points above historic levels. But, inflated PE's are only part of the story. For most companies in the SP 500, top-line revenue growth has been anemic since the Great Recession ended in 2009. Earnings growth (expected to be 5.4%) is coming primarily from corporate engineering facilitated by the Fed's zero interest rate policy.

There has been so much talk about corporations' pristine balance sheets. But, the truth is non-financial corporate debt is up $3.5 trillion since 2009. Businesses have refinanced much of their $13.8 trillion in outstanding debt at vastly reduced levels, which lowers debt service payments and improves EPS. Nearly 90% of this new debt was used to buy back stock and increase dividends. Less shares outstanding, reduces the denominator of the Earnings per share (EPS) calculation-also boosting EPS and making the PE ratio seem less out of balance.

Likewise, households have also been provided relief on their $13.2 trillion of outstanding debt-boosting their ability to consume more of what businesses sell. And, the Fed's war against savings has been paramount in pulling along this consumption-driven economy, which also has helped artificially inflate corporate earnings.

Most importantly, the zero interest rate monetary policy of the central bank has forced money into stock and real estate assets, which has further supported consumer and business balance sheets. This has greatly abetted our consumption-driven economy and vastly increased corporate profitability.

Therefore, it is absurd to ask the question whether it is earnings growth that has justified the increase in equity prices; or the Federal Reserve. This is because the Fed has been the predominate factor behind earnings growth…you just cannot separate the Fed from equation.

But, just as the Perma-bulls convinced themselves in 2007 that a banking system on the verge of collapse was a great buying opportunity, they are again convinced that the lofty level of equities is justified by a sound business sector today. They ardently refuse to let facts get in the way of their great bull story.

However, the truth is corporate earnings will plummet once the Fed ends QE and/or interest rates rise. And the equity bubble will end badly for the third time in last 14 years. The scariest part is that each equity market crash has been worse than the last. The one right around the corner will be no exception. In fact, if past history is any guide, the mere ending of the Fed's asset purchase program will be enough to send equity prices crashing back to earth. Therefore, gullible investors will very soon realize once again that the latest bull story, which is built upon phony fundamentals, was just that...a load of bull.

 

It's Déjà Vu Disappointment All Over Again
July 28th, 2014

Baseball great Yogi Berra had a saying "It's déjà vu all over again", and every year around this time, I am reminded of those words. As we have once again, happened upon that magical time of year I call, recovery summer déjà vu. It's the time of year when Wall Street and Washington apologists trot out their dog and pony narrative, in an attempt to spin the actual data, proving we have finally embarked on the summer that will launch sustainable economic growth.

And this year is no exception, as those same people appear to be downright giddy by the prospect that we finally have something to feel optimistic about. For instance, they are euphoric about the most recent jobs report, some suggesting that there is absolutely nothing to find fault with. Of course, they fail to mention anemic wage growth, the lower quality and part-time jobs created; or the discouraged workers who have left the work force.

Yes, they will admit that they were stunned when GDP contracted in the first quarter, but that was a mere weather-related incident. It was the blizzard of Q1 2014 that left GDP buried under 2.9% inches of negative growth. In truth, a more accurate reason for the economic slump was the move in the 10 year note from 2.48% on October 23rd, to 3.03% on December 31st of 2013. And the move over 3% was the peak of the cyclical advance from the low of 1.63% on May 2nd. The doubling of interest rates, although still to a historically low level, was enough to send this debt-laden asset-bubble driven economy into the freezer. But why allow facts get in the way of a good weather story. So once again we hear cheers for another summer recovery.

The truth is, since 2010 every second half recovery has disappointed and this one will be no exception. The first quarter of 2014 gave us 2.9% negative growth. I am in agreement with most economists that the 2nd quarter will come in somewhere around 3%, resulting in an economic flat line for the first half of 2014. This puts enormous pressure on the second half of year to bring us out of stagnation that has led to the most anemic recovery since WW II. Let's review; after GDP shrank in both 2008 & 2009, growth returned in 2010 by 2.5%, in 2011 it fell back to 1.8%, it then went up slightly in 2012 to 2.8%, but then down again in 2013 to 1.9%. The inability to obtain growth above 3% in each year since the economy collapsed during 2008-2009 underscores this tremendous economic failure to bounce back after the Great Recession.

So why do they think this year will be different? After all, if you subscribe to the Keynesian fairytale of money printing and deficit spending, it was easy to see why they were excited back in the summer of 2010. The economic spigots were over flowing with a treasure trove of demand stimulus and monetary elixirs.

In the summer of 2010 sanguinity was in the air…Time magazine's 2009 man of the year Ben Bernanke was poised to save the day, ready to do whatever it took to get this economy growing again. Today, despite lack luster growth, the Fed is retreating. Essentially conceding-at least for now--printing money didn't solve the problem; QE is set to wind down in just 90 days.

But for a Keynesian it gets worse. Instead of an Obama phone, we have the roll-out of the job-killing Obama-care plan this year and next. In addition, profligate tax-payer subsidized loans that funded the likes of Solyndra, have been supplanted by a capital goods strike. "Shovel ready" has been replaced with anemic real income growth and record debt levels.

Putting the Keynesian fantasy aside, the truth is there isn't much ahead that will stimulate real growth. The middle class, which was already saturated in debt, has not been the beneficiaries of the Federal Reserve's money printing. Instead, those dollars have been funneled into the creation of new asset bubbles and have led to an increase in food and energy prices-like it always has in the past. Stagnant wages are being stretched further to pay for the necessities of living. We still don't have the regulation and tax reform that catapulted the Regan revolution. Companies that have cash flow would rather make stock purchases to increase their Earnings per Share than invest in property, people, plant and equipment. And, unless the economy is headed back into a severe recession, the economic boost from a lower cost of money will be absent.

The truth is there is not much at all on the economic horizon to warrant optimism. Yes, the cheerleaders are hoping if they yell loud enough, a recovery-summer will finally manifest. Unfortunately, until free-market forces are finally allowed to deleverage the system, it will be a disappointing second half recovery--all over again.

 

Inflation’s Real Cause
July 22nd, 2014

According to Pimco’s new Chief Economist, Paul McCulley, the Fed’s war against inflation has been won!  But, before we get out our party hats and plan the tickertape parade, we have to ask ourselves – for the past 27 years have we really been at war with inflation?  Yes, during the late 1970’s and early 80’s a different Paul (Paul Volcker, Chairman of the Federal Reserve) waged a real battle against inflation.  Mr. Volcker painfully took the Fed Funds rate to near 20 percent in June of 1981.  The economy suffered a deep recession, it was a treacherous battle plan, but the Fed stayed the course because Volcker was correctly convinced that limiting the growth rate of the money supply was the key to popping asset bubbles, vanquishing inflation and establishing a sound economy.

Fast forward six years, exit Paul Volker, and enter Alan Greenspan. For the back drop, it was the crash of 1987….and after declaring “mission accomplished” on the inflation war, Greenspan sought to fight a new war against falling stock prices.  Acting as the veritable Navy Seal of financial market defense, Greenspan valiantly leapt to shield markets from corrections.  This “special operation”, was affectionately referred to as the “Greenspan put”.  Over the years the “put” has remained, we have merely substituted Greenspan with Bernanke and now Yellen.  And so for the past 27 years, the only “war” the Federal Reserve has been waging has been to inflate asset bubbles.  These bubbles bring the economy to the brink of financial destruction, leading the central bank to intensify its efforts to fight deflation with each iteration.

McCulley goes on to say "For the last 15 years inflation has been incredibly absent…We've had our cyclical ups and downs but when you look at it on a chart, I think we've achieved the promised land of price stability over many cycles."

I have to assume that McCulley is affectionately gazing at the government-manipulated chart of CPI, where despite all the bureaucratic finessing of these figures, we still can find year over year inflation reaching more than 5 percent during that 15 year period.  But a 15 year chart of the NASDAQ and Home Price Indexes tells a more interesting story.  Perhaps McCulley dismisses the NASDAQ and Real Estate bubbles under the cover of seemingly innocuous “cyclical ups and downs”; mere speed bumps on the way to the “Promised Land”.

McCulley also states that he and Bill Gross strongly support an increase in the minimum wage, giving celebration I’m sure to all the minimum wage bond traders in New Port Beach, CA. I find it ironic those who espouse the belief that inflation doesn’t exist would argue for increasing the   minimum wage.  After all, why should incomes have to rise in the face of price stability? 

Most importantly, Keynesians, like McCulley and Chairpersons of the Federal Reserve, believe inflation is caused by rising wages. They contend that without rising wages inflation cannot become a problem.

Let me explain something to McCulley and his fellow adherents to this Phillips Curve myth. Inflation is caused by a persistent and pervasive fall in the purchasing power of a currency. The market becomes convinced of substantial currency dilution and the value of paper money falls.

The fact that nearly every other central bank on the planet has followed in the footsteps of our Fed has masked much of the currency destruction against our trading partners. But the value of the dollar has fallen against most assets precisely because of massive money printing and artificially-low interest rates provided by the Fed.

Rapid money supply growth can and often does occur while real wages are falling because commodity and import prices respond first to the drop in the currency’s value, while median nominal wages merely lag in a futile attempt to keep pace with the falling purchasing power of the currency.

History is replete with examples of this fact, and the latest proof that inflation can become a problem without wage growth in the vanguard comes from Japan.  The Japanese Yen has lost 30% of its value since 2011 vs. its major trading partners. That’s bad news for an economy that needs to import 80% of its food and energy needs. At the same time, consumer inflation is up 3.7% YOY. In fact, Japan is experiencing the highest inflation rate in 32 years. However, real incomes are down 4.6% YOY and have been falling for 23 months in row.  This is just another example of how nominal wages lag inflation when a central bank pursues policies that promote currency destruction.

But the real problem is that these Keynesian misconceptions are not only held by McCulley and, his boss Bill Gross, they are also held by Janet Yellen and her cronies at the Federal Reserve.  And by continuing to focus on wage growth instead of the growth rate in the money supply, the Fed has put itself in the position where it will be perpetually behind the inflation curve and delayed in pricking the asset bubbles it is fighting so hard to recreate.

The simple truth is you can’t win a war you don’t fight. How can the Fed have conquered inflation if the only battle it has fought since 1987 is against deflation? Both Volcker and Keynesians cannot be correct. Inflation cannot be defeated by taking interest rates to 20 percent; and also through the process of keeping rates at zero percent for 6 years and counting. Inflation also cannot be declared dead by creating an additional $3.5 trillion of bank credit over the past few years. 

Unlike the prosperity induced by Volcker’s deflationary utopia, we now have the dystopia of massive economic imbalances created by central bankers that have completely replaced market forces in the determinations of interest rate and price levels. And it is central bankers’ complete incomprehension regarding the healing forces associated with deflation that will cause the next collapse to be exponentially worse than the financial crisis of 2008. Inflation has not been defeated at all, but rather it is any hope of deflation and economic stability that has been wiped out.

 

Pimco Steals AIG’s Playbook
July 14th, 2014

Pimco is putting all their chips on the table, betting that low interest rates, along with lower and more stable global growth, will last for the next 3 to 5 years; an economic condition it is referring to as the “new neutral”.

In fact, the company is so convinced of this “sure thing”, it’s placing a straight bet--selling insurance against price fluctuations on their $230bn flagship bond fund Pimco Total Return. That means it is offering investors price stability in the bond portfolio, in return for a premium.

Instead of just simply investing clients’ money in a normal bond strategy, it is upping the ante by applying a derivatives trading scheme. To this fact, Mr. Gross asserts that Pimco is one of the biggest sellers of insurance against market volatility.

Selling volatility typically involves selling options, which would pay out if a particular market moved by more than a pre-agreed amount. For example, the Volatility index, also known as the VIX, is based on the price of a combination of options on the S&P 500. The more investors are willing to pay to protect themselves, the higher the index goes. The index is said to measure fear in the market place.

Sellers of these types of security derivatives have profited lately from the lack of volatility in the market. This has allowed Pimco to sit back and collect premiums, without having to pay out on market volatility.

Sound familiar? That’s because back in the early 2000’s, insurer AIG placed a similar seemingly riskless bet. They offered banks a way to get around the Basel rules, via insurance contracts, known as credit default swaps. They insured sub-prime securities for a premium. At the time, I’m sure it seemed like easy money--after all, the historical loss rates on American mortgages was close to nothing. They employed extremely bright people who created incredibly sophisticated computer models and assured them that this bet was a sure thing. They wagered big on what appeared to be a lock. And for a period of time, they too sat back and collected premiums without having to pay out.

Needless to say, AIG’s bad bet ended with an enormous bail out from the Federal Reserve.

But, Pimco is wagering on more than lack of market volatility. Doubling down on its new neutral bet, Pimco is borrowing on the short end to invest in longer end bonds. If rates were to take a sudden spike up, it would be paying more on the short end loans than received in interest payments from their bonds--and would be forced to unwind that trade.

And further pressing its bet, making this a potential trifecta of financial disasters, you have to remember that Pimco is a huge player in the bond fund space, with over $1.9 trillion in assets under management. Pimco’s Bill Gross has decided to go large--betting that it will win, place and show. If his horse fails to come in and interest rates go up, the price of Pimco’s bond funds will fall. Investors, who have already been walking away for a consecutive 14 months straight, will then run to the exit doors, forcing Pimco to sell bonds to meet redemptions, driving interest rates up further. This rise in rates will increase volatility, obliging Pimco to pay out on its VOL insurance and place the company under further duress.

This could be a disaster for both Pimco and the financial markets as a whole. And is reminiscent of the Long-Term Capital Management debacle. LTCM used a combination of leverage and complex mathematical models to take advantage of fixed income arbitrage deals. In 1998, when the market was in turmoil, investors panicked and fled the riskier markets for ones with a higher degree of certainty. LTCM, which also bet on the belief that fat tail events were illusory, found that despite their “supposedly” diversified portfolio, they had basically placed the same bet on low volatility. Like AIG, they too required a bail out.

Pimco is pressing its bet on the belief of a new neutral that low interest rates and low volatility will prevail for the next 3-5 years. If correct, the company will produce a modest return for their clients; but if it is wrong and we get a sudden shock in rates, Pimco’s clients will feel compelled to unwind the multi-trillion dollar bond portfolio creating havoc in financial markets, which will put the entire financial system and country in grave danger.

This is just one example of the consequences resulting from addicting the economy to ZIRP for six years. The fact is that a record amount of debt, inflation-driven central bankers and interest rates that have been artificially suppressed at historically-low levels cannot coexist. It is an incendiary cocktail that will soon explode in the faces of our government central planners.

Therefore, we face the daunting collapse of all types of fixed income and high-yielding debt. As a result of this inevitability, the real estate market will tumble as flippers are once again forced to dump their investment properties. The equity bubble will burst when the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer and business loans will come under duress. Banks’ capital will be greatly eroded as their assets go underwater, just as the rates on deposits are increasing. The Fed will become insolvent as its meager capital quickly vanishes. Interest payments on the national debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives—which Pimco now plays a big part in--will go bust.

But you don’t have to get caught on the wrong side of Pimco’s bad bet. A savvy investor can turn this into their market opportunity by betting that Wall Street and Washington’s fantasy of a normal economic recovery is about to collapse into a nightmare.

 

Asset Bubbles Out of Gas
July 8th, 2014

I've written exhaustively about the real purpose behind the Fed's quantitative easing strategy. So one more time for those who still don't get it; the primary goal of QE is to bolster banks' balance sheets through the process of re-inflating equity and real estate prices. If investors look back at the history of QE they will be able to clearly see what happens when the Fed steps on the monetary gas; and also what occurs once it takes the foot off the pedal.

For example, even though interest rates were already near zero percent, the Fed felt it necessary to begin purchasing massive amounts of bank assets in late 2008 to get the money supply and stock prices moving in the positive direction. The Fed announced a $500 billion Mortgage Backed Security purchase program (QE1) on November 25th 2008. The central bank then followed up on March 18th 2009 with a $300 billion plan to buy long-term Treasury bonds. The total amount of $800 billion in planned QE did exactly what was intended-the U.S. markets, not so coincidentally, ended their massive decline and then started a huge secular advance in March of that same year.

Most investors now agree that massive QE can be extremely positive for asset prices. But most on Wall Street either are not aware, or refuse to acknowledge, what occurs when the central bank stops printing. Therefore, a brief history lesson seems especially prudent at this juncture.

QE1 ended on March 31st 2010. The market soon after headed south, and just over three months later the S&P 500 dropped by 12.6%. The second round of QE ($600 billion) ended on June 30th 2011. This time, stocks began to decline within days after the last bond was purchased, and after three months went by investors experienced a correction of 16.7%. In both instances, a subsequent new round of QE came to the rescue of stock prices, just about when the depth of the correction extended into the double-digit range.

Now that the Fed's QE3 is officially ending, asset prices have lost most of their momentum. The Dow Jones Industrial Average is only up just over 2 percent and most other major averages are either flat to up low single digits so far this year. This is true even though we are over half-way through 2014; and compares to the 30 percent gains experienced last year.

It is important to note that QEs 1 and 2 ended abruptly, whereas QE3 is only being slowly wound down. Therefore, the mere announcement of the Fed's taper back in January of this year did not cause a similar market reaction to that of the other QE terminations. Also, the correction from QE2's end was more profound than that of the first, because equity values become more disconnected from economic fundamentals with each round of intervention.

So investors need to ask why the stock market would be immune from the Fed getting out of the QE business this time around. The truth is that asset bubbles have become more inflated and debt levels have greatly expanded during each iteration of QE. Given this progression, the end of QE3 should bring the major averages down somewhere in the neighborhood of at least 20 percent about three months after QE3 ends in the fall.

However, before the Fed launches yet another QE rescue program like it did after QEs 1&2 failed to generate solid growth, it would have to admit that the previous five years and $3.5 trillion worth of QE have been a complete failure; and that the U.S. economy is addicted to continuous central bank credit expansion. This might not come to fruition as quickly as most on Wall Street now believe it will, and could exacerbate the percentage of the selloff.

Up until now, the perennially-weak economic growth experienced since the Great Recession ended just didn't seem to matter for the stock market. The reason for this was that interest rates were falling from a benign level that already offered little competition for equities. And, the central bank had an overwhelming desire to increase the size of its balance and launch another round of QE at the first sign of falling asset prices.

Contrast that with the situation today. The Fed has become distressed over the amount of bonds it already currently holds and wants completely out of the QE business. In addition, interest rates have ended their decline and must increase along with the rising rate of inflation and the end of Fed bond market manipulation-unless of course rates fail to rise because of a deflationary collapse of the economy.

The overwhelming consensus on Wall Street is that the economy will illustrate vastly improving economic growth during the second half of 2014, in the context of low inflation and quiescent interest rates. And the pervasive belief is also that the end of QE will not have the negative effect on stock prices that it did after the last two rounds ended. Given that this scenario is already fully priced into markets, investors would be wise to maintain a very defensive posture during the next few months.

 

Japan Says Konnichiwa to Stagflation
June 30th, 2014

More than twenty years after its infamous real estate and equity bubble burst, Japan has been plagued by economic malaise, an ailment most main stream economists have attributed to something they call a deflationary death spiral. As one lost decade turned into two, and now well into number three, Japan’s Prime Minister Shinzo Abe has vowed to remedy this deflationary flu with an enormous dose of inflation.

In Japan, they affectionately refer to this elixir as Abenomics. In English, this remedy roughly translates to an enormous injection of public spending, more than a spoonful of currency destruction, chased down with a large dose of a consumption tax.

And, if deflation had actually been what had ailed the Japanese economy – it would appear that after more than two decades, they finally found their cure. The price of food is soaring at the fastest pace in 23 years and core consumer prices jumped 3.2 percent YOY in April.

Unfortunately, those Japanese who were only sick of the stagnant economy, are starting to wonder if “Dr. Abe” misdiagnosed the original disease. With an economy in perpetual stagnation, slightly falling to stable prices was the one salve. As anyone who lived through the 1970’s can avow, low growth can’t be assuaged by raising prices. And with wages excluding overtime and bonus payments falling in Japan for a 23rd straight month in April, Japan’s economy is falling victim to a new kind of outbreak--stagflation. Stagflation is an inflationary period accompanied by rising unemployment and lack of economic growth.

In fact, a favorite stagflation diagnostic indicator, termed the misery index, which adds the jobless rate (3.6 percent) to overall inflation (3.4 percent), climbed in April to 7--a 33-year high. Rising prices helped push Japan’s misery index to the highest level in decades, while wages adjusted for inflation fell the most in more than four years. If inflation continues at this clip, it won’t be long before Abe is forced to forego his Abenomic tonic in favor of a bottle of a Japanese version of WIN (Whip Inflation Now) buttons.

The economy is seen contracting an annualized 4.3 percent in the three months through June, following 6.7 percent growth in the first quarter—the surge in Q1 will prove to be temporary because businesses frontloaded capital spending in a move to avoid April’s well-anticipated and substantial increase in the consumption tax.

And, as Japan falls sick with the stagflation flu, it’s only a matter of time before we see this pandemic spread to Europe, just as it has already infected America. The Japanese prescription for deflation contains the same active ingredients of tax hikes, government spending and money printing that has caused the U.S. economy to begin to resemble that of the 1970’s. Indeed, consumer prices across the developed world have already stopped the healthy decline experienced after the real estate bubble burst in 2007, and since have broadly headed higher.

U.S. consumer price inflation is exceeding the 2 percent Fed target as of May; after falling throughout most of 2009. That should have been enough for Ms. Yellen and co. to abruptly end QE and begin to normalize interest rates. However, since growth targets have remained elusive—and will continue to disappoint until central banks stop looking to boost GDP through money printing—the Fed stubbornly clings to its easy monetary policies.

It seems that no matter how overwhelming the evidence is to the contrary, governments cling to the belief that growth comes from inflation. Perhaps the truth is that governments’ primary agenda is not to produce growth, but rather to find any excuse to create the massive amount of inflation needed to bail out the insolvent condition of their nations by reducing the value of that debt. Therefore, it is sad to say it’s time for Japan, along with Europe and the U.S., to say sayonara to the mollifying condition of deflation and konnichiwa to the dreaded situation of stagflation.

The size of central banks’ balance sheets around the globe have massively expanded into record territory in recent years. This should have caused a commensurate increase in the gold price across multiple currencies. Adding to the upward pressure on the yellow metal is the estimate from China’s chief auditor that the nation used $15.2 billion worth of phony gold ownership to vastly increase access to credit. Chinese security authorities are also probing alleged fraud involving other metals such as copper and aluminum stockpiles, which have been pledged multiple times in order to expand collateral for loans. This factor has aided the Chinese economy to increase debt 25 fold since the year 2000.

Debt levels have exploded across the world alongside the proclivity of central banks to create record amounts of credit. In addition, real interest rates are profoundly negative and persistent inflation has now become the stated goal from most governments. Most importantly, recently-achieved inflation targets set by the Fed are being completely ignored by Janet Yellen. And finally, the manipulation of prices and fraudulent use of supplies have created a tremendous tailwind for gold values. For these reasons, PPS has recently increased its allocation to gold mining shares in its Inflation/Deflation Dynamic Portfolio.

 

Fed's "Noisy" Inflation Fantasy
June 20th, 2014

The Fed wants investors to be as unconcerned as the central bank is about inflation. Even though year over year consumer price inflation is above its target, the Fed chose in its latest press conference to claim the 2.1 percent YOY increase in prices paid merely represented “noisy” readings in the inflation gauge. However, the truth is that rising prices are a direct result of years’ worth of zero percent interest rates and $3.5 trillion in money printing provided courtesy of both Banana Ben Bernanke and the Counterfeiting Queen, Janet Yellen.

It makes no difference to Ms. Yellen that price increases in the major inflation categories are rising above the Fed’s target. For example: Food at Home is up 2.5 percent; Energy went up 3.3 percent; Shelter rising at 2.9 percent; Medical Care Services up 3.0 percent and Transportation Services climbing 3.1 percent. But somehow the widely dispersed increases in year over year inflation, which are already far above the Fed’s target, are being summarily dismissed as “noise” by our central bank. In the spirit of today’s central bankers, inflation is seen not only as a dear friend; but one that they never seem able to recognize face to face.

The Queen Counterfeiter also stated in her press conference that equity prices seem to fairly valued from the Fed’s viewpoint. Perhaps she is also unaware that the ratio of total market capitalization to GDP is currently 122 percent. That figure is the second highest in recorded history—1999 being the only exception—and is 70 percentage points higher than the average from the time Nixon broke the gold window in 1971, all the way through 1990! In fact, this key ratio is a full 10 percentage points higher than it was at the previous peak before the start of the Great Recession in 2007. As a reminder; stock prices proceeded to lose more than half their value from the summer of 2007 thru March of 2009.

The bottom line here is that central banks around the world have fallen into a passionate love affair with inflation and asset bubbles. That is because these fiat-currency apologist believe inflation is commensurate with economic growth; and that the solvency of sovereign debt can only be achieved through massive money printing and negative real interest rates from here to eternity.

But the joke will be on these market manipulators and legalized counterfeiters in just a very short amount of time. Doubling down on the failed strategies of debt, inflation, currency destruction, regulations, taxes and artificially-low interest rates will soon explode in their faces once again—but only to a much great extent this time around.

The most humorous part of all this is Wall St. and Washington have duped most investors into believing the fairy tale that our central bank can end a multi-trillion dollar bond buying program and six years of ZIRP without experiencing any ill effects. And, at the same time they are telling us that economic growth will be accelerating, while the cost of money and the rate of inflation do not increase. I can assure you that there is virtually a zero percent chance of that happening. Therefore, I'm unfortunately completely convinced our government's fantasy will end in a catastrophe for markets and the economy.

 

Mafia GDP
June 13th, 2014

Governments are not engaged in a systemic conspiracy to alter economic data after it has been collected. To get a multitude of individuals agreeing on how to fudge information would be far too difficult to control. Instead, it is much easier for a small group of government officials to simply change the formula for calculating the data points that they desire to manipulate to make the information seem more palatable.

For example, since the world completely abandoned the gold standard back in 1971, governments have repeatedly tinkered with the CPI formula in order to convince the public that prices are vastly more stable than they are in reality. And now, since the developed world is suffering from anemic growth rates due to a massive debt overhang, governments have turned their attention to changing the way GDP is calculated.

Starting this year, the government of Italy will add the mafia's "contribution" of goods and services to its GDP. In fact, illicit activities like smuggling, prostitution and narcotics will now factor into the growth calculations of the U.K. as well. Analysts expect this accounting change to boost Italy's GDP a couple of percentage points each year. And another study found that America's underground economy was worth about $2 trillion annually. That's more than 10 percent of our legitimate GDP. Therefore, you can bet that the U.S. isn't far behind in adopting Europe's new GDP formula.

The U.S. already performed a little hocus pocus on the GDP numbers back in July of last year. The government made a significant change to the gross investment number, which now includes; research and development spending, art, music, film and book royalties and other forms of entertainment as the equivalent of tangible goods production.

GDP numbers have been chronically subpar in the U.S. since the Great Recession supposedly ended. Growth increased just 1.9% for all of 2013 and posted a negative 1% during Q1 of this year. And much the same can be said to describe the GDP data over in Europe as well, as they also have endured subpar and/or negative growth. As further evidence of the deteriorating growth condition, on June 10th the World Bank lowered its global growth forecast and cut U.S. growth to just 2.1% for 2014, from the previous estimate of 2.8%.

Therefore, our government leaders have sought to tinker with the formula more and more until they can produce the desired result they want to portray. Look for official government data on both a nominal and real GDP basis to become even more overstated in the future. Logically speaking, investors can also count on metrics such as debt and deficits as a percentage of the economy to appear much more benign than reality would otherwise present.

However, governments cannot so easily alter the most important metric in relation to the health of a sovereign nation. While it is easy for politicians to embellish the stated level of economic activity and growth, they are unable to increase the revenue to the government without actually extracting and redistributing private wealth through taxation. This means that the revenue available to service national debt will remain unaffected, no matter what formula the government comes up with to calculate GDP. The consequences of this will be devastating as an unprepared public is lulled to sleep with rosy debt metrics; but gets crushed when the bond bubble bursts due to insufficient revenue that is falling sharply in relation to interest payments on government debt.

Officials can triple count illegal activity if they so desire. But since it is illegal, by definition no additional revenue can be directly derived from it-especially from an arbitrary level of illicit activity made up by the government.

The sad truth is that economic growth will continue to disappoint and should worsen throughout the year, after perhaps a marginal bounce in Q2. One of the main reasons why there will be no sustained economic recovery is because the stimulus derived from the massive decline of interest rates has already accrued to the economy.

For example, corporations have been able to generate increasing profits, and individuals were able to reduce debt service expenses through the continuous refinancing of debt. To further illustrate this point, mortgage application are down 17% year over year. This is because the pipeline of people who have the ability to refinance their mortgage or that can qualify to purchase a home has already been vastly drawn down. With the refinancing and first-time buyers' market pipeline mainly exhausted, the housing market's support to the economy is fading. Now that interest rates have leveled off at rock bottom, after falling sharply for over 30 years, the tremendous tailwinds of ever-reducing borrowing costs have abated.

As the economic fundamentals continue to deteriorate, look for official government data reports on inflation and growth to become more imaginative and creative. But here's a brief reality check for investors:

  • Debt levels have exploded in recent years and have now reached intractable levels in the developed world
  • Central bankers-the supposed protectors of our purchasing power--have devolved to the point of now artificially providing zero and even negative nominal rates, with the expressed desire to push real interest rates further into negative territory
  • Asset bubbles now extend beyond real estate and are now also prevalent in equities and bonds as well
  • The middle classes are being eradicated through inflation, falling real incomes and debt

Another sad reality is that we used to live in a world in where asset prices were determined by the unfettered competition of markets. Today, markets have been obliterated by a handful of central bankers competing to provide the lowest interest rate and the greatest amount of monetary manipulation.

But in the end free markets always prevail and the eventual adjustment from the current fantasy world created by central banks and governments will be extremely violent and destructive. The chances are high that the adjustment will begin within the next two months, as the Fed's asset purchases will be nearly halved by the end of July QE. And will end completely a few months after. It is during that timeframe that I believe the gravitational forces associated with the free market reconciliation of asset bubbles begins to take effect.

 

Why Bond Yields are at Record Lows
June 3rd, 2014

It seems that nearly everyone is confounded by the record low bond yields that are prevalent across the globe today. If investors can correctly pinpoint the real reason behind these low sovereign debt yields, they will also be able to find a great parking place for their investment capital to weather the upcoming storm.

Wall Street cheerleaders are explaining that yields in the world's largest economy are falling for strictly "technical reasons." Specifically, they claim that there is a lack of supply of U.S. debt to purchase because deficits have come down so dramatically in past few years. But when you look at the data, you'll find this cannot be correct.

As a point of reference, the 10-Year Note in the United States is now at 2.5 percent, and yields on sovereign debt across the entire globe are likewise at, or very near, all-time record lows. This is true even if when looking back centuries.

In order to destroy the misinformation that there is a lack of supply of Treasuries, I gathered data during the four years when the U.S. actually had an annual budget surplus. The years were 1998 - 2001; and here are the deficit numbers as a percentage of GDP: 1998, positive 0.7 percent; 1999, positive 1.2 percent; 2000, positive 2.2 percent; 2001, positive 1.2 percent.

Those were the surpluses as a share of the economy during the late 1990s and early 2000s. In addition, the national debt back then ranged between $5.4 trillion in 1998, and increased to $5.9 trillion by 2001. And yet, given that we actually had budget surpluses and much lower levels of nominal debt and debt as a percentage of the economy, the U.S. 10-Year was trading from a range of 5.51 percent in 1998, to 5.03 percent by the end of 2001.

U.S. Note yields during the surplus years were more than twice as high as the yields seen today. Therefore, the misinformation being told to the American public that yields are at record lows due to a lack of supply issuance is preposterous. Indeed, sovereign debt levels amongst the developed worlds are at record levels; and yet, bond prices keep rising.

Today we have $17.5 trillion in debt, and the fiscal 2014 deficit is projected to be a negative 3 percent of GDP. And that nominal deficit number is estimated to be $500 billion. The 2014 deficit is being touted as an example of sound fiscal policy; but it should also be noted that the half-trillion deficit for this fiscal year is higher than any other budget deficit in American history outside of the Great Recession era-even when adjusted for inflation.

When people in the financial media try to tell the investment public that yields are down because there is no supply of debt, they should understand that the exact opposite is true. We have a $17.5 trillion national debt-a 250% increase in just over a decade--and a significant portion of that is short-term debt, which has to be rolled over every few weeks. The deficit is extremely large in nominal terms and double the level it was before the economy collapsed in 2008. Also, the amount of Treasury issuance is far greater today than it was 15 years ago.

We currently have falling growth rates in Japan, Europe, China, and posted a minus 1 percent annualized GDP print for Q1 here in the United States. These low yields are predicting that even beyond the slow growth that is evident right now, the risks are extremely high that the global economy will undergo a meltdown similar to what was experienced six years ago. The skyrocketing late payments on Chinese bank loans could be the catalyst that sets this chain reaction into motion.

The only legitimate reason why bond U.S. bond yields would be falling even as the Fed is getting out of the bond-buying business is that we are facing a contraction in global growth. It is not because of "technical reasons", "geopolitical concerns" or, especially not because "there are no bonds to buy."

And you can also throw away the argument that European bond yields are currently at or below those in the U.S.; therefore, global investors are simply doing a yield arbitrage. This reasoning really only serves to underscore the reality of declining economic growth throughout the developed world; and fails to explain how the U.S. economy can function with impunity from a globalized funk.

Unless Mario Draghi is about to make the ECB launch a QE program that would make the Fed blush, there is only one reason why the bond bubble has gone into hyper drive.

The truth is that the world is awash in sovereign debt. And the credit, currency and inflation risks associated with owning that debt has never be more elevated. Therefore, the only reason why yields are at historic lows is because they are predicting the chances of a meltdown in the global economy is extremely elevated at this time.

 

Just How Weak is the U.S. Economy?
May 27th, 2014

The Bureau of Economic Analysis (BEA) recently reported that Q1 GDP was only 0.1% in the United States. Most of that anemic number was blamed on worse-than-usual weather. But it should be noted that if our government accurately accounted for inflation, it would be clear to all that economic growth didn't just stall at the start of 2014; but rather it contracted sharply. And if our economy can be thrown into a tailspin by a few snow storms, it is an economy that simply has not recovered from the Great Recession--which supposedly ended five years ago.

Nominal GDP (Real GDP plus inflation) was reported by the government as 1.4% last quarter. This means that inflation in Q1 was estimated by the BEA to be running at a 1.3% annualized rate. However, according the Bureau of Labor Statistics, energy prices were up 3.3% year-over-year. Food prices as measured by the protein category (meat, poultry, fish, and eggs) were up 6.4% year-over-year. And Health care costs were up 9.9% in the past year--that's the largest increase in health care expenditures in 30 years. Home prices were also up 13% in the past year.

The plain truth is that the cost of living has risen significantly in the past year for anyone accustomed to eating proteins, or anyone seeking to be healthy, or people that use energy, and/or those individuals needing to provide shelter. If those components were correctly weighted in the BEA's inflation index, Q1 real GDP would have been negative. Therefore, taking a more realistic inflation measure off the Nominal GDP print, you can clearly see that the U.S. economy isn't just stuck in neutral, but is shrinking significantly right now. The real figure would most likely close to the minus 2.7% annualized rate it contracted at the start of the Credit Crisis in December of 2007.

The reason why we are in a further period of contraction is that the government never allowed the economy to heal. A period of asset price, money supply and debt deflation is needed to rebalance the economy from the excesses experienced during the last two decades. Instead, the Fed chose to use quantitative easing to re-inflate real estate and stock prices, which also encouraged the public and private sectors to take on debt to a greater extent. This has served to further weaken the American middle class; just as it also increased our wealth gap.

The tapering by the Fed is now halfway done. So we are going to start a new paradigm, which is really a resumption of the old paradigm. Namely, the healing process that began in 2007--the contraction of money supply growth, restructuring of debt and a collapse of asset bubbles.

The Fed will be effectively done with its tapering in the fall. This will once again lead to a healthy period of deflation and recession. Nevertheless, after it dawns of Ms. Yellen that the economy is addicted to QE, she will reverse course and launch another quantitative easing program.

This is because the shocking aspect of the Fed's strategy is that it doesn't grasp how ineffective the QE program is in providing viable and sustainable growth. Yes, massive money printing can send erstwhile falling asset prices higher and also boost the net worth of the wealthy. But it also destroys the purchasing power of the middle and lower classes. And an economy cannot function properly when wealth is unbalanced and concentrated at the very top. QE also prevents the economy from deleveraging, which is a necessary step to promote viable savings and investment. And by not allowing asset prices to fall to a level that can be supported by the free market, more capital is funneled toward the building and servicing of asset bubble, instead of increasing productivity.

As proof of how badly the economy in the United States is struggling, look at the retail sales numbers that were recently released. The following companies that cater to the middle class reported vastly disappointing revenue and earnings: Target, Home Depot, Walmart, Lowe's, Dick's Sporting Goods, PetSmart, Urban Outfitters, Staples, and Sears. And that's just a partial list. This weakness has continued into May, so it has little to do with the weather.

One of the few retailers that beat expectations was Tiffany's. They actually raised their profit forecast on stronger than expected earnings. This best exemplifies how and why the middle class is being destroyed and why this economy cannot grow. You cannot grow an economy in aggregate if you do not have a healthy middle class.

The U.S. economy will never get healthy until we actually address the imbalances that afflict the middle class. This also means the Fed would have to embrace deflation-at least for a little while. But I have sincere doubts about whether the Fed, or any other developed world central bank, will ever allow that to happen.

 

Another Phantom Recovery Fails
May 19th, 2014

Each year since the recession officially ended in the summer of 2009, Wall Street and Washington have tried to dupe investors into believing a second half recovery was in store for the stock market and economy. However, this promise has failed to come into fruition each year, as annual GDP growth has not reached north of trend growth (3%) since 2005. But, with the hope that investors have a perennial case of amnesia, these cheerleaders are yet again trumpeting the illusion that economic growth is about to surge.

The year 2014 didn't start off so good for those who desperately want investors to be convinced the economy has healed from the Great Recession. After posting annual GDP growth of just 1.9% for all of 2013, which was much lower than the 2.8% growth experienced during 2012, this year started off with annualized GDP growth of only 0.1% for Q1. This means GDP growth for Q2 has to be near 5% just to produce the same 2.5% growth pace experienced back in 2010.

But the recent Retail Sales report for April showed an increase of just 0.1% from the prior month--so much for a strong rebound from the winter's weather--and not good news for those that need investors to believe in the fantasy of robust growth in order to keep them supporting stock prices at these levels.

The sad truth is that this year's GDP growth won't produce results any better than those years following the credit crisis. The reason being, our leaders don't understand where growth comes from and/or are unwilling to take the painful steps necessary to achieve it.

Unfortunately, most of those that inhabit D.C. are economic illiterates; and Wall Street enables Washington with alacrity in order to keep the party going. They fail to realize that U.S. GDP growth is stuck in neutral because an economy needs low and stable tax and interest rates; and benign inflation to generate productivity and strong growth. This is the only foundation from which sustainable and healthy growth can be built. And those conditions are virtually impossible to maintain when the U.S. economy is currently carrying a debt level equal to 330% of GDP-the exact level it was at the precipice of the Great Recession.

In order for an economy to grow it needs savings and investment to enhance productivity. The savings rate in the U.S. was well into the double digits before the abolition of the gold standard in 1971. It has now cratered down to 3.8%, which is 1.3 percentage points away from an all-time low and very close to the same level it was leading up to the credit crisis.

Indeed, many conditions are eerily reminiscent to those that led up to the collapse of the economy in 2008. Spreads between corporate bonds and Treasuries are razor thin once again and yield starved investors, backed by a Put from global central banks, are even willing to own a 10-year Greek bond that now yields just 6%. This is despite the fact that the Greek 10-year yielded near 40% just two years ago; and after the nation subjected owners of these bonds to over a 50% reduction in the principal. But history and fundamentals don't matter when investors are convinced, now more than ever, that money printers around the world stand ready to guarantee that asset prices won't be allowed to fall-at least not very far.

Of course, one thing-the really important thing-is much worse now than it was at the start of the Great Recession. Debt levels have exploded across the globe. For examples; Chinese government, corporate and household debt is now about 250% of GDP, up from around 145% in 2008; and U.S. debt has soared by $7 trillion since the Great Recession began. But what else would you expect to occur when governments have the hubris to believe they can repeal recessions by endlessly borrowing massive amounts of money from their central banks.

An economy just can't become more productive when the savings and investment dynamic is broken. And the way it breaks is when investors become aware that; tax levels must significantly increase to help service debt, interest rates face extreme upward pressure because inflation risks have soared, and when investors also understand that the currency's purchasing power will destroyed in an attempt to lower the value of the nation's debt. Under this unfriendly economic environment, investment in capital goods dries up and productivity rates fall. This is why productivity during Q1 of this year fell at a 1.7% annual rate.

Those are the genuine reasons why robust growth has been a phantom for the last six years. And the economy will continue to disappoint until governments allow a healthy deleveraging to take place in both the public and private sectors. Asset prices need to fall, bad debts need to be restructured, and central banks need to allow the market to set interest rates.

Until then, we will struggle with huge volatility in tax and regulatory policies, interest rate levels and currency valuations. This is also the main reason why April's labor force participation rate for Americans between the ages 25 to 29 hit the lowest level since 1982, when the Bureau of Labor Statistics started tracking such data. Old people can't afford to retire and young people are dropping out of productive society-that's the sorry truth behind the decline in the labor force.

However, another phantom recovery this year will be especially troubling for U.S. equities. Stock prices didn't care so much that GDP was anemic when the Fed was expanding credit at a trillion dollar annual pace. But, in just a few months the Fed's QE program will hopefully be finished. And asset prices may finally start to undergo a painfully-necessary correction.

For instance, perhaps by allowing free markets forces to work, first-time home buyers may once again be able to afford a new house, rather than being constantly outbid by hedge funds. Case in point, a study was recently done by real estate researcher Trulia that showed only 25% of homes for sale in the New York area are affordable to middle class buyers. Shockingly enough, the recent response from government to this second bubble in real estate in the last six years is to force Fannie Mae and Freddie Mac to further expand the amount of lending in the housing market! It seems all we have learned since the 2008 economic crisis is how to make the same mistakes as before, but to a much greater extent.

Nevertheless, investors need to take advantage of this brief moment of sanity from the Fed, because it should not last very long. The Fed's tapering of bond purchases should provide an excellent opportunity to acquire assets at a significant discount to the bubble-like valuations seen today. Unfortunately, the economy is now completely addicted to zero percent interest rates and the endless expansion of Fed credit. Once Ms. Yellen realizes the Fed's number one enemy (deflation) will be the result of ending QE, get ready for an inflation quest the likes of which America has never endured before.

 

Dollar/Yen Dynamics and the S&P 500
May 12th, 2014

It is imperative to understand the dynamics between the U.S. dollar and the Japanese Yen in order to grasp what is occurring across international markets. Investors have been borrowing Yen at nearly zero percent interest rates and buying higher-yielding assets located worldwide. These market savvy institutions and individuals realize that buying income producing assets, which are backed by a currency that is gaining value against the Yen, is a win-win trade.

Because of the policies embraced under the regime of Japanese Prime Minister Shinzo Abe, the Japanese economy was subjected to significant currency depreciation, government deficit spending and stagflation. When global investors unanimously become assured that the economic "recovery plan" of Japan would be based on massive debt accumulation and money printing, the yen received a death sentence.

It was on this basis that the Yen suffered a decline of 25% against the dollar, since Abenomics went into effect late last year. The most interesting part of this failing economic plan of the Prime Minister, is the relationship between the Dollar/Yen and the performance of the S&P 500. The U.S. dollar appreciated 30% against the Japanese Yen since the assumption to office for Shinzo Abe (in December of 2013), through the commencement of the Fed's tapering of asset purchases, in January of 2014. It is no coincidence that the S&P 500 also appreciated 30% during that exact same timeframe. You can see the high correlation between the Dollar/Yen and the S&P in the two-year chart shown below.

The relationship between the dollar/yen and the U.S. market is undeniably clear. But it is also important to point out the divergence that has taken place since the start of this year. The dollar is beginning to lose strength against the yen; and yet the S&P 500 has managed to post a very small gain. It is prudent to conclude, given the dynamics of the dollar/yen relationship, that the U.S. stock market is about suffer a correction. This is especially true given the likelihood of further yen strengthening in the short term.

There exists two powerful reasons why the yen should rise against the dollar in the short term.

Reuters reported last month that for the first time in 13 years there was absolutely no trading in Japanese Government Bonds (JGBs) for more than one day. The fact is that no JGBs traded for 36 hours and the volume in Japanese debt is down 70% YOY. The Bank of Japan, in cooperation with the Abe government, has so perverted the bond market that private interest to buy JGBs has fallen to practically zilch.

With virtually no private market for Japanese debt and inflation soaring to over a five-year high, the BOJ may not be incentivized to further depreciate its currency and push JGB yields even lower by increasing its 70 trillion yen per annum stimulus plan at this juncture. In a rare and brief moment of sanity, the government of Japan could try to restore some liquidity in its bond market by allowing yields to incrementally rise from the current 0.6% on the Ten-Year Note. After all, yields must rise to a level that begins to reflect the realities of a bankrupt nation with rising inflation, in order to attract some interest from an entity other than the BOJ.

However, it is also true that the BOJ will eventually have to intervene in the JGB market to an even greater extent in order to keep debt service payments from spiraling out of control. But, in the short term, it is also likely that the Japanese government will not imminently expand its QE program, despite what all carry-trade investors are betting on. This is primarily because the central bank is reluctant to increase the pace of JGB ownership at this time.

The second reason why the dollar should lose ground against the yen in the short run is because the Fed may soon confound all carry-trade investors by getting back in the QE business.

The flat Q1 GDP print for the U.S. was summarily dismissed as a weather phenomenon. Nevertheless, when a "second-half recovery" once again fails for the 6th year in a row, stock market cheerleaders will have to find a different excuse for the perennially-weak economy. But the Fed may stop its tapering just around the time it gets down to near zero on new asset purchases-sometime before the end of this year. It then should actually increase its monthly allotment of QE shortly thereafter. If the Fed gets back in the money printing business it will shock investors-especially those who are trafficking in the yen carry trade.

As the yen carry trade begins to unravel, stock prices will fall across the globe. This will feed on itself, as investors are forced to buy back yen at increasingly unfavorable exchange rates.

The bottom line is that there should be a temporary reversal in the yen carry trade in the very near future. Once the myth of an economic recovery in the U.S. is rejected by most investors, the Fed will be unable to raise interest rates and will be pressured to get back into the QE business In addition, the BOJ will feel compelled to stem the pace of the drop in the yen, especially because its 2% inflation goal now appears to be in sight.

A respite from the yen carry trade will cause a global stock market meltdown in the short term and a sharp drop in the value of the dollar. It will also be the start the next major leg upwards in the secular bull market for precious metals.

 

The Reverse Tepper Argument
May 5th, 2014

David Tepper is the founder and manager of the multibillion dollar hedge fund Appaloosa Management. He is also well known for an appearance made in the financial media back in September of 2010. In that segment Tepper made the case to investors that stocks would go higher regardless of whether or not the then nascent economic recovery was for real.

During that TV segment, he outlined what would be called the Tepper Argument: the premise that the economy would recover, causing stock values to rise; or that the economic recovery would fail, causing the Fed to massively pump up stock prices by expanding its QE program. To learn how the Fed uses QE to boost the market read last week’s commentary.

Mr. Tepper deserves credit for recognizing, in the wake of the financial crises, that stock prices would go up no matter what economic condition prevailed--I also advised investors to go long equities in early 2009, after advising them to head into cash during the summer of 2008.

However, it is imperative for investors to realize that the exact reverse of the Tepper Argument is now in play when analyzing the market today.

The Tepper argument made a great deal of sense in the fall of 2010 for several reasons. First off, the Fed was an avowed money printer and openly proclaimed its ready and willingness to aggressively expand its balance sheet to combat deflation. At that time, the Fed held “only” $2.3 trillion worth of assets. But today, the Fed’s balance sheet has swelled to $4.3 trillion. The central bank has now become fearful about the amount, duration and quality of the assets it holds and superfluity of Fed credit held by financial institutions.

Secondly, the S&P 500 was trading at 1,109 when the Tepper argument was first made. Today, the benchmark index is at 1,878—a 70% increase! In fact, the S&P is up 180% since the March 2009 low. The market has gone from undervalued, to bubble territory in just a few years. For example, the Russell 2000 had a PE ratio of 34 last April. Today, the PE ratio has soared to over 100.

Most importantly, and in sharp contrast to several years past, the Fed is now committed to ending QE and the cessation of its balance sheet expansion. Whereas in 2010, Mr. Bernanke was committed to exorbitant money printing to obtain his inflation quest, the Yellen Fed has made it clear that it will primarily utilize Fed Funds rate targeting to meet GDP and inflation goals, instead of purchasing long-term Treasuries.

Therefore, investors now face an entirely new paradigm that is diametrically opposed to the original Tepper argument.

Scenario number one: Economic growth and inflation reach the Fed’s target levels and interest rates rise sharply on the long end of the yield curve to reflect the increase in nominal GDP. This will cause a selloff in the major averages, as the 10-Year Note jumps to 5% from its current level of 2.70%. Surging interest rates—the result of inflation and the end of QE rate suppression—will provide competition for stocks for the first time in seven years and a correction of around 10-20% occurs.

Scenario number two: The economy once again fails to make a meaningful recovery, and the overvalued market crumbles under the weight of anemic revenue and earnings growth that is woefully insufficient to support the current lofty PE ratios. Without the aid of massive money printing from the Fed, or a surge in GDP growth, a significant correction north of 20% is highly probably. Keep in mind revenue and earnings growth are less than half the historical average, and need to rapidly accelerate in order to justify the current level of the market.

For stocks prices to rise from this point, the economy must grow rapidly without causing interest rates to rise. This is a virtually impossible scenario, especially since the Fed is removing its bid for Treasuries. So, it’s either the economy doesn’t improve and stocks fall—because the Fed won’t reverse course and increase QE on a dime; or the economy improves and the interest rates spike spooks the market. Either way, the market goes down in the short term.

I believe a bear market will ensue from weakening economic growth combined with the attenuation of Fed asset purchases. Further proof of our structurally-anemic economy, came when the BEA released data on April 30th that showed the economy grew at an annual growth rate of just 0.1 percent during Q1.

Our central bank is now buying $45 billion per month of MBS and Treasuries. Down from $85 billion at the start of this year. That number will be near zero in just a few months. Real estate and stock prices have already stopped rising and economic growth has almost completely stalled since the start of 2014. The bear market in equities and stubbornly-high unemployment rates should bring the Fed back into the debt monetization business shortly after the market crashes. This significant selloff should prove to be a crucial buying opportunity in which investors need to be preparing now to take full advantage of.

So where does this leave investors? Here’s a brief synopsis.

  • The S&P 500, Dow and NASDAQ are all expensive when measured by historical norms.
  • The U.S. economy has stopped growing, even as measured by our own government.
  • China’s economy is slowing, as the PBOC tries to restrain the credit growth that created a humongous bubble in fixed assets.
  • Emerging market economies have significantly raised interest rates to defend against plunging currencies, which is dramatically slowing their growth.
  • Japan is a bankrupt nation that is destroying its currency in a quest to create inflation, which is wiping out its middle class.
  • And, the Fed continues to reduce its support for the asset bubbles it has tried to desperately to re-inflate for the last six years.

If this is an environment in which investors want to jump into stocks, they can do so without me. Just as was the case in 2008, a little bit of patience should prove to be an incredibly smart decision, and it should also save investors from a lot of pain.

 

Don't Look Now But The Wealth Effect Is Over
April 28th, 2014

The government's "ingenious" solution to end the Great Recession was to recreate the same wealth effect that engendered the credit crisis to begin with: The definition of the wealth effect is an increase in spending that comes from an increase in the perception of wealth generated from equities and real estate.

Our Treasury and Federal Reserve figured the best way to accomplish this was to rescue the banking system by; taking interest rates to zero percent, buying banks' troubled assets, and recapitalizing the financial system. Most importantly, our government loaded banks with excess reserves. This process, known as quantitative easing (QE), pushed lower long-term interest rates through the buying of Treasury Notes, Bonds and Agency MBS.

It is imperative to understand the QE process in order to fully understand why the tapering of asset purchases will lead to a collapse in asset prices and a severe recession.

The QE scheme forces banks to sell much higher-yielding assets (Treasuries and MBS) to the Fed, and in return the banks receive something know as Fed Credit, which pays just one quarter of one percent. For example, the Five-year Note currently yields 1.75 percent and the Seven-year Note offers a yield of 2.30 percent. The Fed is currently buying $30 billion worth of such Treasuries per month and $25 billion of higher-yielding MBS.

In fact, the Fed has purchased a total of $3.5 trillion worth of MBS and Treasuries since 2009 in a direct attempt to boost equity and real estate prices. QE escalated in intensity as the years progressed. The year 2013 began with the Fed promising to purchase over a trillion dollars' worth of bank debt--without any indication of when the QE scheme would end…if ever.

Therefore, financial institutions did exactly what rational would dictate. These banks bought bonds, stocks and real estate assets with the Fed's credit because not only were the yields higher, but they also understood there would be a huge buyer behind them-one that was indifferent to price and had an unlimited balance sheet. Since these assets offered a yield that was much greater than the 25 basis points provided by the Fed and were nearly guaranteed to increase in price, it was nearly a riskless transaction for banks to make. This QE process also sent money supply growth rates back up towards 10% per annum, as opposed to the contractionary rates experienced in 2009 and 2010.

Of course, most on Wall Street fail to understand or refuse to acknowledge that ending QE will cause asset prices to undergo a necessary, but nevertheless healthy correction. However, looking at the evidence since the tapering of asset purchases began, it is clear that the Fed's wealth effect has ended.

The Fed announced in December of last year its plan to reduce asset purchases beginning in January of this year. Its base-case scenario would be to reduce QE by $10 billion per each Fed meeting. Since the start of this year, asset prices have stopped rising. According to the Case-Shiller National Home Price Index, home values have actually dropped 0.33% during the last 3 months of the survey. In addition, the Dow Jones Industrial Average and the NASDAQ have both dropped in price over the past four months. Only the S&P 500 has managed to eke out a very small gain so far this year-and one third of the year is over.

Real estate and equity values have already lost their momentum, as the Fed is removing its massive support for these assets. In a further sign of real estate weakness, the Commerce Department recently announced that New Home Sales fell three months in a row and plummeted 14.5 percent in March from the prior month's pace. But Wall Street will try to convince investors that the spring allergy season-also known as the pollen vortex--is unusually bad this year. Therefore, nobody wanted to go outside and purchase a new home, even after all the snow melted.

The bottom line is as the central bank stops buying assets from private banks, these institutions won't have the need or the incentive to replace them, and the direct result will be a contraction in the money supply.

But nearly every market strategist believes the Fed's taper will have an innocuous effect on markets. They believe this because of their conviction that new bank lending will supplant the money creation currently being done for the purpose of buying new assets. But what would cause banks to suddenly start lending to the public?

The government has overwhelmed banks with new regulations and announced on April 8th that it will force banks to add $68 billion to their capital, which will negatively affecting balance sheet growth. The public sector is still greatly in need of deleveraging because Household Debt to GDP ratio is still over 80%, opposed to the 40% it was in 1971. Real disposable income is not increasing, which has left the consumer with little ability to take on more debt. There just isn't any reason to believe that consumers will suddenly ramp-up their borrowing.

It wasn't any coincidence that the size of the Fed's balance sheet and the S&P 500 were both up 30% last year. But very soon the amount of QE will be close to, if not exactly at zero. And without banks supporting asset prices by consistently creating new money at the behest of the Fed, stocks and home prices have nowhere to go but down.

I anticipate the reduction of the wealth effect to intensify as the taper progresses. Since the economic "recovery" was predicated on the rebuilding of asset bubbles, a long delayed and brutal recession will start to unfold later this year.

The real question investors need to answer is to determine how long Janet Yellen will wait before admitting the economy is completely addicted to QE, and that there is no escape from the Fed's constant manipulation of money supply growth and asset prices.

Having raised significant funds ahead of this huge selloff in order to profit from the launch of the Fed's next massive round of debt monetization should prove to be one of the most important investment strategies of a lifetime. This is exactly the reason why Pento Portfolio Strategies has been in 75% cash since January.

 

Fed Rigs Markets, Not the Flash Boys
April 14th, 2014

There’s been a lot of attention being paid to high frequency trading (HFT) as of late. The question has been raised as to whether or not HFT rigs markets. It is true that HFT adds nothing to GDP and is simply a legalized form of high-tech front running. However, the real problem with the stock market—and the economy as a whole—isn’t the fact that HFT skims pennies off transactions from institutional traders; but rather that the Fed has rigged interest rates and asset prices to the extent that investors can no longer distinguish reality from fiction.

It is well known that the Fed has already purchased trillions of dollars’ worth of MBS and Treasuries since the start of the Great Recession. It also is no secret that the Fed Funds Rate has been pegged at zero percent since the end of 2008. Yet, somehow, this is not considered rigging the market. Nor do these conditions elicit the proper scrutiny of most investors. But instead, are nearly universally embraced as the perfunctory and necessary undertakings by a prudent central bank.

Market participants are ignoring the fact that the cost of money and the supply of credit and savings--the most important signals in an economy—should be set by the free market and not manipulated by the Fed. But investors are now taking their ignorance a step further. Since investors refuse to acknowledge the central bank’s unprecedented influence in monetary affairs, it then follows that they have also deluded themselves into believing the Fed has not been the primary driver behind stock market gains.

Wall Street is fond of claiming that earnings growth has been relatively healthy throughout this “recovery” from the Great Recession and that earnings are the “mother’s milk of stocks.” Earnings growth comes from consumer spending because consumption drives the U.S. economy. In fact, seventy percent of U.S. GDP is derived from consumption. Therefore, it is logical to conclude that this was the reason behind our government and central bank’s efforts to boost consumption following the credit crisis.

Forty nine percent of Americans receive transfer payments and yet only 47% of U.S. citizens pay Federal income taxes. The Fed has monetized $3.5 trillion worth of government obligations since 2008. It did this in order to allow the Federal government to run trillion dollar deficits for years on end without debt service payments spiraling out of control.

It is abundantly clear that the Fed rigged lower debt service costs for both consumers and the government in order to artificially boost consumption. In addition, keeping interest rates at record low levels directly re-inflated bond, real estate and equity market bubbles. This further boosted money supply growth and fueled greater consumption.

Since real wages have been falling, our government has sought to boost consumer spending by propping up asset prices and lowering interest expenses, rather than seeking a viable market-based economy.

Therefore, it is completely silly to believe our stock market is not rigged. It is. But much more so by the government than it is by the “Flash Boys”. The markets, and the economy as a whole, are rigged in favor of the wealthy and those involved with financial services, but against the middle class and those that embrace free markets.

To believe otherwise is to claim that interest rate levels have no relationship to; debt levels, money supply growth, asset prices, equity market values or economic activity. Only a fool would then maintain that the Fed has not rigged markets. And it has done so for the direct purpose of artificially boosting consumption, which has led to an increase in GDP and earnings growth. This has in turn created a synergistic effect and spurred stock prices to an even more unsustainable level following the initial boost received from the Federal Reserve.

Once the Fed stops buying banks’ assets (the very essence of QE) these institutions will have no need to replace them. Therefore, the money supply will shrink as asset prices tumble. It is then logical to conclude that the end of the Fed’s manipulation of interest rates and money supply will lead to a collapse of this phony consumption-driven economy, as it also takes the stock market along for the ride down.

 

Rising Rate Realities
April 5th, 2014

The entire global economy now clings precariously to one crucial phenomenon. That is, how much longer can the central banks of the developed world artificially suppress interest rates at near zero percent?

The violently-negative market reaction to Janet Yellen's comments during her first press conference was a clear indication of how vulnerable the stock market is to the eventual reality of rising interest rates. All Ms. Yellen did was remind investors that the Fed Funds Rate would have to be moved up from zero percent—probably beginning in the middle of next year. That was enough to send the major averages cascading downward faster than you could say the words “flash trading.”

In typical fashion, a cacophony of Wall Street Cheerleaders were quick to dismiss the negative market reaction by claiming investors misunderstood what the new Chairperson meant to say; or that the rookie Fed Head simply misspoke. And, more importantly, these bubble-apologists also were quick to make the case that even once the Fed eventually gets around to raising interest rates, it will merely be a sign of economic health--a move that the equity market should fully embrace.

The reality is that rising interest rates will soon arrive, either courtesy of the Fed or through free market forces. And a rising cost of money never bodes well for the stock market or the economy. This fact will be especially true this time around because growth—or the lack thereof--won’t be the salient issue; but rather it will be the attempt to end the Fed’s massive manipulation of rates. The removal of the Fed’s all-encompassing and price-indifferent bid for Treasury debt will place tremendous upside pressure on rates. And even if interest rates do not increase, the outcome for investors will be equally devastating—I’ll explain the simple reason behind that in a minute.

But first let’s see if rising interest rates are really all that good for equities, as Wall Street so desperately wants investors to think.

The 10 Year Note is Spain was trading at the 4% level during October of 2010, while the benchmark IBEX 35 was trading at 10,900. Yields then surged to 7.7% by August of 2012. Not because the ECB raised interest rates, but because the free market deemed its sovereign debt to have come under significant duress. The IBEX tumbled 35% to 7,040 in less than two years.

It was much the same story In the United States. Interest rates went through a secular uptrend throughout the 70’s and into the early 80’s. This time it was an outbreak of inflation that caused yields to rise. In March of 1971 the Ten Year Treasury had a yield of 5.5%, while the S&P 500’s value was 100. By January 1982 the benchmark yield soared to 14.8% and the S&P 500 traded at just 115. During those 11 years the market increased by a total of only 15%, even though consumer price inflation skyrocketed 135%! This means in real terms investors in U.S. stocks lost over 50% of their purchasing power.

Staying in the U.S., rising rates in 1987 didn’t bode well for the market either. The Ten-Year Note started off in January at 7.01%, and jumped to 10.23% the month before the Dow crashed 22.6% on October 19th 1987.

It is true that there are brief periods when stocks rise at the onset of rising rates. However, the reasons why interest rates increase in a significant and protracted manner are because of rising inflation and/or burgeoning debt levels--and that is never healthy for equity values or economic growth.

What will happen to our debt-laden economy once interest rates normalize? Municipalities will come under great stress, as they try to manage soaring debt service payments from a tax base that is quickly eroding. Real estate flippers will be dumping their investment properties, as home prices begin to tumble once again. Equity market investors will sell shares, as the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer debt will come under duress, severely hampering discretionary consumption. Banks’ capital will be greatly eroded as their loans, MBS and Treasury holdings go underwater—vastly curtailing the amount of new credit available to the economy. The Fed will be deemed insolvent as its meager capital quickly vanishes. Interest payments on Federal debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives will go bust. This will be the result of creating an economy that is completely addicted to debt, asset bubbles, ZIRP and QE for 7 years.

In essence, the entire economy will collapse…perhaps this is the real reason why the Fed found it expedient to completely remove the numerical unemployment rate target for when it would begin rising rates. Let’s be clear; the Fed is ending QE not because the economy has reached the inflation and unemployment goals it set out to achieve, but rather from fear of the monstrous size of the balance it has created.

But what if interest rates don’t rise as a result of the Fed’s exit from QE? If interest rates stay at these record-low levels it will be because the private market supplanted all of the Fed’s purchases at these ridiculously-low yields. The only reason why that would occur is if the tremendous deflationary forces unleashed in the wake of the Fed’s absence from its support of money supply growth causes equity and real estate prices to tumble, bringing the economy along for the ride.

In either case the outcome for investors will be shocking. Market participants should prepare now for the failed exit of QE. On the other side of this imminent revelation will be unsurpassed volatility between inflationary and deflationary forces, which will dwarf those experienced during the credit crisis. Because of the unprecedented and unsustainable amount of debt outstanding, central banks now face only two choices: stop printing money and allow a devastating deflationary cycle to pop the asset bubbles that exist in equities and real estate; or continue expanding the money supply until hyperinflation eradicates the middle class and the economy.

Therefore, our Investment outlook remains very cautious. It should be noted that the S&P 500 is up just 2%, and we are in April. That paltry return is not worth the risk of being anywhere close to fully invested. In fact, I believe a trap lies in waiting for long-only investors. An anemic global economy, a record amount of margin debt and the Fed’s tapering of asset purchases will cause a sharp selloff very soon. To be specific sometime between now and before summer gets going. We will use that opportunity to get back into the market at much lower prices.

 

Japanese Debt Debacle Now Imminent
March 23rd, 2014

I first warned about the impending bust of Japanese Government Bonds (JGBs) when I wrote "Abe Pulls Pin on JGBs" back in January of 2013. In that commentary I laid out the math behind a collapse of the Japanese bond market and economy stemming from the nation's massive amount of government debt, combined with the Bank of Japan's (BOJ's) folly of pursuing an inflation target.

It was my prediction back then that a spike in interest rates was virtually guaranteed in the not-too-distant future. I also predicted that debt service payments would soon reach 50% of all government revenue, which would be the catalyst behind the rejection of JGB's on the part of the entire global investment community. Sadly, that prediction should come into fruition during the next few months.

The Japanese Finance Ministry recently predicted that debt service payments would reach $257 billion (25.3 trillion Yen) during this fiscal year; up 13.7% from fiscal 2013. Also, revenue for this year is projected to be 45.4 trillion Yen. This means interest expenses as a percentage of total government revenue will reach 56%. Therefore, it should now be abundantly clear to all holders of JGBs that since over half of all national income must soon go to pay interest on the debt, the chances of the principal being repaid in anything close to real terms is zero. A massive default in explicit or implicit terms on the quadrillion yen ($10 trillion), which amounts to 242% of GDP, is now assured to happen shortly.

Exacerbating the default condition of Japan's debt is the BOJ's increasing obsession with creating more inflation. Central Bank Governor Kuroda said recently that the inflation goal of 2% is well on track to be realized. Core inflation is already up 1.3%, and overall prices have climbed 1.6%, while fresh food prices have surged 13.6% from the year ago period. In fact, Japanese inflation is now at a five-year high.

Surging debt levels and rising prices belie the quiescence of the Japanese bond market. For example, the 10-Year Note offers a miniscule yield of just 0.62% as of this writing. That yield seems especially silly when viewed in historical context. The average yield on the 10 year Note is 3.04%, going back to 1984. And you only have to go back 6 years to find a 2% yield on that benchmark rate. Of course, those much-higher yields occurred in the context of significantly less debt and inflation than we see today.

The facts are that Japan has a record amount of nominal debt and also a record amount of debt as a percent of the economy. Deflation has ended, thanks to hundreds of trillions worth of Yen printing by the BOJ, and the central bank's increasing success at creating inflation will lead to insolvency for the nation's sovereign debt.

How can it be possible for interest rates to be at record lows if the nation is insolvent and inflation is rising? The answer is of course that the central bank is the only buyer left. For now, the ridiculous pace of 70 trillion Yen per annum worth of BOJ money printing seems to be enough to prevent rates from spiking. But as inflation waxes closer to the central bank's target, interest rates must rise. The BOJ will soon have to stand up against the entire free market of investors who will be betting more and more with their feet that JGBs will default.

The bottom line is the BOJ will have to dramatically step up its pace of bond buying, as interest rates rise and bets against JGBs intensify.

Unfortunately, Japan isn't alone in the insolvency camp. The U.S. and parts of Europe face the same fate. There will soon be an epic battle taking place between the developed world's central banks and the free market. The sad truth is there isn't any easy escape from the manipulation of sovereign debt on the part of the ECB, BOJ and Fed. The exit of government bond buying from these central banks will lead to a massive interest rate shock and a deflationary depression. On the other hand, if these central banks continue printing endlessly it will lead to hyperinflation and total economic chaos.

 

Fed Changes the Rules to Maintain ZIRP
March 20th, 2014

The New Chairperson of the Federal Reserve showed off her dovish feathers after the latest meeting of the FOMC. Ms. Yellen abrogated the threshold of 6.5% on the unemployment rate as the starting point for short term rate hikes and replaced it with amorphous and ambiguous language that allows plenty of wiggle room with rates.

Just like a child sometimes changes the rules of a game in mid-stream in order to guarantee a favorable outcome, the Fed has ripped up the rulebook to suit its own needs.

The Fed was fully aware when it first stipulated its guidelines for starting rate hikes, that a 6.5% unemployment rate threshold could be breached with the help of a contraction in the labor force participation rate and not fully through increased hiring. However, it still drew a line in the sand in which investors were forced to determine when the cost of borrowing money would begin to be increased directly by the central bank.

To the central bank's credit it did follow through on the promised continued reduction of asset purchases by $10 billion per month. The Fed is now purchasing $30 billion in Treasuries and $25 billion worth of MBS. This reduction was already in the cards and didn't surprise anyone. Nevertheless, the Fed completely abolished a numerical threshold for the unemployment rate to fall below before it begins to raise the Fed Funds Rate. The reason for this is clear; the Fed realizes it cannot raise short-term rates without pricking the asset bubbles it has worked so hard at creating and sending the economy into a deflationary tailspin.

The condition of the U.S. economy (and indeed global GDP as a whole) is so anemic that even after 5+ years of massive Federal Reserve market manipulations, the Fed cannot raise short-term interest rates. In other words, they will keep making excuses as to why they can't raise interest rates and continue to move the goal posts for their convenience.

The Fed is in the process of trying to end QE, but the stock market and Fed don't yet realize that the tapering of asset purchases is tightening monetary policy. This will cause long-term interest rates to rise-and the worst is still to come. For instance, the 10-Year jumped to 2.77%, from 2.68% on the same day of FOMC's decision to reduce asset purchases by another $10 billion. And short-term rates are rising to an even greater extent, despite the fact that the Fed is still posting a bid of $55 billion each month for these debt instruments.

The Federal Reserve's quantitative easing program was the only reason why the 10-Year Note, and longer-term interest rates in general, are as low as they are today. Ending QE will cause a huge spike at the long-end of the yield curve unless the economy is sharply contracting. Whether or not the Fed admits this is irrelevant.

The fact is the Fed is going from buying all of the newly issued Treasury debt, to zero of the newly issued debt market. And there isn't any entity that I am aware of in the entire world that will supplant the Fed's purchases at anywhere near today's rates. So interest rates are going to rise, and that is deflationary and also bullish for the U.S. dollar in the short-term.

But the anemic economic data should continue to worsen as interest rates rise. This means that the Fed will stop tapering sometime in the very near future -- probably in the summer or early fall -- and then they will feel compelled to launch QE V. When this shift in policy takes place it will be incredibly significant for world markets--beyond anything we have seen before.

In the interim, investors that have bet on an easy escape from QE will find out how wrong they have been. The equity market should undergo a severe correction once it becomes clear that asset prices and the economy have been highly reliant on debt monetization from the Fed.

The gold market has priced in a worst case scenario for the yellow metal--a balanced budget and no growth in the money supply. That's clearly not going to happen. In fact, the opposite is much more likely to occur. However, as I've stated many times before, the major move higher in precious metals won't occur until the overwhelmingly-accepted notion regarding the Fed's ability to end QE and raise interest rates with full impunity is proven to be fantasy.

Therefore, a significant spike in hard asset values will occur when the Fed acknowledges the fact that there is no easy escape from QE and the economy is destined to head into a deflationary collapse without the Fed's continuous support of bond prices. Although that would be healthy for the economy in the long term, it isn't going to happen voluntarily because of the hubris of politicians and their constituents. The Fed will stop tapering and undergo a massive and extended QE program in the latter part of 2014. That is when investors need to go all-in on inflation hedged securities. Until then, it is prudent to hold an abnormally high level of cash in your portfolio to be able to take advantage of the coming selloff.

 

The Recovery's New Clothes
March 17th, 2014

I sometimes feel that the economy is living out the Hans Christian Andersen's fable called "The Emperor's New Clothes". He wrote the story back in 1837 about a vain emperor who hired a couple of charlatans that promise to make him the finest robes out of invisible thread. They convinced the Emperor that anyone not appreciating the sartorial splendor of the two swindlers should be deemed hopelessly stupid and unfit for their positions.

The current economic "recovery" and stock market rally have many similarities to Mr. Anderson's work. The underlying fundamentals behind the S&P 500's 180% advance since March of 2009 should be blatantly recognized as phony, even to a child. Yet traders and economists appear to willingly overlook the nakedness of it all.

There has been a subpar increase in personal income, employment, corporate revenue and GDP since the supposed end of the Great Recession back in the summer of 2009. But the key point to understand is, whatever phony growth that has been achieved came from governments' ability to borrow and print enough money to keep asset prices from plummeting. One can't say that equity and real estate values are soaring once again because the economy has healed, and therefore, it's has nothing to do with the Fed. Without the support of protracted and humongous monetary welfare, gratis of the central bank, debt levels, money supply and asset prices would need to contract to a level that can be supported by markets-rather than by government decree.

For example, the U.S. has incurred an additional $6 Trillion more in total debt than it had at the end of 2007. What our government and central bank have been able to achieve is set in stone our economy's addictions to debt, low interest rates and money printing by taking all of those conditions into incredible extremes. The Fed has kept the short end of the yield curve at zero percent for over five years and promises to keep interest rates there for as far as its eyes can see. Our central bank has also increased the amount of high-powered money from $800 billion to $4.2 trillion-and that number is still growing.

The economy and markets are much further away from removing the hand of government manipulations than at any other time in our nation's history. There has been no structural or entitlement reforms done at all. In contrast, Washington has succeeded in piling on an additional entitlement program (The Affordable Care Act), which the nation has no capability of paying for, adding to the myriad of entitlement programs that are already insolvent. Nothing of substance has changed for the good, only the government's ability to massively increase the amount of aggregate debt outstanding and appear to remain solvent by temporarily servicing that debt at an artificially-low rate.

Economically sensitive markets are clearly exclaiming that this recovery is naked. Industrial metals like copper have fallen 17%, while aluminum is down 10% YOY. Also, emerging market currencies and equity markets are reeling from the end of the dollar carry trade. However, faltering economic data in the U.S. has been conveniently and summarily dismissed due to winter's snow. But unless we are headed into another ice age, the excuse of cold weather will soon be undressed with the spring thaw.

The hole in the weather excuse is that the entire globe is showing signs of weakness. Chinese exports tumbled 18.1% from the year ago period, while the Shanghai stock market was down 12.5% during the same time frame.

The obscene amount of money printing by the Bank of Japan has caused the current account deficit to hit yet another all-time record high. The deficit for January was 1.59 trillion Yen ($15.4 billion) and the overall economy grew just 0.7% on an annualized basis in the final three months of 2013. This was a downward revision from the initially projected 1% growth rate.

The government of Japan is a paragon of the Keynesian experiment to avoid a cathartic recession by forcing higher the rate of money supply growth, depreciating the currency, levying new taxes, creating more inflation and drastically increasing the amount of aggregate debt outstanding. It has been well over a year since Abenomics took over in Japan and its failure should be nakedly obvious. Soaring debt levels, huge trade imbalances, a plummeting currency, a sputtering economy and insolvency are the tradeoffs for a stock market that is rising in nominal terms, and not yet back to the where it was before the Great Recession began over five years ago.

Given the above facts, it seems silly to buy into the belief that the global economy is on a sustainable growth pattern. Yet, the overwhelming majority of market pundits purport that fable to true. Perhaps, it is just more expedient and profitable to agree with what our leaders tells us is the truth, rather than to trust what our own eyes see and conscience dictates.

The sad truth is that global governments, in cooperation with their central banks, have now rendered much of the developed world insolvent. And that condition will be made evident to all once interest rates rise and the artificial support of bonds, stocks and real estate is finally, either voluntarily or involuntarily, removed.

For now, investors have decided to ignore the obvious and pretend that the economy-much like the townsfolk in Anderson's story--is in "excellent and magnificent" condition. But, once the economy crashes yet again, we will understand with the clarity of hindsight that the recovery was completely bare.

 

Investors Should Heed Markets; Not Fed Apologists
March 3rd, 2014

Investors are currently receiving mixed messages regarding the ramifications resulting from the Fed’s exit of debt monetization. Officials from the Federal Reserve are assuring market participants that there will be a smooth transition from the central bank’s manipulation of long-term interest rates. But markets are reaching a completely different conclusion.

The major averages in the U.S. are unchanged so far this year and are not giving a clear signal as to the future condition of the economy. However, many other markets around the world are giving investors a clearer indication regarding the negative fallout from the ending of QE.

For example, if the rate of economic growth was indeed improving, as most pundits would have you believe, then why are stock markets in the former engines of global growth, like Brazil and China, faltering? The Brazil and Shanghai stock markets are both down 12% since May 22nd of 2013—the date former Fed Chairman Ben Bernanke first mentioned the tapering asset purchases. Emerging markets like Turkey have plummeted 34%, while the Lira is down 20%, since Bernanke first indicated the ending of QE was imminent. In addition, why has copper, one of the most important industrial commodities, dropped by 11 % in the last year if economic activity is about to enter into a protracted expansionary phase?

Most importantly, sovereign bond yields are falling across the globe at the same time credit spreads are rising. This is completely counterintuitive to the consensus that global growth is accelerating.

In the U.S., nominal debt levels are increasing substantially. Meanwhile, the Fed’s purchases of Treasuries is headed towards 0%, from nearly 100% of all new debt issuance. In addition, the Fed is assuring markets that an inflation target of 2% and a real GDP growth level of 3% is going to be achieved in the near future. But the Ten-Year Note is currently yielding just 2.6%, and that yield is also falling. It is inconceivable to believe nominal GDP is going to be near 5%, while the Ten-Year Note is just half that level. This is even more incredulous given the historically-high deficits, which the Fed is supposedly ceasing to monetize.

The simple truth is the Fed’s taper of asset purchases is going to lead to a collapse of stock and real estate values in the United States. And this will cause major turmoil in currencies, equities and interest rates across the globe.

International equity markets, commodity prices, credit spreads and bond yields are all clearly telling investors that global economic growth is anemic and contracting. Therefore, investors need to decide who they want to put their faith in; the promises from governments that have massively manipulated economies worldwide, or whatever is still left of the free-market.

Putting new money to work into stocks when the S&P 500 is near a record high (predominately through the use of a record amount of margin debt) is a dangerous game. This is especially true in light of the fact that earnings growth is built upon near-zero revenue growth and market cap growth is woefully unsupported by GDP growth.

The only viable conclusion to reach at this juncture is that the real money to be made in 2014 will be to position your investments to profit against a failed exit of QE by the Federal Reserve.

 

Whether or Not it’s the Weather?
February 24th, 2014

Wall Street and Washington have summarily dismissed the recent spate of disappointing economic data by claiming it is solely based upon the weather. The equity market is 100% convinced that winter is to blame for the faltering economy; and that even if stocks have it all wrong, Ms. Yellen and co. will immediately print enough money to make everything ok.

For example, Industrial Production fell 0.3% and Retail Sales dropped 0.4% in January. Also, the last two Non-Farm Payroll reports came in far below estimates, and there were just 113k net new jobs created last month. Especially interesting in this latest report was that 48k construction jobs were added in January. This is totally contradictory to the claims that the anemic employment growth was caused by bad weather.

In addition, December Durable Goods contracted 4.3%, while the housing market is also showing signs of weakness. The Index of Pending Home Sales dropped 8.7%--to over a two-year low--while Home Builder Sentiment in February posted its largest drop in history. Maybe that explains why Housing Starts fell 16% in January to the lowest level since September, which was also the largest drop since February 2011. Staying on housing, Existing Home sales dropped 5.1% in January, hitting their lowest levels since July 2012. Don’t look for the weather as an explanation here either; sales in the West dropped 7.3% where there wasn’t even a drop of precipitation.

Colder than normal weather may account for some of the decline in U.S. GDP. However, it cannot explain the problems currently being experienced in economies all over the globe.

Japan’s GDP fell to a 1% growth rate in Q4; a far cry from the 3% predicted by most economists. The trade deficit hit a record 11.5 trillion Yen for 2013, nearly twice the level of 2012. This is despite (or perhaps because of) the BOJ printing its currency at a 70 trillion Yen annual pace.

China’s economic data shows that not only has the economy slowed from its prior double-digit pace, but news out from the National Bureau of Statistics showed the official Non-manufacturing Purchasing Managers' Index fell to 53.4 in January, from 54.6 in December. That reading is the lowest since December 2008.

The economy in Turkey is emblematic of the turmoil in emerging markets. A tumbling currency, soaring interest rates and a plunging stock market are sending the country into chaos. The Borsa Istanbul 100 Index is down 30% since its peak on May 22 of 2013. It just so happens that the fist mention of the Fed’s taper of asset purchases also occurred on May 22nd during Mr. Bernanke’s testimony before Congress—far before any snowflakes started to fall.

It may come as a shock to main stream economists that it is cold and snowy in the North-Eastern United States during the December-February time frame. However, worse than expected winter weather in certain parts of the U.S. cannot adequately account for stumbling GDP across the developed world and crumbling securities in emerging markets.

The truth is that global economies are being whipsawed between inflation and deflation, as central banks and governments have created massive debt and asset bubbles. Then, once the stimulus begins to be removed, those bubbles burst. These same governments attempt to re-inflate the same bubbles by monetizing an ever-increasing amount of government debt, causing the asset bubbles to become more pronounced with each cycle.

The resulting instability is causing dizzying swings in most markets and economies. Therefore, it is not the meteorological storm that is to blame for slowing global growth, but rather the destructive forces that result from the clash between the intensifying forces of inflation and deflation. The historic magnitude of these boom and bust cycles are directly caused by the unprecedented manipulation of markets by world governments.

Growth in the U.S. is slowing, along with Asia and Emerging market economies. This is occurring under the context of a continued reduction of Fed asset purchases. Meanwhile, U.S. market strategist are busy looking at the weather charts trying to find excuses. Nevertheless, look for the instability in global currencies, markets, interest rates and economies to worsen as the Fed’s taper progresses.

PPS finds it prudent to stay short the Nikkei Dow and the U.S. Treasury market for now. And to hold gold mining shares and cash as we head further into the teeth of the Fed’s taper.

 

Deleveraging Deception Continues
February 7th, 2014

I first wrote about the "Deleveraging Deception" back in September of 2010. Unfortunately, those that would have you believe the economy has paid down its excessive debt levels are still at work trying to deceive you. But here's the truth.

In order to perpetuate their deception that the economy has deleveraged, many Wall Street pundits often site the statistic that Household Debt Service payments as a percentage of disposable income has fallen to 9.2%, the lowest level since 1980 and down from 13.18% at the peak of the Great Recession.

But once again the analysis offered by perma-bulls is marked by sophistry and misinterpretation.

First off, the numerator of the equation has been massively distorted by the lowest consumer borrowing rates in history; provided to us courtesy of the Federal Reserve. In truth, the nominal level of Household debt has only contracted by a meager 6.3% (from $13.96 trillion in early 2008, to $13.08 trillion as of Q3 last year). Therefore, if we strip out the record-low interest paid on debt and just concentrate on Household debt as a percentage of disposable income, the real picture becomes clearer. Household debt as a percentage of disposable income is 103%, as of the latest reading. Taken into perspective, it was 128% at the start of the Great Recession. However, it was just 78% in the year 2000, and just 56% in 1980.

What’s worse, the aggregate level of debt in the economy (taking into consideration all public and private debt outstanding) is 250% of GDP. While that is the same level it was at the start of the Credit Crisis in 2007, it is more than $6 trillion higher in terms of the absolute level.

If we look at some key sectors individually, it is clear to see that the nominal level of debt in the economy has vastly increased during the last 6 years. Since December 2007; business debt is up $2.4 trillion, the Fed’s balance sheet has increased by $3.3 trillion, and the National debt has exploded by $7.2 trillion. Only the banking system has shown significant deleveraging.

It is absolutely crucial to look at nominal debt levels at this time because Household income and GDP have been artificially and temporarily boosted by unsustainably-low interest rates. Rising rates and falling economic growth will put significant pressure on these key debt metrics, as our real addictions to debt become perilously revealed.

A rapidly slowing economy will quickly increase the amount of red ink for the Treasury. In fact, the Treasury Department said just last week that it expects to issue $284 billion in net marketable debt for the January-March period. That is $19 billion more than the department estimated in November of last year. This means the deficit for calendar year Q1 2014 is already $120 billion higher than the deficit for the entire year of 2007 (the year prior to the Great Recession). And, even according to the rosy predictions of the CBO, this year’s deficit will be an incredible $514 billion!

What is especially silly is that adding over a half trillion dollars to the debt in one year is being lauded by Wall Street and the main stream media as a sign of fiscal restraint.

The sad truth is our economy carries more debt today than at any other time in our nation’s history. Taken in aggregate, the nominal level of debt has simply skyrocketed and whatever artificial economic growth the government has been able to manufacture is merely sustaining debt ratios near all-time highs. Therefore, more chaos awaits investors once the Fed either voluntarily or involuntarily loses control over interest rates, causing the denominator of economic growth to fall apart.

 

Markets Say Tapering Is Tightening
February 4th, 2014

Wall Street Cheerleaders like to claim that the tapering of Fed asset purchases is not equivalent to the tightening of monetary policy. But the markets are clearly telling investors something different. Year to date the S&P 500 is down about 4%--not horrific for one month but certainly not following last year’s performance. But the economic data such as; durable goods, initial jobless claims, personal income, and housing sales have all shown a distinctive weakening trend.

The reason why tapering is tightening is because the Fed had been in the habit of taking away $1T worth of higher-yielding bank assets per year and offering them just .25% in return. Banks then needed to purchase a new asset such as; bonds, stocks or by creating a loan, which served to expand the money supply. However, going from $1T worth of asset purchases to $0 of QE, can hardly be offset by the amount of excess reserves held in the banking system. In other words, the banking system isn’t any more compelled to increase its assets and expand the money supply if the Fed’s balance sheet is $5 trillion, rather than when it is $4 trillion. Believing otherwise represents a critical misunderstanding of the QE process and how the level of excess reserves influences the banking sector.

Nevertheless, the Fed continues to promulgate the fallacy that ending QE will not have an adverse effect on asset prices, money supply and the economy. And the majority of the investment public has accepted that nonsense as gospel truth. However, the global turmoil in equities and currency markets are great evidence that the reflation game has changed. Further proof of this is the fact that Treasury yields are falling into the teeth of the Fed’s taper of asset purchases. The only reason this counterintuitive trade would occur is if the market was convinced the overwhelming forces of deflation and recession are going to supersede the falling demand for bonds from the Fed.

The chaos in emerging markets is just one of the destructive ramifications resulting from subjecting the world's reserve currency to 5 years of ZIRP and $3.3 trillion worth of money printing. Because of the Fed's massive manipulation of interest rates and money supply, investors piled into emerging market countries searching for higher-yielding investments denominated in rising currencies. Those foreign central banks had to print local currency to keep it from appreciating too rapidly. That created inflation, which further exacerbated the move higher in asset prices.

Then, at the beginning of this year the Fed started to reduce the monthly amount of QE, forcing investors to panic out of E.M. currencies and equity markets and back into their domestic currencies. The currency market turmoil also forced those E.M. central bankers to raise interest rates to quell inflation and support their currencies.

For example, Turkey hiked its overnight borrowing rate to 8%, from 3.5%. Just imagine what would occur in the U.S. markets and economy if the Fed Funds rate was raised from 0%, to 4.5% in one day!

This is just one example of the unintended consequences resulting from governments’ efforts to bring the global economy out of the Great Recession by massively increasing debt levels and having that debt purchased by central banks.

To be clear, I turned bearish on the markets in 2014, precisely because of the implementation of the deficit-busting Affordable Care Act, soaring interest rates and crumbling currencies in emerging market economies. Also, the Fed’s taper of QE (which will cause asset prices to tumble) and yet another debate and debacle regarding the debt ceiling. Expect global chaos this year to rival that of 2008, at least until the new Fed-head, Janet Yellen, reinstitutes a protracted and substantial QE program.

 

Beggar Thy Neighbor or Bankrupt Thyself?
January 24th, 2014

We are about to witness the sad, but inevitable conclusion, from having a global economic system that is based on fiat currencies. This global experiment in which the quantity of money and credit is left to the discretion of just a few unaccountable individuals is about to come to a disastrous end.

It took a few but decades to reach crescendo, but the end of the Bretton Woods monetary system in 1971 has now led to catastrophic levels of debt and inflation across the developed world. The corrupt business cycle goes like this: Politicians and bankers desire to spend and create more money than what a genuine economy’s savings (through productivity and increased labor force) can generate. Government and private bank interference in the market place continues to grow through the process of increasing the amount of aggregate debt outstanding. When this process goes unchecked for several decades—as is the case in Japan, Europe and the U.S.—debt levels become so onerous that it demands interest rates remain near zero percent in order for the economy to function.

These zombie-like economies cannot grow in a healthy manner because they suffer from: asset bubbles; high inflation; interest rate volatility; currency instability; along with high levels of corruption, regulations and taxation. Therefore, the prescription offered by politicians is more government spending and further central bank intervention in money supply growth and interest rate manipulation.

A great example of the bankrupt economic ideas adopted by these money printers, is the philosophy known as “Beggar Thy Neighbor”; a process in which governments and central bankers try to achieve a competitive trading advantage through the process of destroying the purchasing power of their currencies through inflation. Despite the overwhelming evidence that getting a nation deeply involved into a love affair with inflation does nothing in the way of improving economic growth, it is widely embraced today as a viable method of improving output.

The Plaza Accord of 1985 was an agreement between the U.S. and four of its largest export destinations to dramatically lower the value of the dollar. As a direct result of this agreement, the U.S. dollar lost over 50% of its value against the Yen from 1985 to 1987. Yet, the trade deficit increased from $121.8 billion in ’85, to $151.6 billion a full two years after the devastation to the dollar began. Likewise, there was no improvement in manufacturing as a percentage of the economy either. Manufacturing represented 17.8% of GDP in 1985, and it fell to 17.4% of GDP at the end of 1987.

In another example of the failure of inflation and money printing to fix anything, in 2005 China announced it would increase the value of its currency and abandon its decade-old fixed exchange rate to the U.S. dollar in favor of a link to a basket of world currencies (the U.S. had been pressing for the Chinese to allow a weaker dollar for years and they finally acquiesced). During that time frame, the Yuan rallied from .1208 USD to .1467 USD (a move of over 20%). But the falling dollar had a negligible effect on U.S. exports. For all of 2005 the U.S. deficit with China was $201.5 billion. In 2008, three years into the dollar devaluation and Yuan appreciation, it soared to $266.3 billion (more than a 32% increase). The truth is that inflation and currency destruction makes trade and current account deficits worse not better.

Finally, the new regime of Japan’s Prime Minister Shinzo Abe is also a wonderful example of the doomed policies that promote inflation and currency debauchery. By late 2012, he deployed Abenomics into full effect—the practice of massively increasing; government debt, central bank money printing and currency destruction. The Yen has lost 25% of its value against the dollar so far to date and Abenomics has made the Japanese currency a joke among international traders. Nonetheless, in January of this year their current account deficit soared to an all-time record high 592.8 billion Yen, or $5.7 billion.

So let’s set the record straight. If crumbling a nation’s currency was the pathway to prosperity then all banana republics would soon become manufacturing and economic powerhouses. But that never happens.

Trying to boost manufacturing and GDP growth by lowering the purchasing power of a currency does not “Beggar Thy Neighbor”, but instead bankrupts thyself. It does this by destroying the middle class, discouraging foreign direct investments, disincentives productivity gains and creates damaging imbalances in the economy. These imbalances eventually lead to intractable levels of debt, uncontrollable inflation and unmanageable debt service payments.

The systemic practice of running economies on the spurious belief that inflation and currency devaluation is a necessary pursuit is about to reveal its devastating consequences on a global scale. I expect volatility in global markets similar to what was experienced during 2008 to occur in the middle of this year, as economies experience massive swings between inflation and deflation.

 

Wall Street Welcomes Back Goldilocks
January 13th, 2014

Goldilocks is the term used by Wall Street to describe a nearly perfect environment for stock values to rise. The term is being used again today, just as it was mistakenly uttered in the middle of the housing bubble, to express the belief held by most investors that we have once again reached equity-market nirvana--a point in time where virtually every economic condition is just right.

However, what Wall Street regards as a nearly perfect economic environment is really just another misinterpretation derived from believing money printing, artificial interest rates, debt and asset bubbles can provide sustainable growth.

This same miscalculation occurred when Ben Bernanke first took the helm of the Federal Reserve on February 1st 2006. At that time, former Chairman Alan Greenspan had already slowly and steadily taken the Fed Funds Rate up to 4.5%, from the 1% level back in June of 2003. The newly appointed Bernanke followed Greenspan’s lead and continued to hike the Fed Funds rate three more times in .25% increments. By June of 2006 the Funds Rate was at 5.25% and the Ten-Year Note climbed from 4.5% in February, to 5% by June.

Rising interest rates seemed completely innocuous back then, just as they do today. In fact, the higher borrowing costs were being heralded as a sign that the Fed believed stronger growth was in store; and Wall Street cheered Bernanke and the goldilocks economy on. We all know in hindsight that the 5% Ten-Year Note yield was enough to collapse the entire real estate market, banking system and economy. Because of the lofty debt levels, all it took to kick start the Great Recession was a 10-Year Note that yielded just 5%.

The truth, which belied Wall Street’s ebullience, was that the massively overleveraged private sector was teetering on collapse. And when the interest rate trigger was pulled, the economy fell apart. At the end of 2007 the aggregate level of debt in the economy was $49 trillion, or roughly a staggering 330% of GDP.

That aggregate level of debt has now surged to $55.5 trillion at the end of 2013, which is still about 330% of our economy. We have not deleveraged at all. In fact, the nominal level of debt has exploded by over $6 trillion. This onerous level of debt is merely being masked by low interest rates and an unstable economy that is being levitated by producing renewed asset bubbles. An overleveraged consumer and banking sector—which was the case in 2007--is certainly not a more beneficial condition than having an insolvent government. Once interest rates rise it will again reveal the fragile state of the economy.

There hasn’t been any structural reforms made to this economy and no viable solutions have been offered to remedy the cause of the great recession. No tax, educational or entitlement fixes were put into effect; only our ability to sustain consumption through re-inflating equity, bond and real estate bubbles. The government accomplished this by substantially increasing the amount of outstanding debt and having our central bank monetize most of it.

The Ten-Year Note has already climbed from 1.5% last year, to 3% today. We are now only 200 basis points away from another complete meltdown in stocks and real estate prices. The Fed will learn a painful lesson this year. Namely, that it does not control the long end of the yield curve. A zero percent Fed Funds Rate does not preclude a 5% Ten-Year Note from being realized. Once the Fed’s monthly allotment of asset purchases dwindles to around $25 billion per month, I expect the benchmark interest rate to approach that key 5% level.

The Fed can still keep short-term rates low as long as it wants, but that will eventually create runaway inflation, ravage the economy and push the long end of the yield curve higher. Or, it can alternatively stop QE and raise the Fed Funds Rate, which will prick asset bubbles, cause government revenue to plummet and send debt service payments soaring. In either the case, the two immutable facts are that the U.S. has a historically-unprecedented level of debt and interest rates must soon mean revert. Much the same case can be made for Japan and the Eurozone as well. That toxic combination is what Wall Street describes as a “Goldilocks scenario.”

How all this ends up is sadly very clear. The Fed’s next major undertaking will not be how it can gradually raise interest rates in the context of an improving economy—which is the current consensus view, but rather, how much money it will have to print to keep borrowing costs from spiraling out of control.

 

Gold Prediction for 2014
January 6th, 2014

Gold is a nearly perfect form of money. It is one of the few things on planet earth that contains all of the following attributes; beauty, scarcity, virtual indestructability, and is also transferable and divisible. However, even after five thousand years of utility as a store of wealth, gold is still completely misunderstood by most on Wall Street.

This is why most money managers wrongfully predict another disastrous year for the yellow metal. These advisors have never realized the simple truth that the value of gold never changes; only its expression in dilutable currencies changes. Therefore, it always preserves its purchasing power over time and is the best hedge against a fiat currency that is headed down the pathway of destruction. Gold prices increase when the market presages a currency will lose its purchasing power—it’s just that simple.

The reason why the dollar price of gold soared from $200 per ounce in the beginning of the last decade, to nearly $2,000 per ounce by the year 2011, was because many feared skyrocketing deficits in the U.S. would soon lead to massive money printing and debt monetization on the part of our central bank. Even though the debt monetization did materialize, as many had feared, the government has also managed to manufacture a temporary “recovery” in the economy by forcing interest rates to zero percent and thus producing bubbles in bonds, stocks and real estate. Theses asset bubbles led to a consumption bubble, which brought about an ersatz resurgence in government revenue. Deficits then fell hundreds of billions of dollars (although they are still gigantic and unsustainable), which has in turn caused the price of gold to undergo a correction from its decade-long advance and to consolidate at the $1,200 per ounce range.

However, there are now only two outcomes for the current fiscal, monetary and economic conditions; and they are both bullish for gold.

The Unlikely Scenario

The Fed will stop buying $85 billion per month of bank debt and will be completely out of the bond-buying business by the fall of 2014. Nevertheless, this will have an inconsequential effect on bank lending, money supply growth and economic growth. The continued condition of negative short and long-term interest rates will lead to a rapid expanse of the fractional reserve lending system and inflation. The fear on the part of gold investors about the Fed’s taper will then quickly fade away, as rising inflation sends bullion prices higher, just as it did in the middle of the last decade.

The Realistic Scenario

On the other hand, the Fed’s taper leads to spiking longer-term interest rates, falling asset prices and a faltering economy. Those rising interest rates cause the economy to slip back into a recession and deficits to once again spiral out of control. This will force the Fed to adopt a more substantial and protracted QE program than at any other time before, as it desperately seeks to keep long-term rates low in the context of soaring debt and deficits. Money supply growth in this case would be significant because the Fed would yet again be back in the business of monetizing trillion dollar deficits.

In either case the secular bull market in gold will re-emerge in 2014. I believe the yellow metal will approach $1,600 per ounce by the end of next year. I further contend that mining shares have already bottomed in anticipation of a failed Fed exit and will offer investors significant returns in the year ahead.

 

The Contrarian Trade of the Decade
December 30th, 2013

Mr. Bernanke, in a move made mostly to bolster his legacy, stated in his final press conference as Chairman of the Fed that he would start to reduce asset purchases in January of 2014. Nearly every advisor on Wall Street took the news as evidence the Fed can now remove its manipulation of interest rates with complete economic immunity. However, what these pundits fail to realize is that the Fed's economic recovery strategy was based on artificially boosting bond, equity and real estate prices. Now our central bank is promising to remove its support of asset price. Therefore, the lesson we are all about to learn is that bubble-based economies always fail.

As 2013 year draws to a close, the Ten-Year Note yield has climbed above 3%, from its 1.5% level in the spring. This move higher is occurring despite the fact that the Fed's tapering of bond purchases has yet to even begin. And, even when the taper starts in January the Fed will still be buying $75 billion of MBS and Treasuries. Therefore, Wall Street's ebullient reaction to the taper announcement is both premature and misguided.

Interest rates will rise significantly in the first half of next year, which will send bonds, stocks and home values into a sharp correction. The real estate market (the corner stone of the Fed-engineered recovery) is already starting to see cracks in its foundation. According to the Mortgage Banking Association, the index for applications to purchase and refinance a home fell 6.3% last month, sending the index to its lowest level in thirteen years. Further evidence of waning demand for homes came from the National Association of Realtors (NAR). Existing home sales fell for the third straight month to its lowest level in a year. The NAR also reported that sales were down 4.3% from October to November and were lower by 1.2% YOY. The weakness in housing extended to new home sales also, as they fell 2.1% in November.

Weakening demand for homes hasn't stopped builders from ignoring the fundamentals (much like they did during the housing bubble in the middle of last decade) and continue to increase inventory. New home starts were up 22.7% in November and were up 29.6% YOY. Existing home inventories were also up 5% YOY.

In normal market conditions falling demand and increasing supply would cause prices to fall. However, prices for new homes are up 10.6% YOY, while existing home prices rose 9.4% YOY, according to the NAR. Other measures of home prices, like S&P/Case-Shiller National Index, shows overall home values climbed 13.3% YOY. Why would prices be soaring double digits when demand is plunging and supply is on the rise? The only viable answer is QE!

Turning to the equity market, the S&P is up 25% this year while real GDP has advanced only about 2%? You just can't have strong and sustainable revenue and earnings growth when real GDP is growing at 2%. And, you certainly should not be able to post equity market returns of 25% if growth in the economy is so small. How did investors achieve such lofty gains this year? The only answer can be QE!

Finally, the 10-Year Note is yielding 3%. How could that benchmark yield be offering a return that is four hundred basis points below its 40-year average while the nation's publicly traded debt is up $7.2 trillion (140%) since the start of the Great Recession? You guessed it, QE!

Without the Fed's intentional manipulation of interest rates and money supply, the real estate and stock markets would be in a significant correction. This is because the Fed's debt monetization efforts have distorted all free-market indicators of where prices ought to be.

Keep in mind Mr. Bernanke's taper has yet to begin, and once commenced, it will be diminished only marginally. Nevertheless, if Janet Yellen continues to attenuate asset purchases by $10 billion each month, investors should expect an equity market correction in the first half of next year of at least 15%, as benchmark yields soar past 4%.

My primary market prediction for 2014 is that the Taper of asset purchases will be terminated, and then most likely be reversed by the end of Q2; but only after investors experience a massive correction in asset values and economic growth. This change in monetary policy will mark a significant turn in the U.S. dollar, international equities and commodity prices. Most importantly, the best opportunity for next year is to buy what no one else on Wall Street owns at this juncture. I can't think of anything more hated than the shares of precious metal mining companies. Therefore, the contrarian trade of the decade is to fade the equity market rally that is based on the overwhelmingly accepted, but false assumption, of a successful Fed taper.

 

Taper=1987
December 16th, 2013

On Monday, October 18th 1987, the Dow Jones Industrial Average lost 508 points (22%). There are many theories as to why the crash occurred, but the simple truth is that the panic stemmed from a sharp rise in interest rates. Likewise, another stock market crash awaits investors on the other side of tapering.

Rising interest rates twenty six years ago were a direct result of surging inflation. The year 1987 started out with very benign inflation. Consumer Price Inflation in January of that year showed that prices were up just 1.4% from the year ago period. However, CPI inflation surged to an annual increase of 4.4% by October. Rapidly rising inflation put fear back in the minds of the bond vigilantes, who remembered vividly how the former Fed Chairman, Paul Volcker, had to raise the Fed Funds Rate to nearly 20% in order to vanquish inflation just six years prior. The worry was that the new Chairman, Alan Greenspan, would soon be forced to follow in his predecessor’s footsteps and start aggressively raising the Funds Rate. That fear helped send the Ten-Year Note yield surging from just above 7%, in January 1987, to over 10.2%, the week before Black Monday.

The stock market had soared by 22% in the 12 months prior to the crash of ’87. In similar fashion, the Dow Jones Industrial Average has risen 21% since December of 2012, and is up nearly 150% since March of 2009. Of course, many pundits like to claim the market is not as overvalued now as it was then--the PE ratio was 23 in ’87, while it is 16 today.

But, what those same gurus neglect to realize is that the “E” in the PE ratio is far more artificially derived today than it was before the great crash. Back in 1987, the range for the Fed Funds Rate was a far more reasonable 6.4%-7.2%. And the total non-financial debt of the nation was 176% of GDP—lofty, but still manageable. That compares with a Fed Funds Rate of 0.08% today, and total debt of 245% of GDP. Therefore, since interest rates are dramatically lower and debt is significantly higher than during 1987, it seems logical to conclude that the earnings of corporations and indeed the economy itself are in a far more unsustainable condition.

The same stock market carnage awaits investors just around the corner if the Fed decides it is time to end QE. Only this time the spike in rates won’t be caused by inflation but by the central bank itself. It doesn’t matter if inflation causes investors to fear that the Fed will raise rates (as it did 1987); or if borrowing costs increase due to the fact that the Fed has to stop its indiscriminant and massive manipulation of the yield curve--the result will be the same.

The Doves at the helm of the Fed realize this and that is why they are extremely reluctant to end QE. Investors most likely have at least until March of next year before they have to worry about a genuine tapering of Fed asset purchases...if at all; because the economy should take another turn downward due to the implementation of the Unaffordable Care Act and interest rates that have already increased. Nevertheless, it is essential to have a plan in place to preserve your assets and profit from the equity market crash in the unlikely event the Fed does go down the tapering road early next year.

If the Fed does not begin winding down QE by the early part of 2014, the markets will understand that the central bank will be in the debt monetization business for many years to come and risk assets will soar. On the other hand, if the Fed begins tapering assets within the next few months the markets and economy will tumble. The global economy sits on a narrow ledge. On the one side there exists massive asset bubbles and inflation; and on the other side there lies a deflationary depression. It is now crunch time for the Fed to choose which way we fall.

 

Ten-Year Note Trades Near 6%; If Taper Is For Real
December 5th, 2013

The most important question for investors at this time is to determine how high interest rates will rise; if indeed the Fed’s artificial suppression of yields is truly about to end. To accomplish this we first must consider where yields last were outside of central bank debt monetization, a recession and the Eurozone debt crisis. Then, we need to factor in the increased risks to inflation and solvency, in order to arrive at an appropriate estimation for the level of interest rates during 2014.

The last time there was; no QE is session, no flight to safety in U.S. Treasuries from European debt insolvency, and the economy was not contracting, was in the spring of 2010. During that time, the U.S. Ten Year Note offered a yield just below 4 percent. But it is not accurate to then assume that rates will just gradually rise back to where they were before all three conditions were in place. Here’s why.

Credit Risks Have Increased

It is crucial to understand why the Fed’s inflationary campaign will not succeed in bailing out the economy. The reason for this is while it is true that inflation makes easier for an over-indebted economy to pay down debt, it also (because of ultra-low low borrowing costs) tends to truncate the deleveraging process. And, if those low interest rates stay in place for a protracted period of time it causes the economy to become even more leveraged than it was prior to the crisis. This is precisely what we find today.

The proof for this can be found in the borrowing habits of corporations, consumers and the government after the credit crisis unfolded. It is true that immediately after the collapse of the real estate market, consumers and businesses began to pay down debt. However, the government immediately began piling on new debt in record fashion. Corporations then started to accumulate more debt in the spring of 2010. And consumers have now fully reversed course as well and are happily adding to their debt loads.

Thanks to the nearly-free money offered by the Fed during the past several years, publicly traded U.S. Treasury debt has soared by $4 trillion (46%) since the spring of 2010. debt has increased by $1.6 trillion (8.2%) during that same timeframe. And, in the third quarter of 2013 consumer debt jumped by $127 billion, to reach a total of $11.28 trillion—the largest quarterly increase since Q1 2008. Household debt was up across the board with mortgage debt, auto loans, student loans and credit card balances all increasing substantially.

The significant increase in aggregate debt outstanding in the economy equates to a substantial increase in the credit risk of owning U.S. sovereign debt.

Inflation Risks Rising

The last time the 10-Year Note was trading at 4%, interest rates had been near zero percent for just over one year. Now, money has been nearly free for a total of five years. In addition, the size of the Fed’s balance sheet has soared from $2.3 trillion, to just under $4 trillion (an increase of over 70%). The inflation risks in the economy have vastly increased given the facts that the supply of bank credit (high-powered money) is at an all-time record high, and at the same time the level of borrowing costs are at a record low.

So How High Will Rates Go?

The bottom line is the interest rates offered on sovereign debt are mostly a function of the credit and inflation risks associated with owning that debt--not the level of growth in the economy, no matter what Wall Street likes to claim. Given the above data, it is clear that the 4% yield on the Ten-Year Note seen back in early 2010 will be eclipsed. Since inflation pressures and the solvency risks to the nation have increased by an average of about 50%, it would seem logical to assume the Ten-Year Note should trade 50% higher than where it was back in early 2010. This would put the Ten-Year in the 6% range, which is still about 100 basis points below the forty-year average. Of course, this is providing the Fed is actually going to end its artificial manipulation of long-term interest rates next year.

Don’t be Fooled by the Consensus

The overwhelming consensus on Wall Street is that the economy will slowly improve and the Fed’s taper will cause that benchmark interest rate to rise gradually back towards 3.25% over the course of 2014, from its 2.83% level today. However, the real risk is that rates do not rise slowly and by a small increment. Don’t forget, the Fed is has been buying 80% of all new Treasury debt, and it is a buyer that is totally indifferent to price.

A genuine attempt by the Fed to exit QE will cause interest rates to quickly soar back above 4%, and then perhaps as high as 6% in just a few months after the taper is concluded.

Therefore, it is prudent to assume the new Fed Chairman, Janet Yellen, will abort the tapering process shortly after it begins. That’s because rapidly-rising interest rates would be devastating to real estate, equities and the overleveraged economy in general. The shock for Wall Street will be that the Fed reverses tapering its asset purchases and begins adding to the total amount of QE next year. This would mark a significant turning point for the dollar, international equities and commodities.

 

Money Supply Soars as Fed Eyes Taper
November 25th, 2013

The money supply as measured by M2 is now rising at a 12.1% annualized rate, which is causing the fickle Fed to renew its threats about ending QE. The minutes released from the latest FOMC meeting indicate the tapering of asset purchases could once again begin within the next few meetings.

Could it be the Fed is finally getting concerned about the asset bubbles it so desired to create? The robust increase in money supply has pushed stock prices higher; you could also throw in diamonds, art, real estate and Bitcoins to name just a few assets that are in raging bull markets. All those items just mentioned are not counted in the CPI measurement and therefore allow most on Wall Street and in D.C. to claim there is no inflation.

But despite promises from the Fed that tapering (when and if it ever comes) isn’t tightening monetary policy, the Ten Year Note just isn’t a believer. That benchmark yield was trading below 2.70% before the FOMC minutes were released, and then shot up to 2.84% within 24 hours of learning the taper talk was back on again; clearly illustrating the enormous pent-up pressure on bond yields.

So what you may say? Aren’t rising yields a sign of a healthy economy? Perhaps under normal conditions that is true. But in sharp contrast, today’s rising yields are the result of the combined forces of inflation and tapering fears. In reality, ending QE is all about the government relinquishing its utter dominance of the bond market.

However, the fear over the imminent end of easy money is for the most part unfounded. And even if the Fed were to curtail QE sometime in the near future, it would only last briefly; and the tightening policy would have to be quickly reversed, as I believe the entire globe would quickly sink into a deflationary depression. Precious metal investors may have to wait until the attempted exit from QE fails before a major, and indeed, record-setting advance can occur.

In addition, the odds are also increasing that Janet Yellen (whom I have dubbed the counterfeiting Queen) will allow asset bubbles to increase to a much greater degree than her predecessor, Ben Bernanke ever did. And that should drag commodities along for a nice ride. After all, the gold market has been busy pricing in the end of QE for multiple quarters. There is a good chance that the beginning of tapering would lead to a reversal of the trade to sell gold ahead of the news. But the major averages have priced in a sustainable recovery on the other side of QE, which will not come to fruition. For the Dow, S&P 500 and NASDAQ the end of QE will be especially painful.

But the truth is the U.S. economy is more addicted to the artificial stimuli provided by the Fed and government than during any other time in our nation's history. Aggregate debt levels, the size of the Fed's balance sheet, the amount of monthly credit creation and the low level of interest rates are all in record territory at the same time. This condition has caused the re-emergence of bond, stock and real estate bubbles all existing concurrently as well.

A unilateral removal of stimulus on the part of the Fed will send the dollar soaring and risk assets plunging—you could throw in emerging market equities and any other interest rate sensitive investment on planet earth. The Fed is aware of this and that is why it is desperately trying to deceive the market into believing ending QE will not cause interest rates to rise. This is a silly notion. Since QE is all about lowering long-term rates how can it be that ending QE won’t cause the opposite to occur? This is why the FOMC minutes released today show that the Fed is debating different tactics to run in conjunction with the taper; such as charging banks interest on excess reserves in an attempt to offset the deflationary forces associated with tapering asset purchases.

Nevertheless, the most important point here is most money managers on Wall Street are convinced this is an economy that is on a sustainable path—but they are completely wrong. Disappointingly, it is much more probable that the government has brought us out of the Great Recession only to set us up for the Greater Depression, which lies just on the other side of interest rate normalization.

Sadly, the Fed has killed the buy and hold theory of investing for many years to come. Having an investment strategy for both rampant inflation and sharp deflation is now essential at this juncture.

 

A Requiem for the Bond Market
November 18th, 2013

The central banks of Japan and the U.S. are killing the private market for government debt. The massive and unprecedented bon-buying programs for Japanese Government Bonds (JGBs) and Treasuries have driven yields so low that investors are now simply stepping aside from involvement in that market entirely.

Monthly trading of JGBs has fallen to just $385 billion, the lowest level on record, clearly illustrating that private institutions are no longer comfortable holding Japanese debt. Perhaps because the bench-mark Ten-Year Note yield has dropped by 55% during the last three years and now offers a yield of just 0.6%. This paltry yield exists solely because of the BOJ’s 7 trillion Yen per month worth of debt monetization. Be assured, if the free market were allowed to dictate bond yields, Japan’s 2% inflation target coupled with its quadrillion Yen worth of outstanding debt (244% of GDP) would cause interest rates to soar in that island nation.

Similarly, the U.S. Federal Reserve is on pace to purchase 80% of our annual deficits. The central bank has crowed out and scared away private investors with our $17.15 trillion debt and a zero percent interest rate policy--that will probably be in effect for at least eight years. Investors are very much aware that our massive debt and a $4 trillion Fed balance sheet pose huge credit and inflation risks that is not at all reflected by a Ten-Year Note trading below 3%.

But market fundamental don’t matter in the short run when central banks completely overwhelm the private sector. However, with each passing day these bond markets—and indeed entire economies—become more addicted to these artificial rates. And, as money printing succeeds in creating rising inflation, interest rates are becoming more and more negative. Negative real interest rates that are falling over time are cause investors to eschew sovereign debt ownership by ever-increasing numbers.

Rising inflation rates, massive outstanding debt and zero percent interest rate levels are completely antithetical to free markets. Therefore, what the Fed and BOJ have created is an interest rate vacuum. The BOJ and Fed may eventually step aside from debt monetization programs once inflation targets are reached. But this will create a sudden and tremendous move upward in yields, as bond prices to plunge to a level that begins to once again attract the interest of private investors.

I have warned many times in the past and even written a book about the coming bond market collapse. These central banks will have to continue in perpetuity being the dominate buyer of government debt, which will lead to hyperinflation, or choose to step away from debt monetization and allow interest rates to soar, which will lead to a deflationary depression. Either decision will carry with it incredible ramifications to investors.

Nevertheless, the major point being overlooked by the Fed and the markets is If the Fed, ECB or BOJ were to decide to move away from quantitative easing they will have to coordinate that tightening amongst all three banks. If any one of these central banks acts unilaterally, it will cause a humongous and disruptive move in currencies. For example, if Janet Yellen were to start tapering the Fed’s QE program while the BOJ and ECB kept its monetary policies intact, the dollar would soar. This would cause the new Chairman to panic about deflation (deflation is public enemy number one, according to this new era of Keynesian central bankers), while the stock market crumbed due to downward pressure on earnings from U.S. based multinational corporations. Of course, the chances of getting the Fed, BOJ and ECB to agree on tightening monetary policy in the near future are about the same as their target rate on interest rates—zero.

Therefore, expect interest rate manipulations on the part of these central banks to last far longer than most on Wall Street anticipate. This means inflation is now the primary threat to investors’ portfolios. The need to own hard assets should become even more pronounced next year, as markets gradually come to realize that central banks have totally killed the private market for sovereign debt. And any resuscitation of government bonds will require a rise in interest rates that will be, unfortunately, catastrophic.

 

Bernanke’s Broken Record
November 12th, 2013

By now we have all heard it many times before…the Fed’s mantra about ending QE is starting to sound just like a broken record. Our central bank is aware it has to stop manipulating credit and interest rates some day, and on a basic level it really wants to end that game, but the right time never seems to come. Sort of like someone who wants to quit smoking is often heard exclaiming that this will be his last pack of cigarettes. But a hundred cartons later he’s still puffing away. He knows it’s wrong, so he vows to stop. However, soon everyone realizes he’s just full of smoky-hot air.

Likewise, the Fed is quickly losing all credibility with investors. Very soon its threats to stop QE will be laughed at in the same way as we do the empty promises to quit from a chain smoker. After all, QE is all about lowering long-term interest rates for the purpose of encouraging more borrowing and forcing investors to purchase more risk assets. Therefore, it is the height of hypocrisy and stupidity on the part of the Fed to maintain that ending QE will not force the long end of the yield curve higher and cause a massive selloff in equities and real estate.

The Fed keeps insisting this won’t happen and is trying to convince the market that it has things wrong. However, they know rates will rise; and that is why it is so reticent to start tapering bond purchases. So, all Mr. Bernanke can do is make repeated threats about tapering and hope the bond market’s reaction will be different this time around. But it won’t…and the longer the Fed waits to end QE the more drastic the move higher in interest rates will be.

Tapering talk started on May 22nd during Mr. Bernanke’s congressional testimony. In it, he claimed the Fed could start to reduce QE by year’s end. That first salvo sent the 10-Year Note on a journey higher from below 2%, to 3% by September 5th. However, like a good addict, the Fed saw the ensuing slowdown in the economy caused by those rising rates as an excuse to keep printing money. Its no-taper surprise delivered at the September 17-18th meeting saw the 10-Year Note drop from 2.9%, to below 2.5% in a month. The excuse given for not tapering was “tightening financial conditions”, which were of course caused by the Fed itself! Then, at this latest meeting held on October 29-30th the Fed stated that some imaginary improvement in economic conditions has been recently achieved. Despite the fact that the economic data has been mixed, the bond market took the Fed’s exuberance as a signal the taper was back on and to once again sell Treasuries. The Ten-Year Note climbed from 2.47% to 2.62%, just two days after Bernanke’s statement was read and it has now reached 2.75%.

So let’s get all this straight, the Fed threatens to taper its asset purchases and that causes the entirely rational response to sell bonds, which sends rates higher; and that soon causes the Fed to panic and to once again promise to keep the printing presses rolling, which causes interest rates to fall; and that then allows the Fed to find the courage to talk about tapering again…wee! Aren’t you glad these people are in charge?

Of course, the Fed knows that buying $85 billion worth of government debt each and every month without end and without regard to price has sent bond prices and risk assets far higher than they would ever possibly be if they were instead driven by free-market forces. This is what the Fed set out to do in the first place. Therefore, the Fed knows ending its QE program equates to a massive tightening of credit conditions no matter what it would otherwise have you believe. Mr. Bernanke claims tapering isn’t tightening, which is about as credible as President Obama’s claim that, “If you like your insurance plan you can keep it…period.”

Wall Street would also like investors to believe the stock market is being powered by strong earnings that are the result of a vastly improved economy. But if this is true then why does the market tank each time the Fed threatens to end buying over $1 trillion worth of government debt per year?

The real truth is the Fed will not end QE until consumer debt is once again dwarfed by the phony wealth created through asset bubbles. It is at that point the consumer will start to desire more debt accumulation and the private banking system will then be able to expand the money supply. This will bring inflation up to where the Fed is comfortable and can persist without the continued expansion of its balance sheet. Once banks are lending money again to consumers that can’t pay it back, the money supply will grow without having to grow the monetary base. And all will be well once again just as it was before the economy collapsed in 2008.

Therefore, investors that are worried about inflation have great reason to be fearful. The Fed will not stop expanding credit until the purchasing power of money is under great duress and debt levels in both the public and private sectors are at incredible extremes. The Fed wants you to believe once it is successful in creating massive bond, stock, real estate and debt bubbles it can then allow interest rates to rise from zero percent—where they have already been for the last 5 years-- with economic impunity. Nevertheless, investors would be wise to reach an entirely different conclusion and prepare their portfolios now for the coming economic chaos. That means having the ability to anticipate intractable inflation and or a deflationary depression, the inevitable bond market crisis; and being ready to deploy an investment strategy for each outcome.

 

Obama Care and Inflation to the Rescue?
November 4th, 2013

The market averages continue to set record highs, as investors are forced by the Fed into stock market speculation due to artificially-suppressed interest rates. But neither our central bank nor corporate measures deployed solely to increase earnings per share while ignoring revenue declines (see IBM’s announcement of a stock buyback) can hide the fact that the underlying economic growth is deteriorating.

In the past few days alone stocks have had to ignore a spate of bad economic data. For example; Durable Goods Orders for capital expenditures fell 1.1% in September, Pending Home Sales plunged 5.6% last month and were down four months in a row, and the ADP Employment Report for October showed that just 130k private sector jobs were added last month. This is just a small snap shot of the overall data that clearly shows the economy has been growing below trend—at best.

However, despite falling home sales, durable goods orders and disappointing employment trends the stock market is powering higher. In fact, not only are investors undaunted by the anemic economic data but they are enthused to the degree that it has sent NYSE margin debt to an all-time record high.

It should be abundantly clear to any unbiased observer that the Fed has succeeded in creating an economy fueled by debt, money printing and asset bubble creation. And, as history has clearly demonstrated, any such economy based on those conditions eventually falters.

Unfortunately for us Americans, Washington is merely proposing snake-oil solutions for the economy. The elixirs prescribed are the Affordable Care Act and more Fed-induced inflation.

Obama care is projected to force about 80% of the 14 million consumers who buy their insurance individually to get a cancellation notice because their current policies do not meet ACA mandates. These individuals, who are mostly small business owners, (the generators of job growth) will see an increase of nearly 100% on average for their new premiums. Obama care will also thrust over 25 million people on to the health care system through government assistance. Providing premium support for millions of individuals will place a huge burden on debt and deficits that are already at a disastrous level. And, placing more than 25 million individuals onto the health care grid without increasing the supply of health care can only serve to drastically push the cost curve up instead of down. Obama care will not fix the economy; rather, it will only exacerbate its decline.

Adding to the health care woes is the view on the part of the Fed that inflation will be our panacea. The NY Times reported recently that President Obama’s nominee to head the Fed, Janet Yellen, believes a little inflation is desirable when the economy is weak. Economists like Yellen maintain that rising prices help companies increase profits and rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly. The article stated that some prominent economists desire inflation to rise by 6% for several years! It also quoted Charles Evans, President of the Chicago Fed, who went on record saying, “Let me just remind everyone that inflation falling below our target of 2 percent is costly,” And, the paper quoted Fed Chairman Ben S. Bernanke saying, “The evidence is that falling and low inflation can be very bad for an economy.”

However, the truth is inflation destroys profit margins, as the costs for crude and intermediate goods tend to rise faster than finished goods. The view that rising wages should come from inflation is faulty as well. Rising wages should be the result of increased productivity and not from depreciating money. The fact is that salaries tend to fall in real terms when overall prices are rising. Also, as the article stated, inflation does encourage consumers and governments to take on more debt; but this is exactly the wrong approach when the overall economy is in drastic need of deleveraging. Deflation causes asset prices and debt levels to fall. And, as a result, the end product is a rising standard of living and a viable economy.

But be assured our central bank won’t quit expanding the supply of money and credit until inflation is well entrenched into the economy. If QE alone doesn’t serve to dramatically expand the money supply the Fed may force banks to lend the excess reserves by relaxing capital requirements and/or through charging interest on those reserves.

Unfortunately, the bottom line here is to look for health care costs to soar, debt and deficits to rise, inflation to surge and economic growth to falter. Investors should prepare their portfolios first for a massive increase in asset bubble levels first and then for economic chaos to follow.

 

Monetization without End
October 23rd, 2013

I have long predicted that our central bank’s debt monetization efforts would be of greater quantity and duration than most everyone at the Fed and on Wall Street expected. The reason; it is simply pure economic fallacy to try to engender viable economic growth through the process of creating inflation. Japan is trying the same failed economic strategy as well; and it will end in disaster…just as it will here in the United States.

Here’s why. Each of the past five years Wall Street and Washington has repeatedly offered a rosy forecast of a second-half recovery that has not come to fruition. Latest case in point, the NFP report for September (before the government shut down) showed that just 126k private sector jobs were added last month. However, the answer we get from government is to do more of the same thing that isn't working. More debt, more money printing and a further extension of asset bubbles are the only solutions they provide.

It doesn't matter that five years of zero percent interest rates and QE have failed to spur real growth. Their prescription only leads to a zombie economy that limps along because it is based on creating consumption through rising asset prices and not through resolving structural issues like; allowing the economy to deleverage, simplifying the tax code, fixing our educational system, reducing regulations, or through stabilizing interest rates and the value of the dollar.

Therefore, five years and over three trillion dollars later, investors are clamoring to learn if the Fed will finally acknowledge that QE is actually preventing a return to healthy GDP growth; or will it merely persist in the folly of printing money without end.

That vital question was answered in a recent interview with Chicago Fed President Charles Evans on CNBC. Mr. Evans was asked a specific question about the boundaries of money printing and how much new credit the central bank is willing to create. The incredible exchange went as follows:

CNBC: “Does the fed have a limit to its balance sheet? Charlie, is there a limit? You’re headed towards $4 trillion. Could it be $5 trillion, could it be $12 trillion? What limits the size of the Fed's balance sheet?” Charles Evans: “Well, I think the Fed needs to do whatever is necessary to help meet our dual mandate objections…is there a limit, I don’t really think about it that way because I think there is a tremendous amount of capacity, we can go on as long as necessary…”

The Fed President shares the same sentiment as the soon to be appointed Chairman Janet Yellen. Those statements assure investors that the central bank is far more concerned about deflation than it will ever be about inflation; and that it will not stop printing money until it creates the latter.

So, what will be the effects of ever-expanding money supply and credit creation? Interest rates will be negative in real terms and that condition will only worsen over time. Public and private sector debt levels will explode higher as the artificially-low interest rate environment encourages the economy to lever-up to record highs. Cheap money will continue to force intractable speculation in stocks, commodities and real estate, which will further impoverish the middle class and lead to the exacerbation of asset bubbles that are already at dangerous levels.

While there is some anemic economic growth generation based on the building and servicing of asset bubbles, it is a miserable tradeoff for the massive debt bubble being created--which is setting up the economy for a devastating crash.

The total amount of public and private sector debt already amounts to 350% of our unsustainable GDP. The central bank’s monetary policies will cause this level to grow both in nominal and GDP terms. These debt and asset bubbles should all implode in unison once interest rates normalize. It is prudent for investors to ride the asset bubble wave higher for now. But it is also imperative to have an escape plan in place before the inevitable crash occurs.

 

De-crowning the Dollar
October 21st, 2013

The gradual erosion of the U.S. dollar’s status as the world’s reserve currency has been greatly hastened of late. This is due not only to the perpetual gridlock in D.C., but also our government’s inability to articulate a strategy to deal with the $126 trillion of unfunded liabilities.

Our addictions to debt and cheap money have finally caused our major international creditors to call for an end to dollar hegemony and to push for a “de-Americanized” world. China, the largest U.S. creditor with $1.28 trillion in Treasury bonds, recently put out a commentary through the state-run Xinhua news agency stating that, “Such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated.” In addition, Japan (our second largest creditor holding $1.14 trillion of U.S. debt) put out a statement through its Finance Minister last week saying, “The U.S. must avoid a situation where it cannot pay, and its triple-A ranking plunges all of a sudden.” It is both embarrassing and hypocritical to be lectured by Japan about an intractable debt situation. However, the sad truth is we have become completely reliant on these two nations for the stability of our bond market and currency.

We arrived at this condition because our central bank has compelled the nation to rely on asset bubbles for growth and prevented the deleveraging of the economy by forcing down interest rates far below a market-based level. For example, instead of allowing debt levels to shrink, the Fed’s virtually-free money has now caused consumer credit to surge past the $3 trillion mark by Q2 2013; that is up 22% in the past three years. And of course, the Federal government massively stepped up its borrowing beginning in 2008, piling on over $6.8 trillion in additional publicly traded debt since the start of the Great Recession.

While most are now celebrating the end of government gridlock (however ephemeral it may be), the truth is few understand the consequences of our addictions. The real problems of government largess, money printing, artificial interest rates, asset bubbles and debt have not been addressed at all. Rather, Washington has merely agreed to perpetually extend its lines of credit and to have the central bank purchase most of that new debt.

Instead of placating the fears of our foreign creditors we have cemented into their minds that the U.S. dollar and bond market cannot be safe repositories of their savings. The eventual and inevitable loss of that confidence will ensure nothing less than surging prices and a complete collapse of our economy.

The fear of an economic meltdown was the genesis of a constitutionally-based third-party political movement. The Tea Party was formed to prevent runaway inflation and an economic depression resulting from a crumbling currency and devalued debt. It appears by the absolute and universal vilification of its members by both republicans and democrats indicates that U.S. citizens are not yet ready to undergo the pain associated with the removal of our pernicious addictions. Since there appears to be no political solution is site, it would benefit investors to take steps now to protect their portfolios from the de-crowning of the U.S. dollar as the world’s reserve currency.

 

Raising the Roof on the Debt Ceiling
October 7, 2013

Former Treasury Secretary Hank Paulson weighed in on the budget and debt ceiling gridlock in Washington and offered a solution last week by saying, “I hate the whole concept of a debt ceiling”. He also indicated that putting a legal limit on our nation’s borrowing authority is a “flaw in the system”. In other words, if we just did away with the strictures of a debt limit our problems would go away. Unfortunately, this view is shared by most in our government.

As usual, the majority of those in D.C., regardless of their party affiliation, have it exactly backwards. The problem isn’t that we have a law which caps the total amount of our nation’s public obligations. The real issue is that our leaders consistently pass spending bills which breach our legal borrowing limit. In fact, D.C. has raised the debt ceiling 74 times since 1962 alone.

The majority of politicians in both houses of congress believe that not raising the debt ceiling would impugn the full faith and credit of U.S. Treasury Debt. In sharp contrast, it is our habit of raising the debt limit without getting our deficits and entitlement obligations under control that poses the most threat to Treasury prices.

Of course, no sane person advocates defaulting on our sovereign obligations; but that is exactly what we are doing right now anyway through the Fed’s massive monetization of bonds. And if we do not finally address our addiction to debt, our default level will increase dramatically as real interest rates plummet. Therefore, what a few rational members in government are trying to accomplish is preventing the inevitable spike in nominal interest rates and an even greater surge in inflation stemming from the loss of confidence in our nation’s ability to service our debt through taxation. By adhering to the current $16.7 trillion debt limit the U.S. can greatly reduce the need for debt monetization on the part of our central bank.

It is a fact that the current level of revenue is not enough to pay down the amount of total debt outstanding because our annual deficit for fiscal 2013 will be $750 billion. President Obama likes to claim he cut our deficits in half from the $1.4 trillion deficit incurred during 2009. However, this distorts the truth because the deficit for 2008, the year before his first term, was $458 billion, and the year before that the deficit was just $160 billion. So, we are growing the debt because we are increasing the deficits and, most importantly, we are still growing the debt as a percentage of GDP.

These debt and deficits should soar in the coming years to an even greater degree because the premium support provision in the Affordable Care Act (ACA) is another huge entitlement that will provide a government subsidy for millions of Americans that cannot afford health care insurance. In fact, the Congressional Budget Office recently raised the cost for the ACA to $2.6 trillion over the first 10-year horizon. The ACA is the law of the land; but the debt ceiling is as well. Washington cannot claim that some laws are malleable and others which are not.

Nevertheless, it is our addictions to debt and inflation that will eventually collapse Treasury prices, not having a legal borrowing limit on our nation’s debt. It is a travesty that many in D.C. are claiming the failure to raise the debt ceiling will lead to Treasury default. Quite the contrast, it would be tantamount to adopting a balanced budget amendment, which would serve to dramatically boost confidence in Treasury ownership.

The tremendous amount of outstanding debt, unchecked deficits and intractable entitlement program spending virtually guarantees that the Fed will have to increase its monetization of Treasuries at an even greater level than the incredible trillion dollar annual pace. This unfortunately means that inflation and our addiction to asset bubbles will be growing in ever-increasing fashion over time.

 

Read for QE Five?—It’s Already Here
September 30, 2013

The sad truth is that the primary function of the Fed and Treasury has now become the sustention and expansion of disastrous asset bubbles. In fact, while Mr. Bernanke officially acknowledges QEs one through three, the truth is he has embarked on QE V. What's QE five all about? Putting a lid on U.S. Treasury yields.

The reason for this is our anemic economic recovery has been predicated upon artificially boosting consumption, which is 70% of US GDP. That consumption is, in turn, predicated on borrowing; because we don't have any real income growth on the part of the consumer. The borrowing has been predicated on government's ability to build upon the asset bubbles in stocks, bonds and real estate. And the creator of all these bubbles is our central bank, which is the progenitor of this deadly-addictive cycle. The Fed does this by providing ultra-low interest rates and through the massive monetization of government debt.

To prove we have learned nothing from the previous Great Recession; we now have a situation where the FHA will most likely need a $1 billion bailout for the first time in its 79 year history. But why do taxpayers have to bail out the FHA, which provides insurance to lenders such as banks and other financial institutions? The reason is because our government has once again compelled lenders to make loans with next to nothing for a down payment, to individuals who cannot afford to purchase a home-doesn't this all sound chillingly familiar? Therefore, we have subjected ourselves to yet another bubble in housing, where home prices are once again rising at double-digit rates and marginal home owners are just a few points higher in interest rates from foreclosure.

It's not just house prices which are in back in a bubble. Stock prices are also growing at double-digit annual rates. These double-digit gains in stocks are taking place in an environment of little earnings and revenue growth. Meanwhile, Treasury bonds offer only half of their average yields going back over 40 years. So, for the first time in our lives we have three bubbles that exist together -- equities, bonds and real estate. But the real catastrophe this time is that these bubbles will become exponentially larger than previous episodes. Therefore, when they burst the devastation will be many times worse.

For those that believe the Federal Reserve is soon going taper its asset purchases, what they fail to understand is that the central bank has devolved into an institution that now exists solely for the perpetual expansion of stock, bond and home prices. Last week, Minneapolis Fed President Narayana Kocherlakota stated the central bank must be, "…willing to use any of its congressionally authorized tools to achieve the goal of higher employment, no matter how unconventional those tools might be." He continued, "Doing whatever it takes will mean keeping a historically unusual amount of monetary stimulus in place -- and possibly providing more stimulus -- even as the medium-term inflation outlook temporarily rises above the Fed's 2 percent goal and asset prices reach unusually high levels."

What he is saying is that the central bank of the United States should draw a line in the sand and take the opposite stance of former Fed Chairman Paul Volcker, who once stated the Fed will do whatever it takes to crush inflation. In sharp contrast, this Federal Reserve is now saying we will do whatever it takes to create sustainable inflation and asset price bubbles.

The bottom line is that the Fed has now launched QE5, which is in reality QE-to-infinity. This latest round of QE is absolutely unprecedented because it attempts to permanently cap long term interest rates.

Banana Ben Bernanke will soon be succeeded by the Queen of the Counterfeiters, Janet Yellen. There will be no significant winding down of bond purchases as far as the eye can see and the Fed's balance sheet will be expanding for many years to come. And if there were to be any small tapering in the future, it will be inconsequential in nature because the Fed is on record stating rising interest rates will not be tolerated

The free market will eventually trump our government's desire to constantly push asset prices to an artificially-high and unsustainable level. If investors thought the collapse of home prices was devastating in 2008, just imagine what will occur once real estate, equities and bonds prices collapse concurrently. That is why government needs to end its manipulation of asset prices, suppression of interest rates and superfluous credit creation now!

 

Fed Puts Ceiling on Long-Term Rates
September 23, 2013

The President of the Europe’s central bank said back in July of 2012 that it would fight rising borrowing costs by doing “whatever it takes” to ensure sovereign bond yields do not spiral out of control. This past week Mr. Bernanke took a page from Mario Draghi’s playbook and tacitly indicated that the Fed will now also promise to keep long-term interest rates from rising by any means necessary.

Starting from its inception, the Fed influenced the economy by adjusting the interbank overnight lending rate and providing temporary liquidity for financial institutions. However, in the modern era of central banking (post 1971) the Fed has resorted to unprecedented and dangerous manipulations, which are increasing by the day.

The Fed began in November of 2008 to purchase longer-dated assets from banks. Bernanke’s plan was to greatly expand the amount of banking reserves, put downward pressure on long-term interest rates and to boost the value of stocks and real estate assets. He has since succeeded mightily in accomplishing all three. But since viable and sustainable economic growth cannot be engendered from artificially manipulating interest rates and boosting money supply, GDP growth and job creation have been anemic at best.

Therefore, the Fed has resorted to trying yet another unprecedented “solution” to fix the economy. Mr. Bernanke stated in his press conference following this week’s FOMC meeting that the level of asset purchases would remain at $85 billion per month because,” the rapid tightening in financial conditions in recent months could have the effect of slowing growth…” The only possible meaning Bernanke could have in mind when saying “the rapid tightening in financial conditions” is the increase of interest rates. The shocking part is that the rise from 1.5% to 2.9% on the Ten-Year Note does not even bring borrowing costs to half of the average level going back to the time when Nixon completely unpegged the dollar to gold.

What the Fed has done is historic in nature and yet it has received nearly zero attention in the main stream media. Bernanke has essentially admitted that just the threat of reducing QE—let alone actually bringing it down--was enough to send interest rates rising to the point in which economic growth is severely hampered. In other words, the Fed was forced to acknowledge that tapering is tightening and is now obligated to expand the balance sheet without end or be willing to allow a deflationary depression to reconcile the imbalances of its own creation.

This is because the price of risk assets and level of aggregate debt are so far above historic measures that even the slightest increase in borrowing costs renders the economy insolvent.

Investors would be wise to ignore the Fed’s rhetoric about ending QE and concentrate only on what it actually does. Hard assets offer the best protection against a central bank that is incapable of extricating itself from monetary manipulations.

 

Five Years Past or Five More in the Making
September 17, 2013

Wall Street is now reflecting upon the fifth anniversary of the Lehman Brothers bankruptcy and the start of the Credit Crisis. In fact, most are celebrating the belief that the complete collapse of the American economy was avoided thanks to a massive intervention of government-sponsored borrowing and money printing.

However, it is much more accurate to maintain that the Great Recession was only temporarily mollified by our proclivity to re-inflate old bubbles. Therefore, the Great Recession should not be thought of as something that is behind us. Quite the contrary; the last five years have been spent creating the conditions conducive for producing a depression.

It was our reliance on asset bubbles to generate economic growth that caused the Great Recession of 2007. Therefore, to believe that we have truly overcome our problems we should have already weaned the economy from its addictions to debt, low interest rates and inflation. But nothing could be further from the truth.

Our central bank pushed down interest rates to one percent during 2002-2003 and that was the primary contributor to the creation of the housing bubble. Now the Fed has resorted to providing a zero percent overnight lending rate from December of 2008 until today. The monetary base has jumped from just $800 billion, before the start of the Great Recession, to $3.7 trillion-and it's still growing at a rate of one trillion dollars per annum. The money supply is back to the same growth rate as witnessed during previous bubbles. Our nation's debt is now at 107% of GDP and the aggregate debt now stands at 350% of our annual output-the same level as it was at the start of the Credit Crisis. Home prices are back rising at the same double digit clip as they were during the height of the real estate bubble and stock prices are up nearly 20% YOY on little or no earnings and revenue growth. And, keeping in line with our tradition of lending money to people who can't pay it back, subprime auto loans now make up 36% of all car financings.

Yet despite of all the above facts, most investors now believe our problems are behind us and interest rates can rise without causing a slowdown in growth. But if that were indeed the case, why is it that the Fed is still conflicted over whether or not the economy can withstand even a slight reduction in its $85 billion worth of monthly counterfeiting? It seems they are tacitly admitting that our GDP growth (anemic as it may be) is still contingent on the perpetual growth of asset bubbles, debt, low interest rates and money printing.

The truth is that the U.S. economy is more addicted to the artificial stimuli provided by government than during any other time in our nation's history. Aggregate debt levels, the size of the Fed's balance sheet, the amount of monthly credit creation and the low level of interest rates are all in record territory at the same time. This condition has caused the re-emergence of bond, stock and real estate bubbles all existing concurrently. If investors choose to believe this is an economy that is on a sustainable path they can do so at their own peril. Disappointingly, it is much more probable that the government has brought us out of the Great Recession only to set us up for the Greater Depression, which lies on the other side of interest rate normalization.

Gold mining shares are currently struggling under the weight of rising real interest rates. However, the steadily weakening economy should soon end the Fed's talk of reducing its asset purchases. If that is indeed the case the PM sector is getting set to make a significant and substantial advance.

 

Cash and Gold are Kings this Fall
September 10, 2013

After being bullish on equities for most of 2013, back on July 16th I warned that the U.S. stock market was due for a significant correction. Allow me to briefly expound on why another 10% selloff in the averages is highly likely from now until the end of October.

It was announced recently that the nation of Japan has finally produced the highest annualized rate of inflation that it has seen in the last five years (.7%). Therefore, it makes no sense that their 10-Year Note now offers the same yield as their inflation rate-especially given the fact that their government wants inflation to increase significantly from current levels.

No sane investor would loan money to a regime that has promised, and is delivering, a higher rate of inflation than what can be garnered from owning its debt going out ten years. This means the only buyer of JGBs at the current rate will be the BOJ (Bank of Japan). The sad truth is that Japan is very close to experiencing extreme chaos in its bond market and economy. This chaos will send shock waves throughout the globe. Investors should take heed.

Adding to the downward pressure coming from Japan is the chaos happening in emerging markets. Many of these formerly booming economies have recently suffered falling growth rates, equity market debacles, and currency collapses, which have gone virtually unnoticed by most of the developed world up to this point.

For example, the talk of Fed tapering its bond purchases has helped send the Rupee down 20% verse the USD; and the BSE (Bombay Stock Exchange) SENSEX down 10% in the last three months. Other countries such as Thailand, Turkey, Brazil, Indonesia, and the Philippines (just to name a few), have suffered the same fate or even worse. The U.S. markets cannot continue to ignore the carnage taking place in the emerging world for much longer.

Despite the recent move towards a peaceful resolution to the crisis in Syria, oil prices remain well above a hundred dollars a barrel. Consumers are already suffering from falling real incomes and a job market that mostly offers part-time work. Stubbornly high oil prices will crimp consumer spending and hurt GDP growth. Unless oil prices drop significantly in the near future, it would be improbable to expect corporations to meet earnings expectations under this scenario. Look for earnings and multiple contractions to be the result if oil prices remain elevated.

Political gridlock in Washington D.C. has to be resolved within the next 60 days. The debt ceiling must be raised and government agencies need to have funding authorized through a Continuing Resolution by mid-October, or the U.S. government will be effectively shut down. The last time this situation arose was the summer of 2011. During that time, the Dow Jones shed 2,000 points in just 30 days. It would be prudent to anticipate a similar result from another round of government gridlock.

Finally, the Fed still believes the size of its balance sheet determines interest rate levels. Therefore, it may start to gradually bring down the level of its monthly asset purchases toward zero beginning next month. However, the mere threat of tapering bond purchases has already caused long-term rates to spike over 100 basis points. The Fed doesn't believe tapering is tightening but the free market disagrees.

The 10-Year, which is now yielding 2.8%, has already contributed to causing business spending and home sales to fall. Durable goods dropped 7.3%, and capital spending fell 3.3% in July, while new home sales plunged 13.4% in the same month. A significant reduction in the Fed's asset purchases will send the benchmark 10-Year Note towards 4%, which should cause the economy to fall back into recession.

Investors must realize that any one of the factors listed above could send this over-valued stock market much lower and the odds are low that they all will be resolved innocuously. Nevertheless, Wall Street continues to promote the fantasy of a second-half economic rebound, and is currently pounding the table on stocks. In sharp contrast, I recommend going mostly into cash and owning physical gold and silver as insurance against the imminent turmoil and chaos which could take place in global markets in the near future.

 

Fear the Inflation
September 3, 2013

While officials from the Federal Reserve gather recently in Jackson Hole Wyoming to bemoan that inflation isn't yet high enough for their liking, the truth is that inflation is already ravaging the middle class.

To prove my point, the government's official reading on core CPI inflation (one of the Fed's preferred metrics that removes food and energy prices) increased just 1.7% from July 2012. So, in the mind of those who control the value of our currency, inflation is well below their target of 2%; and therefore needs to be increased.

Nevertheless, let's try another, more real-world way of calculating the data. The labor department correctly judges that prices paid for shelter should be a significant proportion of the core CPI calculation (about a 40% weighting). According to the Labor Department, prices for shelter increased only 2.3% from July of last year. When the government uses such an incorrect assessment of home price appreciation it is then able to report only a slight increase in core inflation.

However, according to the National Association of Realtors, existing home prices surged 13.7% YOY. And new home prices jumped 8.5% YOY, according to the Commerce Department. If you include the increase in the other items in core CPI ex-housing (up 1.2% YOY) a more accurate measurement of core CPI can be achieved. Consumer prices would be up 5.1% from the year ago period--assuming you simply average the cost of purchasing a new with that of an existing home. In reality existing home purchases exceed the number of new home sales and would therefore increase the core rate reading. Of course, the difference between the government's data and what is collected from private sources is that the Bureau of Labor Statistics measures the imputed rental value of homes, instead of actual increases in what consumers have to pay for real estate.

A core rate of inflation that is rising north of 5% YOY should send shivers down the spines of those at the Fed and consumers alike. Amazingly though, Mr. Bernanke is still debating if a $3.6 trillion Fed balance sheet and the $85 billion worth of new credit creation each month is doing enough damage to the value of the dollar. The Fed's inflation is especially painful to the middle class due to the fact that real median incomes have fallen 6.1% since the start of the Great Recession, which began in December 2007.

Our economy is so addicted to money printing that the Fed can't agree on when, or even if, it should reduce the level of its asset purchases. Mr. Bernanke's confusion over monetary policy is evident despite the fact that he has built up a stock, bond and real estate bubble. This trifecta of asset bubbles exists concurrently for the first time in American history.

Our central bank will soon have to decide whether or not it will continue allowing these bubbles to grow to a more dangerous level (intractable inflation); or to start selling trillions of dollars worth of bonds and send interest rates soaring. We already have witnessed what a mere one percent increase in mortgage rates did to new home sales (down 13.4% in July, the lowest level in 9 months). This occurred without the Fed tapering its purchases of MBS and Treasuries by even one dollar. Just imagine what will happen to interest rates when the Fed not only stops buying that debt; but also starts unloading its balance sheet.

It seems apparent that we should prepare for fireworks in the bond, currency and equity markets across the globe in the very near future no matter what Mr. Bernanke decides to do. Therefore, it would be prudent to purchase portfolio insurance in the form of precious metals to help mitigate the fallout that is sure to come from massive central bank manipulations.

 

Will the Last Person to Exit the Treasury Market Please Turn Out the Lights
August 23, 2013

Wall Street and Washington love to spread fables that facilitate feelings of bliss among the investing public. For example, recall in 2005 when they inculcated to consumers the notion that home prices have never, and will never, fall on a national basis. We all know how that story turned out. Along with their belief that real estate prices couldn't fall, is one of their favorite conciliatory mantras that still exists today. Namely, that foreign investors have no choice but to perpetually support the U.S. debt market at any price and at any yield.

But, unlike what their mantra claims, the latest data show weakening demand in oversees purchases of Treasuries. According to the U.S. Treasury Department, there was a record $40.8 billion of net foreign selling of Treasuries in June. That was the fifth straight month of outflows in long-term U.S. securities. China and Japan accounted for $40 billion of those net Treasury sales. Those two nations are important because China is our largest foreign creditor ($1.27 trillion), and Japan is close with $1.08 trillion in holdings.

This shouldn't be a surprise to those who are able to accurately assess the ramifications from the Fed removing its massive bid for U.S. debt. In truth, yields currently do not at all reflect the credit, currency or inflation risks associated with owning Treasuries. If the Fed were not buying $45 billion each month of our government bonds, investors both foreign and domestic would require a much higher rate of return. Investors have to be concerned about the record $17 trillion government debt (107% of GDP), which is growing $750 billion this year alone. In addition, holders of U.S. debt must discount the inflation potential associated with a record $3.6 trillion Fed balance sheet, which is still growing at $85 billion each month. Also, foreign investors have to factor into their calculation the potential wealth-destroying effects of owning debt backed by a weakening U.S. dollar.

Of course, some people may claim that Japan has more debt outstanding as a percentage of its GDP than we do and yet the nation's interest rates are much lower than ours…so what's the problem? But, unlike the U.S., Japan has a long history of deflation and only 10% of its debt in foreign hands. The U.S. has not enjoyed any such history of deflation and is also a country that has only 50% of its debt held domestically. Therefore, there hasn't been any real concern about foreigners abandoning the Japanese bond market because of a fear that the yen may collapse. But the tremendous number of foreign U.S. creditors need to be constantly vigilant of the dollar's value. However, due to its foolish embracement of Abenomics, Japan will also have to fear a collapse of its debt market from rising inflation in the near future, just as we do in here.

If the free market were allowed to set interest rates and not held down by the promise of endless Fed manipulation, borrowing costs would be close to 7% on the Ten Year Note. Let's face it, the only reason why anyone would loan money to the U.S. government at these levels is because of a belief that our central bank would be there to consistently push prices up and yields down after their purchases were made.

Our central bank has now adopted an entirely new paradigm. Fed intervention used to be about small changes in the overnight interbank lending rate, which has averaged well above 5% for decades. However, not only has the Fed Funds rate been near zero percent for the last five years, but long term rates have been pushed lower by four iterations of QE. The latest version is record setting, open-ended and massive in nature. Since QE is mostly about lowering long-term rates, it shouldn't be hard to understand that its tapering would send rates soaring on the long end.

When the Fed stops buying Treasuries, foreign and domestic investors will do so as well. This means for a period of time there won't be any one left to buy Treasuries unless prices first plunge. The effects of rising rates will be profound on currencies, equity prices, real estate values and economies across the globe.

It would be wise to prepare your portfolio for a massive interest rate shock in the near future.

 

3 Reasons to Fear the Fall
August 12, 2013

I generally shy away from making time-specific economic and stock market predictions simply because they are extremely difficult to accurately pinpoint. During 2006 I warned about a coming real estate collapse that would cause a severe recession in 2007. Back in January of 2009, I urged investors to start buying the stock market because I felt the majority of the selling was behind us. In general, making such predictions is a dangerous game and should be avoided in most cases because odds are very low you’ll be correct on both the prediction and the timing.

However, there are certain times when the environment is conducive for a prediction that comes along with an expiration date. Today is one of those times. Therefore, the following 3 reasons are why I believe the stock market and the economy could be in for some serious trouble by the end of October.

  1. The fiscal dysfunction and discord in Washington comes to a head once again in late September and into October. There is an October 1st deadline for funding the government and a debt ceiling that needs to be raised around that same time. Such acrimony in D.C. has caused major disruptions in the stock market in the past. In the summer of 2011, Congress attempted to use the debt ceiling as leverage for deficit reduction. The delay in raising the debt ceiling led to the first ever downgrade in the U.S. government's credit rating. The Dow Jones Industrial Average dropped 2,000 points from July 7th to August 8th. And the very same day of Standard and Poor’s downgrade on August 5th, the DJIA had one of its worst days in history (down 635 points). There is a high probability of more such action over the next few weeks because the gridlock in D.C. has only become worse.

  2. The Japanese stock bubble has been extremely volatile of late, as the nation sprints towards a bond and equity market crisis. The Nikkei Dow surged over 70% in less than 6 months on the back of Abenomics—an economic system that is predicated on raising taxes and creating inflation by destroying your currency. However, the benchmark index has since peaked in mid-may. The relatively new Abe regime has already been able to create inflation even after the Japanese economy witnessed years upon years of falling prices. The problem is, this new paradigm of perpetually rising prices must very soon be reflected by rising bond yields as well. The Japanese Ten-Year note is trading at 0.76% even though the nation now has accumulated over one quadrillion Yen in debt. The interest rate level is far below the 1.5% yield it displayed just prior to the Great Recession of 2008. It should be noted that the yield was twice as high as it is today, despite the fact that Japanese CPI was near zero percent. Nevertheless, we have recently viewed the YOY change in inflation rising from -0.9% in April, to +0.2% in July. At this current pace, the rate of inflation will be close to 1.0% within three months. This should cause a significant back up in yields and force the nation to use most of its revenue just to pay the interest on its debt; leading to extreme turmoil in Japanese equities. Depending on the response from the BOJ, investors may see a reversal of the Yen carry trade, which will also lead to extreme disruptions in currency values and equity exchanges worldwide. The tenuous situation in Japan is not currently being factored into global markets and is another shock that could hit the system within the next 90 days.

  3. Perhaps most importantly, the start of Fed tapering in the fall will send U.S. Treasury prices lower and pop the bubbles that exist in stocks and home prices. I say bubbles in stock values because the S&P 500 is up 23% since last August, despite the fact that there hasn’t been any revenue growth to accompany that move. And home prices are up double digits YOY (the same growth rate seen at the height of the real estate bubble) primarily because interest rates have been artificially suppressed to record lows for the past 5 years. Money printing and interest rate manipulation are the reasons why we have re-ignited those two asset bubbles. Markets are currently extremely confused about when the tapering will commence and how much Mr. Bernanke will reduce his purchases of bonds. But who can blame investors for feeling this way? The Fed seems to swing between dovish and hawkish stances with every economic data point and the subsequent stock market reaction. However, I believe Bernanke wants to start unwinding his purchases before his tenure is completed this year. Wall Street is currently miscalculating how important the Fed’s bond purchases are to the continued bull market in equity and real estate. An extremely high percentage of investors either believe tapering won’t start this year; or believe if such a reduction of bond purchases occurs, the effect on asset prices and bond yields will be inconsequential. The truth is that the removal of the Fed’s bid for bonds could cause a stampede out of fixed income products and cause interest rates to soar. The free market wants no part of a U.S. Treasuries at current yields unless investors can be sure that the Fed will continue to be the dominant buyer. A spike in bond yields would put more pressure on the real estate sector, which has already witnessed increased order cancellations for new homes and a 30% hit to the stock prices of home builders since the tapering talk began in May. And without $85 billion worth of newly created credit stuffed into banks’ coffers each month, a significant bid in the stock market will be removed as well. Of course, I have to mention the government’s fiscal duress that will come from ballooning deficits caused by increased debt service payments on U.S. debt. Whether or not the bond market crashes before November cannot be known for certain. Nevertheless, the bond market will eventually collapse with devastating consequences whenever it does occur.

Although there are no guarantees in this game of investing, I find it imperative to understand that the odds of a correction in the magnitude of around 20% for the major averages have greatly increased during the next three months. The economic turmoil resulting from any one of the above scenarios should bring central banks around the globe into a new money printing spree that would dwarf anything investors have seen to date.

 

Second Half Recovery Predictions Fail Again
August 9, 2013

Each of the last five years Wall Street pundits have predicted, and our government has promised, that a second half recovery in the economy will occur. Since 2009, they have come up with different reasons why GDP would boom in Q3 & Q4 of that year; and that this time a different and better outcome is in store. This year, the reason we are supposed to believe in a second half recovery is because the damage from the Sequester cuts will wear off starting in…drum roll…July.

But the truth is there hasn’t been any significant damage to the economy from the Sequester. This is because cutting government spending leaves more money in the hands of the private sector. Also, the Fed has continued to pump $85 billion into the economy even though there has been a small contraction in the deficit. So there hasn’t been any drag on GDP from which we will rebound. However, what is news is that there has been a surge in bond yields and oil prices, which will crimp consumers’ ability to spend. But those cheerleaders choose to ignore these facts.

The release of the NFP report for July is already dashing hope of a second-half rebound. There were only 162k jobs created last month. What’s worse is that more people left the workforce, aggregate hours worked fell and average hourly earnings declined. These aren’t numbers that would even hint that the economy was going to rebound from the pitiful 1.4% growth rate experienced in the first six months of this year.

Of course, the answer we get from government is to do more of the same thing that isn’t working. More debt, more money printing and a further extension of asset bubbles are the solutions they provide. It doesn’t matter that five years of zero percent interest rates and QE have failed to spur real growth. Their prescription only leads to a zombie economy that limps along because it is based on creating consumption through rising equity and home prices and not through sustainable income growth.

The strategy deployed by government prevents the economy from undergoing a genuine healing. Deflation (which has now become the archenemy of the Fed) is the real solution. We must allow our total debt—which stands at 350% of GDP—to contract to a more sustainable level (somewhere well below 200% of our economy). In order to bring aggregate debt levels down to size, we must first let the free market set interest rates, shrink the money supply and allow asset prices to fall.

This would bring about real and lasting growth because it would not only ameliorate our debt burden but also; stabilize the dollar, keep interest rates low, reduce our tax burden, and eliminate the threat of runaway inflation. Those conditions are the only real progenitors of a healthy economy.

Unfortunately, since this real solution would also include a short but nasty depression, politicians won’t allow it to occur. Instead, our government and Fed would rather continue to promulgate, to a Wall Street community that is more than willing to believe, that a recovery in GDP is just around the corner. And that it would be foolish to stop borrowing and printing money now that growth (in their opinion) is about to achieve “escape velocity”—whatever that means.

More debt and more inflation are constantly being shoved down our throats without our consent. Nevertheless, the market always trumps government interventions…and eventually it will eschew our debt and currency. This means investors must protect themselves by owning PMs from the inevitable economic chaos that is sure to come soon.

 

U.S. of OPEC
August 5, 2013

As someone who cheers for the success of this great country, I desperately want to believe in the concept of America’s energy independence. In the past decade we have been inundated with predictions of the U.S. becoming the next Saudi Arabia of oil and natural gas production. Fracking, tar sands, shale gas…et al, are supposed to bring about a manufacturing renaissance and trade surplus in the near future. But, as of now there isn’t much evidence we are headed in that direction.

It is true that the U.S. is importing much less oil than in the past. During 2005 we imported 60% of our oil consumption--that dropped to just 40% last year. The fact is we are producing more oil and natural gas--so why aren’t we enjoying any of those real benefits?

Natural gas prices have plunged from the low double digits in 2008, to $3.5/mcf currently; most of which was caused by the overwhelming belief that we would be suffocating in natural gas by now. However, prices bottomed 18 months ago and now seem to be headed higher. Conversely, in the case of oil, prices have been rising over the past four years from below $60, to over $105 per barrel today. Therefore, so far at best it’s been a mixed picture on seeing reduced energy prices from the oil and gas revolution we were promised.

But has the increased energy production boosted our manufacturing sector or helped with our balance of payments deficit? The short answer is no. Manufacturing as a percentage of GDP was 11.9 for last year. That figure is down from 12.1% during 2007. And, most importantly, there was an average of 13,879,000 persons employed in the manufacturing sector during 2007. The average number of persons employed in this sector by 2012 plummeted to just 11,919,000. This trend is continuing, with the U.S. losing 52k manufacturing jobs Y.O.Y. from June 2013. It’s simply hard to come up with a story about a domestic manufacturing renaissance when we lost nearly 2mm jobs in just the last five years. Also, there hasn’t been any significant improvement in our trade deficit since the Great Recession ended. The downturn in the economy and global trade occurred in the summer of 2009. The U.S. trade deficit was $32 billion in July of 2009; it has slowly climbed back to over $45 billion in May of this year.

It is my hope that our increased energy production will lead to: low natural gas prices that are sustained; much lower oil prices from where they are today; a boom in manufacturing jobs, and a trade surplus in the near future. Nevertheless, we don’t seem to be headed in that direction at this time. Perhaps the best explanation for this is that a revival of the goods-producing sector of the U.S. economy requires much more than just an increase in domestic energy production. If we don’t also reform our tax structure, reduce regulations, lower labor costs, boost the educational system, stabilize interest rates and strengthen our nation’s balance sheet it won’t fix the problem…even if we had all the energy production in the world.

 

Housing Recovery in Jeopardy
July 29th 2013

A major determinant for U.S. GDP growth is the state of the real estate sector. The construction of new homes contains only small section of the total picture. New appliance purchases and home furnishings go hand in hand with all the ancillary employment surrounding the housing market. Real Estate brokers, banking and legal functions are all necessary to support the buying and selling of new and existing houses. Most importantly, rising real estate prices increase the net worth of consumers, which in turn boosts credit creation, consumption and economic activity. These points were overlooked back in 2007; and the major reason why nearly everyone on Wall Street and in Washington was blindsided by from the fallout of collapsing real estate prices.

The real estate debacle was the cause of the Great Recession and it is also now being credited for bringing it to an end. But the lynchpin behind this economic recovery has been the government’s ability to increase home prices through the process of artificially creating record-low interest rates and by having the Fed purchase impaired loans from banks’ balance sheets.

However, this ersatz and temporary recovery is now running into trouble.

The affordability of homes once caused by plunging prices and record low borrowing costs caused investors to flock into the housing sector. According to the Case-Shiller Home Price Index, real estate prices dropped 35% from peak to trough. Speculators scooped up foreclosed properties that were being dumped on the market without much regard to price. Private Equity firms and hedge funds purchased properties mostly with cash; and whatever extra money they desired to borrow came nearly for free.

Those days have now past.

Home prices had been plummeting up until 2009, but then started to stabilize during 2010. However, now they have returned to their growth rates experienced during the bubble era of 2000-2006. The National Association of Realtors reported that median existing home prices increased 13.5% from June of last year. What’s more, formerly plunging bond yields have also started to increase. Freddie Mac reported that rates on thirty-year fixed mortgages have soared nearly 35% since early May.

Perhaps this is why the NAR reported last week that investor purchases made up only 15% of June sales, which is the lowest percentage since the realty association began tracking the data in 2008.

Investors are now saturated with foreclosed properties and much of the easy money has been made. So it is up to first-time home buyers to take up the slack. However, with real median incomes rising just 1.1% YOY (far below the increase in home prices) there isn’t much hope for individual consumers to supplant the hedge fund community…especially since first-time home buyers cannot pay cash and will be required to meet the now tightened lending standards of banks.

What’s more, a recent report from the Special Inspector General of the Troubled Asset Relief Program indicated that 46% of distressed home owners that received loan modifications from the government during 2009 had re-defaulted. Therefore, expect hundreds of thousands of foreclosed properties to hit the market in the near future. Perhaps the increased inventory and rising mortgage rates will bring down prices and eventually cause speculators to jump back into the picture. Nevertheless, this probably won’t occur until property values decline significantly first.

Evidence of this slowdown can already be found in the earnings reports of major home builders. PulteGroup reported that rising borrowing cost have already started to hurt sales. The largest U.S. home builder by market value reported that orders decreased 12% for the second quarter.

Back in 2009, plunging mortgage rates and home prices allowed the real estate market to bottom. In contrast, we now have rising borrowing costs, soaring homing prices and little income growth. Those factors are all working against the affordability of real estate.

It is also important to understand that rising interest rates are not affiliated with a surge in economic growth. The Bernanke Fed has recently indicated that a reduction in MBS and Treasury purchases may occur in the next few months, causing investors to fear the eventual removal of the Fed’s bid on fixed income. If such tapering occurs, the rate on the thirty-year fixed mortgage could go north of 6% in very short order.

Soaring mortgage rates will cause the housing market to undergo another leg down. Of course, the economy will go along for the ride and a severe recession will ensue. Once the Fed realizes how addicted the real estate market and the economy are to artificially-low interest rates, it will end the tapering of QE and dramatically increase the allotment of monthly purchase. I expect a significant increase in hard assets and a protracted bull market in PMs once the central bank makes the proclamation that the size of its balance sheet is without limit.

 

Stock Market Correction Ahead
July 16th 2013

The S&P 500 is trading at all-time nominal high, despite the fact that revenue growth has been hard to come by. So, where is the U.S. economy headed and what does it mean for earnings and equity prices?

The U.S. Ten-Year Note yield has been rising of late. Absent another recession, or renewed European debt crisis that threatens the existence of the Euro currency, or the Fed launching QEV; the yield should approach 4% by the end of this year. How much should we be concerned about yields rising to that level? Well, the surge in yields from 1.6%, to 2.6% since the beginning of May has already caused purchase applications for new homes to plunge 28% month over month. Mr. Bernanke predicated the economy's healing on saving the real estate market. Since the Fed is now threatening to begin removing its stimulus programs, that primary support column for the economy is being eliminated

One has to question what rising rates will do for this so called recovery. The U.S. economy (and indeed the rest of the globe as well) is already suffering from anemic growth. Now we are told by the puppet masters of the economy that the manipulation of long-term interest rates is finally going to end. Or at least that's the plan; until those in charge realize how addicted the economy has become to artificially low rates.

There's plenty of evidence that the global economy is just treading water. Base metal prices have fallen sharply in the last six months. Chinese exports were down 3.1% in June on a YOY basis, while exports to Europe plunged 8.3%. The IMF lowered its growth forecast for the U.S. to just 1.7% in 2013. And the European recession is deepening (unemployment rising to 12.2%) with Greek unemployment hitting a record 26.8%. Emerging market economies are suffering, while Japan is headed towards a complete collapse of its currency and bond market. And, U.S. GDP growth in Q2 should be close to zero, which will be down from the already anemic growth rate of just 1.8% during Q1.

So, where do we go from here? Now we have to add to this global malaise; the surge in oil prices, Middle East revolutions, an attempt at ending QE, and most importantly, rising borrowing costs in the United States. But yields aren't just rising in the United States. For example, the Portuguese 10 Year Note jumped from 5.2% in the middle of May, to 7.5 by early July%.

The rise in debt service payments and cost of money will cause the already fragile global economy to fall sharply lower. Revenue and Earnings growth will suffer as a consequence. Look for a correction of at least 10% in the S&P 500 by the end of this summer.

 

How High Will Interest Rates Go?
July 9th 2013

To best answer the question as to where U.S. Treasury yields are headed in the next quarter or two, it is important to know where they would be without the manipulation of our central bank, where they would be in a growing economy and, also, absent the threat from an imminent collapse of a major foreign currency. The current yield on the Ten-Year Note is 2.6%, up from 1.6% less than two months ago. True, that rate has surged of late but it is still far below its 40-year average of around 7%. But just prior to the beginning of the Great Recession (in fall of 2007) the yield on the Ten-Year Note was 4%--150 basis points higher than today.

And in the spring of 2010; a year after the recession ended, the conclusion of QEI and prior to the Greek bailout, the Ten-Year posted a yield of 3.8%. Therefore, it isn’t at all a stretch to anticipate yields going back toward 4% in the very near future--If indeed it is true that we are not currently in a recession, the Fed will soon start to winding down QE and there is no mass piling into Treasuries from a collapsing foreign currency.

What’s more, the Fed now holds over $3.5 trillion worth of securities on its balance sheet, $1.9 trillion of which are U.S. Treasuries. That compares with just $800 billion at the start of 2008. This means if the market now believes the Fed has started down the path of eventually unwinding its balance sheet the selling pressure will be immensely magnified as compared to several years ago. In addition, due to banking distress in China and a back up in yields in Japan, these sovereign governments may not be able to support Treasury prices to the same extent as they did in the past. These two nations already own $2.3 trillion of the current outstanding $11.9 trillion worth of Treasury debt.

Meanwhile, the Fed persists in sophomoric fashion to scold the market for misinterpreting its mixed messages about tapering the amount of asset purchases. But the big surprise for Mr. Bernanke and co. will be the realization that they have much less control of long term rates than they now believe.

I’ve been on record warning that once the market perceives the exit for QE is near, yields will rise. Nevertheless, expect most on Wall Street to claim the increase in rates has its basis in a growing economy and, therefore, represents good news for markets. But the true fallout from interest rate normalization will not be pretty; for it will reveal a banking system and an economy that is perilously close to insolvency.

 

Unprecedented Volatility has Begun
July 1st 2013

I have warned investors in the past that the Fed’s rapid expansion of credit would cause the U.S. economy to enter a period of unprecedented volatility between inflation and deflation. This would lead to violent moves in most markets, especially interest rate sensitive investments. That time has now arrived.

The easy monetary policy from most central banks has led to low interest rate addictions and global imbalances on a massive scale. Therefore, any threatened removal of central banks’ liquidity would cause the pendulum to swing intensely from inflation to deflation. Recent communications from the People’s Bank of China and Fed (although a parade of FOMC members has been trying to recant Bernanke’s comments) have tried to wean the market’s dependency on free money.

The problem is markets have become so addicted to low interest rates and liquidity injections that even a hint at preparing markets for the eventual increase of rates caused massive repercussions. Perhaps that is the message plunging commodity prices have been telling us.

In China, the threat of withdrawing stimulus caused their interbank lending rate (SHIPOR) to spike from 3%, to over 10% within a week. This tells us Chinese real estate assets are in such distress that banks do not trust each other’s collateral when making overnight loans. Sort of reminds you of our LIBOR market debacle the U.S. suffered through back in 2008 before the S&P 500 plunged 60%. The manipulation of money supply and investments by the Chinese government caused runaway inflation in their housing sector. Now, the attempt at normalization in the real estate market by the new Xi Jinping regime has revealed its insolvent condition and helped send the Shanghai Stock Market down 15% in the last month.

Some countries have just begun the pursuit of record-breaking inflation. In Japan, the Abe regime is not pursing policies that promote viable economic growth; but has instead based a recovery on currency destruction and inflation. Europe has already aggressively tried the growth model that is based on deficit spending and inflation. And by all accounts their problems continue to mount, with Ireland falling back into a recession; just as Italy’s recession protracts and deepens. Emerging markets continue to suffer slow growth. The Emerging Market Index, which is down 16% YTD alone, shows the condition is only getting worse. These countries depend on supplying materials to the developed world for growth. However, as these established economies suffer through the devastating effects from massive inflation and deflation, demand for imports suffers greatly.

But the Fed seems convinced that the U.S. economy is strong enough to withstand the negative effects from a global economic malaise. Despite the chaos that is brewing all over the globe, Ben Bernanke still provided the markets with a timeline for ending his QE program and predicted the economy will magically recover in 2014. If that is indeed the case, it will be the first accurate forecast made since the Federal Reserve was created in 1913.

Why should the U.S. economy strengthen next year? It wouldn’t come from strong exports to a vibrant global economy. There hasn’t been any reduction in taxes or regulations and the dollar has become very unstable. And, most importantly, it appears the thirty-year bull market in Treasuries has ended quite abruptly. The yield on the Ten-Year Note soared from 1.6%, to 2.67% in a matter of days. The Fed seems oblivious to the fact that markets have become completely reliant on perpetual inflation; and merely indicating the intention of stopping to manipulate interest rates causes a violent move upward.

Despite all this, I believe the Fed has realized QE can’t go on forever and is desperate to start winding it down. However, I am even more convinced the U.S. economy will dramatically slow this summer (from an already anemic 1.8% growth rate) and cause a reluctant Ben Bernanke to hold any tapering of asset purchase in abeyance. In fact, he may even increase the current monthly $85 billion allotment.

This means, unfortunately, investors and consumers will suffer yet more violent moves between inflation and deflation in the future. Gold miners are now in the process of putting in a bottom and telegraphing the fact that in the near future central bankers will acknowledge their addictions to low interest rates and credit creation; and probably print even more.

 

Baffled Bernanke Sinks Stocks
June 20th 2013

The incredibly confused Fed is desperately trying to maintain its unprecedented control over the most important price signal in our economy, which is the level of interest rates. But it is failing. Mr. Bernanke not only doesn’t control long-term interest rates (as he now believes) but he is also unaware that the economy has become completely addicted to Fed’s level of credit creation and its ability to create asset bubbles.

Some on the Fed contend inflation is too low, while others want to begin tapering immediately.

From the Fed’s Statement released last week: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”

Mr. Bernanke also stated that if the economic conditions continue to improve, the Fed would begin tapering QE in the fall and could terminate the program by mid-2014. However, that very same day, the Federal Reserve also trimmed its growth forecast for 2013 and slashed its inflation outlook…going against both its mandates!

The economy is now expected to grow at an annual rate of 2.3-2.6 percent, slightly below the 2.8 percent top-end growth previously forecast. It also projected inflation would come in between 0.8-1.2 percent in 2013, instead of 1.3-1.7 percent seen in March. Keep in mind, Mr. Bernanke thought inflation and growth were so anemic only six months ago that the he started buying $85 billion worth per month of unsterilized MBS and Treasuries. And now he wants to start taking all that QE away, even though he has simultaneously downgraded the outlook for growth and inflation.

Bernanke is completely confused; but markets are not. The yield on Ten-Year soared to 2.67% by Monday.

The aggressive tapering laid out by the Fed would crush bonds, real estate, equities and the economy because the $54 trillion in total U.S. debt cannot be easily serviced without perpetually low interest rates. Investors should now be laser focused on future economic news. Unless the data is profoundly weak, the Fed’s taper will begin on schedule in the fall. I believe Mr. Bernanke wants to leave at year’s end and is now working on his legacy. Bernanke wants to say he started to reverse his unprecedented stimulus and returned the economy on a path towards free markets. But our central bank would not be tapering into strong economic growth, as they would like you to believe, but instead because of the fear that Fed has simply gone too far.

Bernanke may be making a tacit admission that five year’s worth of interest rate manipulation and credit creation has done all it is able to do for the economy and the size of the Fed’s balance sheet has become too daunting.

Investors need to be on red alert and get defensive until the data turn decidedly negative. Expect violent moves between deflation and inflation going forward. When the next recession looms (perhaps in early 2014) the Fed will announce the tapering strategy has been put on ice and the rebuilding of the Fed’s balance sheet has recommenced. Asset bubble blowing will once again become in vogue and the markets can start to celebrate the re-inflation of equity prices. However, the middle class will once again suffer, as they witness their purchasing power and standard of living further erode.

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

 

Market Calls Fed's Bluff
June 17th 2013

The Fed has recently expressed a desire to begin winding down its Quantitative Easing program in the next few months. This would be the first step towards the eventual raising of interest rates. Mr. Bernanke and the other members of our central bank believe the normalization of interest rates would occur within the context of robust markets and rising GDP growth.

However, it seems the Fed has only succeeded in duping some perennial bulls (and possibly even trying to convince itself) into believing that ending QE and the subsequent increase in rates would not adversely affect the economy…but markets are not so easily fooled. Their threat of reducing mortgage and Treasury purchases caused the yield on the U.S. Ten-Year Note to rise from 1.6% on May 2nd, to 2.23% by June 12th. The sharp percentage jump in borrowing costs caused markets to quake around the globe.

European and Asian bond yields became unglued and equity markets retreated across the board. For example, the Power Shares emerging market sovereign debt fund plunged 12% in the last 30 days. In addition, the Italian MIBTEL dropped 10% in less than one month and the Nikkei Dow plunged over 20% from its May 22nd level. Interest rate sensitive stocks in the U.S. took a tumble as well. Utility stocks dropped over 10% since the start of May. Homebuilders like The Ryland Group dropped 19%, while Toll Brothers shed 15%. If there was any doubt how the real estate market would fare under a rising interest rate environment the selloff in real estate stocks settled that debate. Markets are telling the central bank in clear terms that rising rates will crush equities, bonds and economies once the crutch derived from artificial interest rates is removed.

There are unanticipated and unintended consequences from the central banks' manipulation of interest rates. The Yen carry trade is one of them. Investors borrowing Yen to purchase assets denominated in other currencies has been a common trade under Abenomics-the economic recovery strategy adopted by Japan's Prime Minister that uses currency destruction and inflation as a substitute for viable growth. However, the addiction to low interest rates and a falling Yen becomes massive once protracted. Therefore, a forced and panicked unwinding proves to be devastating.

In the U.S., rising interest rates will be pernicious as well. This is because our debt cannot be serviced at much higher interest rates without engendering another severe recession/depression. Household debt as a percentage of GDP was 80% at the end of Q1 2013. That's higher than any period of time prior to Q1 2003 and twice as high as it was when Nixon broke the gold window in 1971. More importantly, the government deficit for 2013 will be the 5th greatest in U.S. history and the total national debt is currently $16.8 trillion, which is 105% of GDP and the highest level since 1948.

The Fed is aware of the above data; but up until recently has refused to publicly recognize the danger of increased borrowing costs. Instead, the central bank persisted in its quest to convey to markets the notion that it can allow rates to rise without significant consequences. But perhaps the recent market reaction to trial balloons regarding the attenuation of QE has shaken the Fed's demeanor.

A correspondent for the WSJ and noted mouthpiece for the Fed wrote the following in recent blog; "Federal Reserve officials have been trying to convince investors for weeks not to overreact when the central bank starts pulling back on its $85 billion-per-month bond-buying program. An adjustment in the program won't mean that it will end all at once, officials say, and even more importantly it won't mean that the Fed is anywhere near raising short-term interest rates." His commentary sent the Dow Jones soaring 180 points and Ten-Year yields to drop sharply the same day of its release.

A relatively small advance in the Ten-Year Note (63 basis points) towards its inevitable average of over 7% caused the Fed to backpedal on its plan to wind down QE. The fact is the Fed cannot allow rates to rise unless it is also willing to let a deflationary depression reconcile the economic imbalances created over the past few decades.

Most importantly, the biggest surprise is yet to come for the Fed. Mr. Bernanke and co., will learn in a relatively short amount of time that they do not control long-term interest rates no matter how they may try. Inflation and record debt levels; or an eventual selling off of the Fed's balance sheet will send interest rates on the long end of the curve soaring.

Expect unprecedented turmoil in global markets when that inevitability occurs. Ownership of precious metals will help investors preserve their wealth during the coming economic calamity.

 

Here's Your Inflation
June 10th 2013

Wall St. Pundits have summarily exculpated Ben Bernanke from the negative effects derived from artificial interest rates and massive increase in the Fed’s balance sheet. Specifically, most market commentators now claim with certainty that the central bank’s unprecedented manipulation of markets has been done without creating any inflation.

This assertion is untrue in every aspect. Most importantly, the Fed’s quest to boost asset prices has been accomplished by creating credit by decree. In other words, Mr. Bernanke has purchased more than $2.5 trillion worth of MBS and Treasuries with newly manufactured money within the last five years alone. Therefore, there has already been $2.5 trillion worth of inflation that has been directly injected into mortgage and Treasury securities; and this number is still growing at a rate of $85 billion each month. This means the Fed is causing a tremendous amount of inflation to occur in bond prices.

Banks have taken the Fed’s new money and purchased new assets including equities, MBS and Treasuries, which in turn has helped push interest rates down to record lows. Bernanke’s debt monetization has sent stock prices up 140% from their lows and sent home prices rising 10.2% YOY on a national basis, according to the S&P/Case-Shiller Index. Inflation is very evident in stocks values and has now even caused real estate prices to jump.

This process of balance sheet expansion has caused the broad money supply M2 to rise 7% YOY. With real GDP growing at just 1.5-2% annual rate, the excess money growth is causing asset prices to rise.

But the major point here is the Fed has convinced many that re-inflating asset bubbles doesn’t count as having produced any inflation. The best illustration of this point is the price of oil. Throughout the decades of the 80’s and 90’s the price of oil fluctuated around $30 per barrel. It started the 80’s at $32 and began the new millennium at just $27 for a barrel of WTI crude. Starting in the mid-2000’s, low interest rates, a falling dollar and Fed-engineered bubbles caused the oil price to eventually rise to $147 by 2008. Then, the Great Recession helped send the oil price back to $33 a barrel in early 2009. However, the Fed’s quest for ever-increasing inflation has propelled the oil price back to $94 today.

This is how our central bank views inflation: keeping asset prices (in this example oil) more than 200% above its two-decade average doesn’t count as inflation; it’s just keeping asset bubbles from correcting. The same can be said about the equity market as well. Stock prices are at all-time nominal highs, which the Fed counts as a victory, and as such, Mr. Bernanke is disregarding the fact that they had previously been in an unsustainable bubble.

What’s worse is the inflation debate isn’t at all over. Money and interest rate manipulations courtesy of the Fed have allowed the government to amass a debt load that far outstrips its tax base. Therefore, since the tax base cannot support the amount of outstanding debt it will have to monetized in a more aggressive and permanent fashion. In other words, if you think prices are already killing the middle class and destroying your standard of living; just stay tuned, the worst is yet to come.

 

Low Interest Rate Addictions
May 31, 2013

It is amazing so many investors are oblivious to the fact that the developed world is completely addicted to artificially-produced low interest rates. Perhaps that is why there is still a debate over whether the ending of QE will adversely affect the economy, and if rising rates can occur within the context of a healthy economy.

It isn’t so much about whether or not QE is about to end, or even if growth is now causing interest rates to become unglued. The truth is the end of QE and the normalization of interest rates—for whatever reason--means it will be the end of this anemic and unsustainable recovery in both Japan and the U. S. economies. This is because you cannot separate the central banks’ influence on markets from their affect on economies. The BOJ and Fed have dramatically supported equity and real estate prices by taking interest rates to record lows. Therefore, it is simply illogical to then assume that rates can increase without negative ramifications.

The nascent and fragile recovery in Japan has been predicated on vastly lowering the Yen’s value and by inflating asset prices. Likewise, our economic stabilization has been accomplished through the Fed’s dilution of the dollar. The Fed has monetized trillions of dollars in deficits and helped send the S&P 500 up 140% in five years. One should not credit corporate earnings for the rebound in equity prices and then ignore the fact that better profits have been realized as a result of our central bank’s ability to re-inflate the consumption bubble. And, most importantly, record-low interest rates have provided consumers and government with massive debt service relief. Without the aid of rising real estate and equity values (brought about by central bank debt monetization), along with drastically reduced debt payments, the consumer and the economy would be in full deleverage mode.

Rising interest rates have now become the lynchpin in the Japanese and U.S. economies. Japan’s national debt to GDP was “just” 170% in 2008. Today it has climbed all the way up to 230% of the economy. In the U.S., the publicly traded debt jumped by $7 trillion since the start of the Great Recession. Our total debt hit a record $49 trillion (353% of GDP) at the end of 2007—which precipitated a total economic collapse. But by the start of 2013, total U.S. debt increased to $54 trillion, which was still 350% of our GDP. It is clear, once that interest rate “pin” is pulled, the entire house of cards will collapse.

Evidence of this interest rate addiction is very easy to find. Just this week the U.S. 10-Year Note yield spiked to 2.16%, which eclipsed the dividend yield on the S&P 500 and reached a 13-month high. Stock prices didn’t like it at all and the S&P 500 dropped as low as 2% on Wednesday the 29th, before rebounding slightly after a speech was given by Federal Reserve Bank of Boston President Eric Rosengren. He indicated in his prepared remarks that the Fed should continue with record stimulus to engender stronger growth, reduce unemployment and boost inflation. His promise of continued interest rate manipulation calmed bond yields back down to 2.12%.

The same is true for Japan. Their 10-Year Note jumped from 0.6% on May 9th, to near 1% in a matter of days, which sent the Nikkei Dow down over 1,100 points on May 23rd.

Central banks have created the illusion of growth that is based upon re-inflating asset prices. And, it is also predicated on their ability to suppress interest rates.

However, record debt levels and central bank inflation targets are a deadly combination. Once those inflation targets are achieved, the bond vigilantes will have the central banks in checkmate. The Fed and BOJ will then have to choose whether they want to aggressively raise interest rate; by not only ceasing bond purchases but also unwinding their massive balance sheets in order to fight inflation. Or, they can sit idly by and gradually let their balance sheets run off; while watching inflation—the bane of the bond market—send bond prices plunging and yields soaring. In either case it will mean the end of the over thirty-year bull market in bonds. And it will finally prove beyond a doubt that the combination of interest rate manipulations, massive levels of debt and betting the economy’s future growth on creating ever-increasing inflation is nothing short of a miserable mistake.

 

Why Tepper Should Fear the Taper
May 17th 2013

Billionaire hedge fund manager, David Tepper, made news this week when he emphatically stated that investors have nothing at all to fear regarding the eventual tapering off of Fed's $85 billion worth of monthly debt monetization. His assertions were based on the fact that our annual deficit is shrinking and would thus require less of Bernanke’s money printing.

Besides the fact that the deficit for fiscal 2013 will still be about $500 billion higher than it was before the Great Recession began at the end of 2007, markets have two other reasons to fear the cessation of quantitative easing. What Mr. Tepper doesn’t realize is the end of QE will cause the U.S. dollar and interest rates to soar. And that will have devastating consequences for the markets and economy in the short term.

Since February of this year, the dollar has increased by 6.3% against our six largest trading partners. Just imagine how it would then surge if the Fed were to start aggressively reducing its bond-buying program…especially in light of the surging debt monetization now occurring over in Japan and the protracted recession in Europe. Of course, a stronger dollar would be greatly beneficial to the American economy in the long term, as it engendered a period of deflation that is needed to reconcile the current imbalances of debt, money supply and asset prices. However, that same deflation would likewise do significant damage to equity prices; as it also vastly lowered the revenue and earnings of S&P 500 corporations.

But the most important problem if Bernanke were to taper QE this summer and bring it completely to a halt by the end of this year, is that the market would then begin to factor in the unwinding of the Fed’s near $3.5 trillion balance sheet. This would, at the very least, cause interest rates to rise back towards the forty-year average of about 7% on the Ten-Year Note.  Interest rates have already been around zero percent for nearly five years. The condition of artificially produced low rate for years on end causes the economy to become addicted to cheap money. Misallocations of capital and economic imbalances occur; like bubbles in equities, real estate and bonds.

In 2007 the real estate bubble popped once the cost of borrowing money to purchase over-priced homes became unaffordable. This caused banks to become insolvent because their assets were primarily involved with real estate loans. Insolvent banks and over-leveraged consumers sent the economy into a depression.  Today, banks and consumers have deleveraged on the margin, but the government has vastly increased its borrowing. At the start of the Great Recession, we had $48.8 trillion in total debt and our GDP was $14.2 trillion (343% debt to GDP). At the end of Q4 2012, the U.S. economy had $53.8 trillion in total debt sitting on top of a $15.8 trillion economy. The current debt to GDP ratio is 340%.

Therefore, we can be sure rising interest rates will bring down the economy this time just as it did six years ago because the total debt to GDP ratio at the start of the Great Recession is exactly the same as it is today. The only difference is the interest rate attached to that debt has been artificially reduced to the low single digits. When rates rise, as they will if the Fed aggressively tapers QE, the government will then learn it does not have the tax base to service its debt.

This is why every time the Fed threatens to end QE the markets tumble and why Tepper, and investors, should fear the eventual taper. Evidence of this fear is abundantly clear. On February 20th the minutes of the January FOMC meeting were released, which indicated members of the Fed were growing concerned about the amount of asset purchases. That very same day the NASDAQ dropped 1.5% and commodity prices tumbled.

In addition, stock market gains appear to have decoupled from market fundamentals and are merely clinging to the hope of endless Fed credit creation. This week’s economic data was profoundly anemic, yet markets still rallied. On Wednesday news came out that Industrial Production dropped 0.5% in April, and the Empire State Manufacturing Index fell to a minus 1.4 in May, from a positive 3.1 in April. Also on Wednesday, we learned that France entered into a double-dip recession and Europe’s recession extended into its sixth straight quarter. Nevertheless, the S&P 500 gained 0.5% that day.

The following day’s economic data was just as bad. On Thursday we learned that the Philly Fed Survey dropped to a minus 5.2 in May, from a positive 1.3 in April, and Initial Unemployment Claims surged 32k for the week ending May 11th. However, the S&P 500 spent most of the day on Thursday in positive territory; until 2:30pm. That’s when San Francisco Fed President John Williams said in a speech, “We could reduce somewhat the pace of our securities purchases, perhaps as early as this summer, and end the program late this year.” The market cared nothing about the current weak economic data but was very much concerned about the threat to end QE. The S&P quickly sold off 0.5% once news broke that the Fed may begin slowing its asset purchases.

The truth is rising debt service payments on government debt will wreak havoc on the economy just as it did for real estate and banks back in 2007.  Artificially-produced low interest rates, record amounts of debt and inflation targets set by central banks make for a very dangerous cocktail. An expeditious tapering on the part of the Fed from QE may be the prudent and necessary thing to do for the long-term health of the country, but it would also send markets and the economy into a cathartic depression in the interim.

 

Bubbles Inflating Faster Than GDP
May 13th 2013

Global central banks have clearly demonstrated the ability to re-inflate stock and real estate bubbles. Global stock markets are roaring ahead of their economies and real estate prices are quickly rebounding from their recent collapse. However, rock-bottom interest rates and massive money printing have yet to show an aptitude for creating sustainable GDP growth.

There has been a lot of talk about a rebound in the equity and real estate markets helped along by the Fed's free money. That much is for sure the truth; but the evidence of a viable and sustainable recovery built on free-market forces just isn't there.

For example, the percentage of consumers who own their own home continued to fall during the first quarter of 2013, dropping to a national level that hasn't been seen since the fall of 1995. The Census Bureau reported that the nation's homeownership rate slipped to 65% in Q1 2013, a decline from 65.4% posted in the last quarter of 2012. The rate of home ownership now stands at a 17-year low!

But if the housing market was gaining ground on stable footing then why is it that first-time home buyers and owner occupiers aren't participating. Instead, it has been hedge funds and speculators that are sopping up all the foreclosures. One has to wonder if these "investors" will hold onto their rental properties if the economy tanks once again and home prices take another steep drop.

In addition, the labor market isn't rebounding as the Fed had hoped and projected it would. Last month's NFP report showed that despite $85 billion per month of QE, 9k goods-producing jobs were lost. And even though you here the MSM talk about resurgence in the manufacturing sector, there were zero manufacturing jobs created in April. What's even worse is that aggregate hours worked fell by 0.4% in April over March. Therefore, despite the fact that the Labor Department says that 165k net new jobs were created, the actual total number of labor hours worked was in decline.

There is a reason why the Fed and other central banks have been unable to achieve a healthy and viable economy even after five years of trying to manufacture one from a printing press. The truth is an economy that is soaked in debt just doesn't grow because it is always marked by at least one, if not all three, of the following growth-killing conditions; high interest rates, rampant inflation and onerous tax rates.

Any country with outstanding debt that is equal to or greater than its GDP is forced into sucking an exorbitant amount of capital out of the private sector due to burdensome rollovers and interest payments on that debt. In addition, rising tax rates act as a disincentive to increase productivity and whatever money that is taken from the private sector is always redeployed in an inefficient, GDP-destroying manner. Rising interest costs also discourage borrowing and lead to capital shortages. And finally, inflation destroys the purchasing power of the middle class by eroding the value of the currency and leaving consumers with an inability to make discretionary purchases.

But central bankers don't acknowledge this truth and are instead seeking to increase their efforts in pursuit of ever-increasing money supply growth. Of course we are all familiar with the counterfeiting undertakings of the Fed and BOJ. Now Australia's central bank is joining the crowd of inflation lovers and cut its key interest rate by 25 basis points on Tuesday, to a record low of 2.75%.

Investors need to be aware that if a central bank wants to set an inflation target it will be achieved. ECB President Mario Draghi said recently that the ECB was "technically ready" to shift the deposit rate into negative territory, meaning it would start charging lenders for holding their money with the central bank. A bank cannot accept a negative return on its assets. Therefore, if Draghi follows through on his threat, expect money supply growth and inflation to kick into high gear over in Euroland.

The bottom line is that central bankers are totally inept at creating economic growth but extremely proficient at building asset bubbles. Inflation targets will be met and exceeded as they deploy their new "tools" of charging interest on excess reserves and buying up the stock market. They are in the process of rebuilding the equity and housing bubbles and have already created a massive bubble in the sovereign debt of Europe, America and Japan. Once this bubble breaks (like every other bubble has done in the past) expect economic chaos in unprecedented fashion.

 

GDP Bag of Tricks
April 30th 2013

If you're not happy with the stumbling U.S. economy all you have to do is just wait a few more months. It seems the Bureau of Economic Analysis (BEA) will perform a little hocus pocus on the GDP numbers starting in July 2013. According to the Financial Times, U.S. GDP would become 3% bigger due to the new change in its growth calculations.

It shouldn't come as a surprise they are going to change the way this number is reported. When GDP numbers are chronically bad (averaging just 1.45% in the last two quarters) and the labor force participation rate is perpetually falling, our government will do the same thing they did for the inflation data; tinker with the formula until you get the desired result. But lowering the reported rate of inflation wasn't able to increase the standard of living for the middle class. And neither will fudging the GDP methodology engender an improvement in the creditworthiness of the nation.

The government will make a significant change in the gross investment number, which will now include; research and development spending, art, music, film and book royalties and other forms of entertainment as the equivalent of tangible goods production. The U.S. will be the first nation on earth to pull off this magical GDP trick.

But the shenanigans played by government may fool some people into thinking that growth in the U.S. is gaining strength. It may even convince some investors that the debt and deficit to GDP ratio is falling. In addition, it may cause politicians to claim that government spending as a share of the economy is shrinking, so it's ok to ramp up the largess.

However, the BEA and our leaders in Washington have overlooked the most important point, as they so often do, which is that revenue to the government cannot be faked. Even if D.C. desired to count all the sea shells washed up onto America's beaches as part of our gross domestic product, it would not increase the amount of tax receipts to the government by a single penny. Therefore, it cannot alter the only metric that really counts; and that is our nation's debt and deficits as a percentage of government income. It will not increase by one penny the amount of revenue available to the government to service our debt and this, in the end, is all our creditors are really concerned about.

Revenue to the government was $2.58 trillion in fiscal 2007. But despite all the government spending and money printing by the Fed, revenue for fiscal 2013 is projected to be just $2.7 trillion. The growth in Federal revenue has been just over $100 billion in 6 years! Nevertheless, our publicly traded debt has grown by $7 trillion during that same time frame. The fact is that the U.S. economy isn't growing fast enough to significantly increase the revenue to the government, but our debt is still soaring.

It all comes down to this, the U.S. government will not be able to service its debt once interest rates normalize, and that will be the sad truth regardless of what voodoo tricks Washington uses to report GDP. It's a shame they won't just implement real measures to grow the economy like reduce regulations, simplify the tax code and balance the budget. At least we can all still purchase precious metals and mining shares to protect our portfolios when the curtain finally comes down on government's shameful magic act.

 

Gold Reveals Global Economy on Thin Ice
April 19th 2013

Explanations for this gold selloff abound everywhere and nearly all of them are inane and incorrect. The silliest among all the reasons offered for the current bear market in gold is that Bernanke has recently morphed into a form of Paul Volker; even though he has maintained the Fed’s zero percent interest rate policy and massive money printing continues unabated. His policies have, and will continue to significantly weaken the intrinsic value of the dollar—so you can just summarily dismiss that reason. Another vacuous reason to explain the drop of the gold price is that the U.S. is eventually headed towards a trade surplus. This is because some predict our energy independence in the next ten years, causing the dollar to soar sometime in the future. But the dollar fell from 83 to 82 on the DXY during the month of April, which coincided with the selloff in gold, so that can’t be the reason either. In addition, our National Debt should be near $30 trillion in 10 years; and that would far outweigh any benefit for the dollar that would be gained from a potential trade surplus.

To understand the real reason behind gold’s selloff, investors first need to acknowledge that it’s not just gold coming under pressure. Industrial and growth stocks are plummeting across the board. For example, Caterpillar (CAT) is down 20% in the last 30 days, base-metal commodities are headed into bear market territory and copper is down 15% since February and is now trading at a over a 52-week low. Oil is also dropping sharply of late, falling down to $86 per barrel from the mid-90’s a few week ago. Also, the recent stock market rally has been very narrowly based. Those equities that have been working are defensive in nature like healthcare and consumer staples…that is not representative of a healthy market. What gold is really telling us is that the global economy is on very thin ice.

So it comes down to this; investors should not make the same mistake they did during the fall of 2008, namely, ignoring the deflationary forces that are at work in certain parts of the world. Commodity bear markets aren’t good for earnings if they are representative of a worldwide economic collapse. Going long equities in September of 2008 because oil was headed from $147, to $33 a barrel wasn’t a very good idea. To be clear, I’m not claiming that this is at all the case today. Indeed, Japan and the U.S. are well on the way towards reaching their inflation targets. But investors should be aware that the European economy may be facing a long drawn out battle with deflation. It should be noted that deflation is a necessary circumstance when rebalancing an economy from the ravages of inflation; but in the short term is very negative for stocks. Global GDP will be weak and this will put downward pressure on stocks and commodities that are pegged to growth. However, central banks that are pursuing inflation targets should help boost precious metal prices as they guarantee a stagflationary environment in those economies.

The truth is that deflationary forces are currently very strong in Europe and, to a lesser degree, in China. This week, the IMF lowered the projection for global GDP and reduced its Eurozone GDP forecast, saying it would fall by 0.3% in 2013. Meanwhile, European car sales are approaching a 20-year low; registrations fell 10% in March to 1.35 million vehicles, the 18th consecutive monthly decline.

Major global economies and markets have become bifurcated between those that are aggressively seeking inflation and those that are embracing austerity and deflation. Japan and the U.S. are printing money at record paces, while Europe’s monetary base is static. This makes investing extremely difficult at this time. Investors must be very selective in which country they place funds and be careful to avoid the trap of believing growth will accelerate later in 2013. That is why it is imperative to hold a portfolio that is diversified among countries that are pursuing inflation targets and avoid being over-exposed in sectors of the market that rely on growth.

The bottom line is the selloff in gold bullion is almost over and the vicious bear market in mining shares is soon coming to an end. Those countries that have adopted inflation targets will keep printing until they are achieved and those that have yet to state they are officially pursuing inflation goals should soon (but foolishly) join in the fight. Once all major economies are once again in sync with inflation as their goal, the investment climate will become clearer. In the meantime investors need to buckle their seatbelts because—as I have warned many times in the past—major global economies will be whipsawed between inflation and deflation until they finally crash due to bond market meltdowns.

 

What Drives the Gold Price?
April 8, 2013

There is still an incredible amount of misunderstanding on Wall Street about the relationship between the price of gold and the true value of the U.S. dollar. Most pundits simply claim that a rising dollar, as measured by the Dollar Index (DXY), causes gold prices to fall…and that is the end of their analysis.

In truth, the dollar’s intrinsic value carries the most weight in determining the price of gold and not simply how the dollar is faring vis a vis a basket of other fiat currencies. According to many market analysts, the 5% rise of the dollar on the DXY since February has been attributed to the return of “king dollar” and that, as they claim, is why gold prices are falling. But they simply choose to overlook the fact that the economies of our major trading partners are in recession and the Bank of Japan’s monetary policy is more aggressive in relative terms towards the depreciation of the Yen than our Federal Reserve is to the dollar. The BOJ will increase the size of its balance sheet by $1.4 trillion by the end of 2014. Our Fed may end up doing the same but the Japanese economy is just one third the size of the U.S.

Nevertheless, the intrinsic value of the dollar is being eroded at a record pace, despite what is evidenced from merely looking at the DXY. There has been no change in the Fed’s zero interest rate policy and no diminution of its $85 billion per month pace of debt monetization. National deficits continue to rise ahead of nominal GDP growth and persistently weak employment data (more evidence was displayed from the March NFP Report released on Friday) should keep the Fed’s level of QE unabated for at least several more quarters to come. In addition, the nominal interest rate on the One-year Treasury is below .15%, while the rate of inflation recorded a 2% YOY increase in February. Therefore, real interest rates remain firmly in negative territory and the real value of the dollar is falling against gold.

Some market analysts also claim that the Fed and Treasury should print and borrow more money, so much so, that the dollar would lose value even as it is measured against the Euro, Pound and Yen. They not only believe a falling dollar will help boost GDP growth and balance the trade deficit; but also contend a weakening currency only produces a negative effect on U.S. consumers if they purchase foreign goods, or while they are on vacation abroad. But there isn’t any evidence to suggest that you can balance a current account deficit by lowering the value of your currency or boost GDP growth either. Also, this theory shows a complete lack of understanding about the true effects of currency devaluation. Printing money to lower the value of your currency creates domestic inflation, not only because (all things being equal) import prices should rise; but also due to the fact that commodity prices, which are limited in supply, must increase in response to the increase in money supply.

To prove this simple point that investors should not just look at the dollar’s value as measured against other fiat currencies in order to determine its value, just imagine what would happen if there was just one world currency controlled by one central bank. These same pundits would have to claim that inflation is impossible to occur under a one-currency regime because rising prices can only come from a falling currency relative to another—and that can’t occur if there is only one currency in use. Therefore, they also must contend that this global central bank could increase the money supply by any amount it desired without any negative ramifications on consumers’ purchasing power.

But if the monetary base of this global currency were to double every year—not such a stretch given what the Fed and BOJ are up to—aggregate price levels would eventually surge given the massive increase of the money supply in relation to the supply of goods and services available for consumption. This is especially true for rare commodities like PMs, whose supply cannot be expanded at the same rate of monetary creation.

Dollar holders should find zero solace from owning a currency that is only gaining value against other pieces of confetti called Euros, Pounds and Yen and investors will soon realize the absurdity of believing the dollar is strong simply because other fiat currencies are currently weaker. This is why money flows into precious metals will become massive once again as the intrinsic value of the dollar continues to diminish under the weight of the $17 trillion national debt and $1 trillion yearly deficits that are being monetized by the Fed.

 

The Real Fallout from Cyprus
April 1, 2013

Holders of the Euro currency should be glad that the Troika is finally doing something besides just making more loans, printing more money and monetizing more debt—unlike what the Treasury and Federal Reserve is in the habit of doing. For me, this has to be positive for the Euro in the long term because the ECB is not expanding its balance sheet, while the Fed is rapidly expanding the U.S. monetary base.

When institutions are insolvent somebody is going to get hurt and there are no painless solutions. Either its creditors take the direct hit; or all holders of the currency must suffer through the central bank’s dilution of its purchasing power. This is true on both sides of the Atlantic. At least those in Cyprus who placed money in an insolvent institution and above the safety threshold provided by government will share in the burden. Doesn’t capitalism necessitate that the process of creative destruction be allowed to occur?

Large depositors of Cyprus Popular Bank, known as Laiki, will take a haircut and it will serve as the paradigm for the rest of Europe’s insolvent banks. The only real danger would have been if the EU forced those depositors to take a hit below the insured level. That could have caused a run on the Euro and European banks, but that was thankfully avoided. However, this doesn’t fix the problems evident in European banks or economies.

The EU is simply setting the tone for the future in that more banks will go under and not all creditors and depositors will be made whole. Therefore, expect more depositors to lose their money. But the important point here is that future bailouts from the IMF, ECB and EU will also involve some deleveraging from the private sector. And that is several steps towards capitalism ahead of the U.S.

We shouldn’t forget that when the U.S. had its financial crisis in 2008, our government—unlike what the Troika is trying to accomplish now in Europe--guaranteed all bank debt and actually expanded deposit insurance provided by the FDIC. Shouldn’t holders of Euros find some long-term solace that their central bank is taking a stand against endless money printing?

It should also be noted that Cyprus’ debt to GDP ratio is about 127% and the U.S. only carries a slightly less burden of 107%. Therefore, expect the high probability of massive currency depreciation and bailouts needed here once our interest rates rise. This will not bode well for the dollar in the long term and will be a strong catalyst to send gold prices higher.

 

Equity Bubble is Based on Unsustainable Earnings
March 20th 2013

The most pervasive question on Wall Street these days is if the Dow Jones Industrial Average, which is at a record level in nominal terms, reflects strong corporate profits and an improving economy; or simply has been achieved by the manipulations of the Federal Reserve. For me, this is sophomoric question to ask because, in reality, there can be no separating what the Fed has been able to achieve for the economy through its artificial measures and the effect it has had on corporate earnings.

The reason most market pundits claim that the Dow's new high does not represent a bubble in equities is because the price to earnings ratio is not out of line in historic terms. This is true. However, their specious reasoning assumes that the E in the PE ratio is genuine. In reality, the growth in earnings and the overall economy have been factitiously derived and are therefore unsustainable. To believe that stock prices are now fairly valued investors must also be convinced that massive deficits, free money and central bank debt monetization can be reversed without affecting the economy and corporate earnings.

There are short-term benefits derived from the Fed's ability to support real estate prices with their purchases of mortgage backed securities and manipulation of mortgage rates. Since most acknowledge the central bank is causing real estate prices to rise, can they also then put aside the fact that improving home prices helps boost the economy? If investors are forced into equities because the Fed caused real interest rates to become negative, doesn't that wealth effect from rising stock prices engender consumer confidence? When the Treasury issues $7 trillion in new debt and the Fed helps boost the money supply by 40% since 2007 in order to keep the consumption bubble afloat, doesn't that help corporate sales and profits?

I guess we can pretend when the Fed finally stops buying trillions of dollars worth of banks' assets and raises interest rates back to a normal level that corporations and the economy won't notice the difference. But it would be more prudent to conclude that once interest rates normalize the housing market will feel an extreme amount of duress because it will erode banks' capital and crimp lending. Whenever the Fed finally backs away from all its money printing, equity prices will suffer, as investors begin to receive a real rate of return on fixed income and their bank deposits. Rising interest rates will send service payments on corporate, private and government debt skyrocketing and that will severely hamper economic growth. The economic fallout from the end of artificial stimuli cannot (in the short term) be supportive of the level of corporate profits.

The bottom line is starting in 2008 the government began to bail out the crumbling asset bubble known as the real estate market, which also benefited the financial sector of the economy tremendously. This was accomplished by simply doubling down on the same philosophy that created the bubble in the first place; namely, money printing, very low interest rates and debt accumulation.

Therefore, what government has succeeded in doing is making the corporate and banking sectors appear to be solvent, while simultaneously bankrupting the Fed and Treasury. Since this is the case, investors should not take any solace in a PE multiple that appears not to be too far stretched. If market forces were allowed to prevail and the government permitted the economy to deleverage, earnings of U.S. corporations would be in a depression. And the price to earnings ratio would reveal that stock prices are already in a bubble. A bubble that is only becoming more dangerous with each day of the Fed's money printing.

 

Fed's Bubbles to Slaughter Middle Class
March 11th 2013

When central bankers dedicate their existence to re-inflating asset bubbles, it shouldn’t at all be a surprise to investors that they eventually achieve success. Ben Bernanke has aggressively attempted to prop up the real estate and equity markets since 2008. His efforts to increase the broader money supply and create inflation have finally supported home prices, sent the Dow Jones Industrial average to a record nominal high and propelled the bond bubble to dizzying heights.

The price of any commodity is highly influential towards its consumption. This concept is no different when applied to money and its borrowing costs. Therefore, one of the most important factors in determining money supply growth is the level of interest rates. The Federal Reserve artificially pushed the cost of money down to 1% during the time frame of June 2003 thru June 2004. It is vitally important to note that these low interest rates were not due to a savings glut; but were rather created by central bank purchases of assets. This low cost of borrowed funds affected consumers’ behavior towards debt and was the primary reason for the massive real estate bubble.

Today, the Fed Funds rate has been pushed even lower than it was in the early 2000’s. In addition, unlike a decade ago when the Fed held the overnight lending rate at 1% for “just” one year, the central bank is in the process of pegging short-term rates at near zero percent for what will amount to be at least seven years. However, this time the primary borrower of the central bank’s cheap money isn’t consumers as much as it is the Federal government. Mr. Bernanke has already increased the monetary base by over $2 trillion since the Great Recession began in late 2007, which has helped cause the M2 money supply to grow by $3 trillion--an increase of 40%!

Therefore, it isn’t such a mystery as to why there are now partying down on Wall Street like it is 1999; and we are once again amused with anecdotes of real estate buyers making millions flipping homes.

But all this money printing has not, nor will it ever, restore the economy to long-term prosperity. Despite the Fed’s efforts to spur the economy, GDP growth increased just 1.5% during all of 2012 and grew at an annual rate of just 0.1% during Q4 of last year. The future doesn’t bode much better. This year consumers have to deal with higher taxes, rising interest rates and record high gas prices for March. Don’t look for exports to rescue the economy either. Eurozone PMIs are firmly in contraction territory and Communist China is busy dictating the growth rate of the economy by building more empty cities—clearly an unsustainable and dangerous economic plan.

This means that the Federal Reserve will keep interest rates at record lows for significantly longer than the time it took to construct any of its previous bubbles. Also, the central bank will take years to reduce its $85 billion per month pace of monetary base expansion back to neutrality. Meanwhile, surging money growth will continue to force more air into the stock, real estate and bond markets for several years to come.

The ramifications for investors and the economy will be profound. Not only will the economy move gradually toward a pronounced condition of stagflation, but, more importantly, the bubbles being created by the Fed will be far greater and more devastating than any other in history. Equity and real estate prices are already stretched far beyond what their underlying fundamentals can support. But they are nothing compared with the distorted valuations being applied to U.S. sovereign debt. The bursting of the bond bubble will be exponential worse than the deflation brought on by the NASDAQ and real estate debacles. It is sad to conclude that the middle class is set up to get slaughtered even worse than they did when the previous two bubbles burst.

The economy is heading for unprecedented volatility between rampant inflation and deflation courtesy of Ben Bernanke’s sponsorship of the $7 trillion increase in new Federal debt since 2008. Investors need to plan now while they still have time before the economic chaos begins.

 

Is the U.S. Becoming a Banana Republic
March 5th 2013

It is sad to say there are just two reasons why the U.S. is not yet a banana republic. The first reason is that the US dollar has not yet lost its world’s reserve currency status, which is helping to keep interest rates at record low levels. If the dollar, yen and euro were not involved in a currency war, the dollar’s intrinsic decline would become much more evident, causing domestic inflation to soar, and our bond market to immediately collapse.

However, the perpetual erosion of fiat currencies will eventually cause investors to eschew the sovereign debt issued by the over-indebted nations of America, Japan and Europe—even if the dollar’s decline does not manifest itself against the euro and the yen.

The other reason why we have not been declared a banana republic is because America is not located between the Tropics of Cancer and Capricorn.

The Definition of a banana republic is a nation that suffers from chronic inflation, high unemployment and low growth; primarily due to massive government debt and deficits that are purchased by its central bank. There is no doubt that the U.S. has suffered from structurally high unemployment, stubbornly high aggregate price levels, and low growth for the past five years, which is the direct result of our debt-saturated economy.

So let’s just assume there exists a country located 15 degrees north of the equator that had amassed $7.5 trillion of new debt in the last 5 years alone. This nation also has nearly $17 trillion in issued debt outstanding, a debt to GDP ratio above 106%, and has clearly shown it is incapable of preventing that ratio from rising.

The central bank of this tropical land artificially pegged interest rates at 0% for over 4 years, has pledged to keep them there for at least three more years, owns $1.8 trillion of government debt and has pledged to buy $1 trillion more during 2013. Let’s not forget that $1 trillion worth of central bank buying just happens to coincide perfectly with the projected annual deficits of $1 trillion for the foreseeable future. What adjective would you use to describe this country? Of course, any objective observer would designate it a bona fide banana republic!

This is the reality of the economic backdrop of the U.S. But, as mentioned previously, the legacy effects of having the world’s reserve currency postpones the most pernicious effects of such economic fundamentals that exist in our country. Nevertheless, even though the Japanese and European economies also suffer from debt and stagflation, this isn’t enough to purge the U.S. economy from its insolvency; nor will it save our bond market from that inevitable historic rise in yields.

The problem is now even the mere normalization of bond yields would send interest payments on our unprecedented amount of debt soaring. This could force the Fed to step up its dollar creation far in excess of what the BOJ or ECB would dare to create in order to stem that rise; and this could be the catalyst to send the dollar and bond market crashing even further.

While some love to speak about the return of “King Dollar,” the truth is any nation that seeks to remain viable through the life support provided by its central bank purchases of sovereign debt should be designated a banana republic--regardless of its geographic location. That is why the U.S. is headed down the road to serfdom…or fruitdom as it is in this case.

 

No Easy Escape for the Fed
February 25, 2013

I've said since the beginning of 2009 that any future "recovery" experienced by the markets and the economy would be derived through massive government spending and Federal Reserve debt monetization. Therefore, the logical conclusion must be that when or if fiscal and monetary austerity is eventually adopted, the economy and markets would crash.

More proof of that very fact was witnessed last week as the release of the January FOMC minutes showed that the governors discussed the risks of additional asset purchases, as well as the problems such additional purchases would pose for the eventual QE exit strategy.

It made little difference that no immediate action was to be taken; just the mere reminder that someday, in our yet-born grandchildren's lives, the Fed would have to stop printing money and raise interest rates. That was enough to panic investors in risk assets.

It is no coincidence that the very same day the FOMC minutes were released, commodity and equity markets plunged. This is what happens every time investors become concerned about the return of economic reality. For example, the Junior Gold Miners ETF (GDXJ) fell over 5% on Wednesday alone and the NASDAQ composite index dropped 1.5%.

This clearly illustrates what the Fed is utterly unable to see or is willing to acknowledge, namely that the economic healing process of reducing debt and inflation, which is absolutely necessary for viable economic growth, had been cut short in 2009 by Bernanke's massive monetization of government debt. Hence, our central bank and government are currently able to levitate asset prices and consumption-thus giving the temporary illusion of a recovering stock market and economy.

However, any hint of a reduction in this activity causes the eventual and necessary deleveraging process to recommence-in other words, a depression ensues in which money supply, debt levels, and asset prices are dramatically reduced. But such an economic outcome is absolutely politically untenable for D.C. and the Fed. Nevertheless, that is exactly what awaits us on the other side of government's interest rate and money supply manipulations.

Therefore, the Bernanke Fed has no real mechanism for reducing the size of its balance sheet or in its ability to raise interest rates without massive repercussions for the markets and economy. If the Fed were to pull back on its monetary stimulus now, one of the most salient outcomes would be to send the U.S. dollar soaring against our largest trading partners.

A rising Fed Funds rate and shrinking central bank balance sheet is the exact opposite direction to where the BOE, ECB and BOJ are all headed. The Keynesians that run our government fear a rapidly rising currency more than any other economic factor because they believe it would crush exports and send GDP crashing along with our markets.

In contrast, the truth is that in the long-term a rising currency is an essential ingredient for providing stable prices, low taxes, low interest rates and healthy GDP growth. However, in the short-term our government is correct in believing a soaring dollar would cause most markets to plummet; just as they did in the fall of 2008.

During the timeframe between August 2008 and March 2009, the DXY soared from 74.5 to 89, sending the S&P 500 down 50%! The same dynamics are also true at this moment in time given our continued reliance on rising asset and equity prices to keep the economy afloat.

All the hype about an imminent exit for the Fed is just noise. Not only will its policies be in place for a very long time to come, but the odds actually favor an increase to the current amount of annual debt monetization rather than a decrease.

Investors need to understand that since there is no easy escape for the Fed, they are relegated to just bluffing about an eventual exit. But bluffing alone will not be able to save the U.S. dollar or economy in the long run.

 

Why Interest Rates are rising
February 19th 2013

The interest rate on the Ten-year Note has risen from 1.58% on December 6th of last year, to as high as 2.03% by mid-February. Most equity market cheerleaders are crediting a rebounding economy for the recent move up in rates. According to my count, this is the 15th time since the Great Recession began that the economy was supposedly on the threshold of a robust recovery.

However, the reading on last quarter's GDP growth was negative, while the January unemployment rate actually increased. Therefore, it would be ridiculous to ascribe the fall in U.S. sovereign bond prices to an economy that is showing signs of an imminent boom.

The truth is that rising bond yields are the direct result of stability in the European currency and bond markets, the inability of the U.S. to address its fiscal imbalance, and a record amount of Federal Reserve debt monetization.

The Euro currency, which was thought to be on the endangered species list not too long ago, has surged from $1.20 in the summer of 2012, to $1.36 by the beginning of February. In addition, bond yields in Spain and Italy have recently fallen back to their levels that were last seen just before the European debt crisis began. Renewed confidence in the Euro and Southern Europe's bond markets are reversing the fear trade into the dollar and U.S. debt.

Washington D.C. was supposed to finally address our addiction debt and deficits in January of this year. Instead of refusing to raise the debt ceiling and allowing the sequestration to go into effect, our politicians seem to be able to agree on just one point; that is to delay austerity. President Obama claims that the nation has already cut deficits by $2.5 trillion over the last few years. Nevertheless, the fact is that deficits have totaled $3.67 trillion in the last three years alone! The absolute paralysis of Congress to agree on a genuine deficit reduction plan has finally given bond vigilantes a wakeup call that was long overdue.

Finally, the Fed increased its level of money printing to $85 billion, from $40 billion on January 1st. This record amount of debt monetization comes with unlimited duration and is accompanied by an inflation target of at least 2.5%. The Fed's actions virtually guarantee that real interest rates will fall even further into negative territory, despite the fact that nominal rates are rising.

So how high will interest rates go in the short term? It seems logical to figure they will increase at least to level they were prior to the European debt crisis. Back in the fall of 2010, just prior to the spike in Southern Europe's bond yields, the interest rate on the U.S. benchmark Ten-year Note was yielding around 3.5%. Therefore, unless there is another sovereign debt crisis in Europe (or perhaps one starting in Japan), I expect interest rates to trade back to the 3.5% level in the next few quarters.

This means U.S. GDP growth will be hurt by the rising cost of money and the tax hikes resulting from the January expiration of some of the Bush-era rates. Rising tax rates, one hundred dollars for a barrel of oil and increasing interest rates significantly elevate the chances of a recession occurring in 2013.

Since rates are increasing due to debt and inflation concerns, it also means the Fed will have to decide between two very poor choices. It would never choose to stop buying new debt and start selling its $3 trillion balance sheet, as that would send bond yields soaring in the short term and the unemployment rate into the stratosphere. So investors can't really count this as a viable option for Mr. Bernanke. He could simply do nothing and watch another recession ravage the economy-not a high probability given the Fed's history. Or, Bernanke most likely will be forced into embarking on yet another round of QE in an attempt to keep long-term rates from rising further.

This would be the most dangerous of all the Fed's options as it will send inflation soaring and cause interest rates to rise even higher down the road. The resulting chaos from violent interest rate instability is the main threat to the stock market and the economy in the very near future.

 

Currency Cold War
February 14th 2013

It isn't much of a secret that gold mining shares have suffered greatly in the past 18 months. In fact, since the summer of 2011 the Market Vectors Gold Miners ETF (GDX) has plummeted nearly 40%. That has caused many precious metal investors to give up hope on mining shares altogether; and to also now anticipate a tremendous plunge in gold prices.

Nevertheless, I believe gold and gold mining shares offer investors a great value at this juncture and let me explain why.

Interest rates in nominal terms are at record lows and have been promised by the Fed to remain near zero for an indeterminate duration. To highlight this point, Fed Vice Chairman Janet Yellen said in a speech to the AFL-CIO this week that the central bank may hold the benchmark lending rate near zero even if unemployment and inflation hit its near-term policy targets. Yellen said the Fed's objectives of a 6.5% on the unemployment rate and 2.5% inflation rate are merely, "…thresholds for possible action, not triggers that will necessarily prompt an immediate increase" in the FOMC's target rate. "When one of these thresholds is crossed, action is possible but not assured." Her statements underscore the fact that the $85 billion per month worth of Fed debt monetization and ZIRP will not end anytime soon.

Since the Fed is NOT anywhere close to raising interest rates or reducing its bond purchases, this should also allay fears that the U.S. dollar is about to enter into a secular bull market. The greenback is just about unchanged on the DXY over the past 12 months and has been mostly range-bound between 79 and 81 during that timeframe. There isn't any evidence that the USD is ready to soar in value against our six largest trading partners. Without a new bull market in the U.S. dollar, the price of gold cannot enter into a secular bear market.

Regarding the notion that the dollar is about to re-emerge as the world's most desirable currency holding, the G20 nations meeting in Moscow this week released a statement proclaiming they are not currently engaged in a currency war. In saying they embrace "market-determined" exchange rates, these most wealthy nations sought to calm fears that Europe, Japan and the United States were outwardly competing to win the crown of the world's weakest currency.

However, in truth the U.S. and Japan are already in the middle of a currency cold war…at the very least. The BOJ has committed to a 2% inflation rate, which is the same target inflation rate the Fed has adopted. To that end, both the Fed and BOJ are purchasing massive quantities of bank debt. Asian Development Bank President Haruhiko Kuroda (the most likely candidate to take over the Japanese central bank next month) said this week, "A two percent inflation target has become a global standard, and it is a landmark decision on the BOJ's part to adopt the same target." The only way a nation can achieve a sustained rate of inflation is to commit to a perpetual increase in the rate of currency creation. This action will send real interest rates further into negative territory. Since both the BOJ and Fed are in a tacit currency war, the only guaranteed winner will be precious metals.

Another factor boosting gold prices is the fact that debt accumulation in the U.S. continues unabated. Not only is the debt to GDP ratio already above 105%, but future deficits are projected to accrue at rates that are 4 times larger than before the Great Recession of 2007. Even if D.C. adopts the sequestration come March 1st, the 2013 budget deficit will still be $845 billion! However, in the unlikely event that sequestration is actually adopted, there is tremendous pressure for Washington to increase its deficits even more. The afore mentioned most likely replacement for Ben Bernanke, Janet Yellen, said in the same speech to the AFL-CIO, "I expect that discretionary fiscal policy will continue to be a headwind for the recovery for some time, instead of the tailwind it has been in the past," she continued. "... Fiscal austerity does raise unemployment, weaken the economy and ... in addition undermines the goals for which it is designed to achieve." Former President Bill Clinton is also exhorting larger government spending saying last week that, "Everybody that's tried austerity in a time of no growth has wound up cutting revenues even more than they cut spending because you just get into the downward spiral and drag the country back into recession."

With such huge pressure to increase government spending there is a real prospect of the U.S. producing deficits that continue to increase at far greater rates than GDP growth. This further strengthens the notion that the central bank will continue to monetize government debt in order to prevent interest rates from spiking and rendering the country insolvent.

In addition, because of the cheap cost of money and huge buildup of the monetary base in the U.S., the money supply growth rate as measured by M2 is up 8% YOY. And the Japanese money supply should also be booming soon, as their monetary base was up 10.9% YOY in January.

Finally, central banks have become net buyers of gold instead of net sellers. According to Bloomberg, before the credit crisis began central banks were net sellers of 400 to 500 tons a year. Now, led by Russia and China, they're net buyers by about 450 tons. That isn't news. However, the news is what Russia is now saying about fiat currencies. Vladimir Putin's regime is actively downplaying the dollar's role as the de facto world's reserve currency by saying last week, "The more gold a country has, the more sovereignty it will have if there's a cataclysm with the dollar, the euro, the pound or any other reserve currency," said Evgeny Fedorov, a lawmaker for Putin's United Russia party in the lower house of parliament. Putin's Russia has added 570 metric tons of gold in the last decade.

All of the mainstream media chatter about gold entering a bear market is patently false. Instead, every bullish fundamental behind a strong bullion market is currently in place-and if anything those factors are becoming even more pronounced each day. Currency cold wars, massive debt accumulation, negative real interest rate levels, rising inflation targets, central bank bullion purchases, rising money supply growth rates and the tenuous condition of the dollar as the world's reserve currency; all lead to the conclusion that gold is nearing the end of a long consolidation inside a secular bull market, and readying for the next major move to new all-time highs.

 

Bernanke Blows Bond Bubble into Stocks
February 4th 2013

Ben Bernanke was instrumental in creating a bubble in U.S. Treasuries. His actions have served to inflate it to the point that it has now become the greatest bubble in the history of global investment. Not only has the Chairman of the Federal Reserve guaranteed that current bond holders will get destroyed once the sovereign debt bubble bursts, but he has also begun to inflate yet another massive bubble in U.S. equity prices.

In the summer of 2007, just before the start of the Great Recession, the Fed Funds rate and the One year T-bill were both trading north of 5%. Then, starting in September of 2007, the Fed began to aggressively lower its target rate on interbank lending. Global investors were put on notice that bond yields, which were already at low levels, would soon go down to unchartered territory. Both the Fed's target rate and the One Year T-bill would be near zero percent by the end of 2008. And smart investors made a fortune taking the toboggan ride down Bernanke's yield slope.

But now we find the central bank doing something it has never done before. Something that will guarantee the Fed will prick the very bubble it worked so hard to create. First interest rates were taken down to the zero percent range. Then, the Fed adopted an inflation target. In other words, a minimum rate of decline in the purchasing power of dollars--a rate that is once achieved by official government metrics will be much greater in the real world. And then Bernanke more than doubled the amount of debt monetization to a record level of $85 per month starting in January 2013-with an indefinite duration. How can any sane investor really still desire to put new money to work in the bond market under that scenario?

Leave it to the government to do exactly the wrong thing at the exact worst time; while all along claiming to have the country's best intentions in mind. First, our central bank created a housing bubble in order to increase home ownership, which led to an overleveraged consumer and banking industry. Then, when the housing market toppled on top of the private and financial sectors, the government bailed them both out by taking on an unprecedented amount of debt. This was done in order to save us from a depression. So much debt, in fact, that the Fed had to artificially peg interest rates at zero percent just to keep the country from going completely bankrupt. So what's the absolute dumbest thing a central banker could do now? Put sovereign creditors on notice that the Fed will continue to print money until inflation is well entrenched into the economy.

Inflation is the bane of any bond market. A sustained increase in aggregate prices, along with a currency that is losing its purchasing power, will cause yields to rise faster and higher than any other economic factor. What the USA really needs to do is convince Treasury holders that inflation will not become a problem and the central bank is encouraging deflation to occur. Instead, our Fed Head is printing trillions of dollars with the expressed intent to push inflation higher.

Investors were already aware that there is little room for yields to fall any further. But now are being told by the Fed that they will continue to lose an ever-increasing amount of money, as real yields are guaranteed to go further and further into negative territory. Therefore, any new money created by the central bank is no longer going into government debt, but is instead rushing into stocks and commodities.

I expect this condition to intensify greatly this year and cause equity and commodity prices to soar substantially. Of course, the move higher will not be due to a booming economy. Just think about the negative Q4 2012 GDP print and the rising unemployment rate reported last week. However, strong money supply growth and the passing of fixed income as the preferred repository of new funds will cause commodities and equities to boom. This huge move higher-especially in commodity prices-will remain in place until the Fed or the free market begins to raise interest rates.

Keep this in mind; with $16.5 trillion in Federal Debt and $12.9 trillion in Household debt, the last thing the Fed can do is cause debt service payments to increase substantially. Therefore, since a depression and a bankrupt nation awaits us on the other side of the Fed's bond bubble, I expect it will not be until inflation becomes a serious and undeniably-painful condition for the economy that Mr. Bernanke begins to change his mind. And any change that does eventually occur will be slow and gradual...at best.

 

January Jobs Data Will Disappoint; Fed to Keep Monetizing Debt
January 29, 2013

The recent spate of better data on initial jobless claims has caused bond yields to rise, stock prices to rally and gold shares to tumble in the last few days. For the 6th time since 2010, an oasis of improving economic data (that has proven to be ephemeral each time in the past) is once again giving investors the false signal of a robust and sustainable recovery. This has in turn caused investors to once again wonder when the Fed would finally stop buying assets from banks and raise interest rates, which have been at zero percent for over four years.

But the data on initial claims has been distorted by seasonal adjustments at the Labor Department. On an adjusted basis, initial jobless claims for the week ending January 19th dropped to 335k, which was the lowest level since January 2008. However, the raw data offers a different take on the labor condition. The unadjusted claims totaled 436,766 in the week ending January 19. That was 20k HIGHER than the 416k claims reported in the comparable week of 2012. The question is, how can initial claims be higher this year than the same week as last year; yet at the same time register the lowest level in 5 years?

Other data on the jobs front confirms the view that the labor market is not improving substantially whatsoever. From the January Empire State Manufacturing Report released last week: "Labor market conditions remained weak, with the indexes for both the number of employees and the average workweek remaining below zero for a fourth month in a row."

And then there is this from the Philly Fed's Manufacturing Survey: "Labor market conditions at reporting firms deteriorated this month. The employment index, at -5.2, fell from -0.2 in December. The percentage of firms reporting decreases in employment (16 percent) exceeded the percentage reporting increases (11 percent). Firms also indicated a decrease in the average workweek compared with last month."

Don't expect a NFP number that is much better than the 150k anticipated by the market. In fact, the odds are better for a significant miss to the downside.

Therefore, the market's view that the Fed will soon end its bond-buying program because the unemployment is about to drop near 6.5% is extremely premature. After all, QE IV is only a few weeks old. Bernanke just increased his purchases of MBS and Treasuries to $85 billion from $40 billion on January 1st. And the Fed's balance sheet just jumped by $46 billion last week, to reach a record $3.05 trillion as of January 23rd. That's because Mr. Bernanke is very much concerned about the level of austerity yet to be adopted. The Fed is also worried about consumers and businesses losing their confidence stemming from; the recent tax hikes, another debt downgrade of U.S. Treasuries, the $1.2 trillion spending cuts due to the sequestration, a three-month punt on the debt ceiling and continuous continuing resolutions to fund the government.

Overall, the economic data suggests that this Friday's Non-farm Payroll Report will not show significant job improvement. The Fed will remain loose for the foreseeable future; and that should cause bond yields to fall and gold prices to rally next week.

 

Abe Pulls Pin on JGB Grenade
January 23, 2013

Japan has already suffered through a quarter century's worth of an economic malaise because they have refused to allow the free market to work its reconciliation magic. Their reliance on government borrowing and spending to rescue the economy has proven to be a miserable failure. Because of this fact, Japanese politicians have succeeded to increase the debt to GDP ratio to 237%, which should have already caused a collapse in Japanese Government Bonds (JGBs) and the Yen.

However, JGBs have held their value for two reasons: The Japanese own 92% of their sovereign debt; And, up until now, deflation has reigned over the island.

Since foreigners do not own a large portion of Japanese bonds, there isn't a big concern about a mass exit from JGBs due to the fear of a weakening Yen. If foreign ownership of sovereign debt was more in the area of 50% (like it is in the U.S.), there would be a palpable fear on the part of those creditors that their wealth could be wiped out upon currency repatriation-especially in light of the new administration's love affair with inflation and a falling currency. More importantly, since aggregate prices have dropped in 10 of the last 15 years and inflation has averaged a negative 0.6% in the last 4 years, holders of JGBs weren't so concerned about yields being so close to zero percent. Falling prices allowed the government of Japan to issue debt with very little cost.

Both those conditions needed to stay in place in order for JGBs and the Yen to hold their values. Thankfully for Japan, foreign creditors still hold a very small proportion of sovereign paper. However, deflation is soon to become a thing of the past. If Shinzo Abe achieves his goal of at least a 2% inflation target, it will remove the most important support pillar for Japanese debt. In effect, the Japanese government has pulled the pin on a debt grenade that will explode in the very near future.

As of now, the Japanese 10-year note yields just 0.75%. That's a very poor yield; but since holders of Yen are currently experiencing deflation, they still are provided with a real return on their investment. But if inflation does indeed rise to 2%, the yield on the 10-year note would have to rise above 3.3% in order to offer the same real yield seen today.

However, the problem is that Japan is already spending nearly 25% of all national revenue on debt service payments-despite the fact that interest rates are close to nothing. If the average interest rate on outstanding debt were to increase over 2%--or anywhere close to offering a real yield on JGBs--Japan would be paying well over 50% of all government revenue on debt service payments alone. Of course, some will say that yields won't go that high even if inflation creeps higher. But these investors should be reminded that the Japanese 10-year note was 1.8% back in May of 2008. That was not too long ago and it occurred during a time when inflation was just rising at a one percent annual rate.

If the government of Japan has to pay 50% of its income on debt service payments it will be game over for JGBs. Domestic investors will flee the sovereign bond market in search of a real return on their investments, as they collectively realize that there is zero chance of being repaid their principal and interest in real terms.

Unfortunately, it is that not only Japan which has chosen to go down the path that leads to a currency and bond market catastrophe. The BOJ wants the Yen to go lower; and yet at the same time the Fed wants the dollar to lose value as well. Both Bernanke and Shirakawa want more inflation and a weaker currency vis a vis the other. That begs the question; when two central bankers launch an all-out currency war who will win? History shows us that the answer is clear. The absolute losers will be the middle classes of both countries. And the winner will be those who have the intelligence and foresight to eschew fiat currencies and the sovereign debt they support.

With so much monetary madness crossing the globe it isn't such a shock to learn that the U.S. mint has sold out of 2013 American Eagle silver coins. Exchange traded products now own a record $20.1 billion worth of silver. Since central bankers are more determined than ever to destroy their currencies, it seems more important than ever for investors to store their wealth in alternative currencies that cannot have their value inflated away.

 

Trillion Dollar Banana
January 14, 2013

It should be clear to all that Keynesian Counterfeiters now control many of the major governments across the globe. Fiscal and monetary "stimulus" led to the bond market collapses of southern Europe a couple of years ago. The Greek bond market was the first to crack at the beginning of 2010. Borrowing massive quantities of printed money caused yields on their 10-year note rose from 5.8% in January, to over 40% two years later. But the problem in Europe wasn't confined to just a Greek tragedy. In Portugal, their 10-year note yield soared from 4.07% at the start of 2010, to 15.4% in just 24 months. Similar, but less dramatic, bond duress occurred in Spain and Italy as well.

However, yields in all the above nations have since sharply contracted in the last few months. The credit for the reduced borrowing costs has been placed directly on the ECB and their Outright Monetary Transactions. As well as Mario Draghi's guarantee to do "whatever it takes" to placate Europe's debt market.

Yet the European economy has continued to deteriorate despite the efforts of their central bank. The unemployment rate in the Eurozone reached an all-time high last week of 11.8%, while the unemployment rate for those under 25 years old living is Spain reached a record 56.5%! But the worst is yet to come, as the blowback from the ECB's massive debt manipulation has yet to be fully realized. This is because the collapse of the European debt market was basically a conclusion made by their international creditors that they not only lost faith in the debt of those governments, but also in their currency. In other words, holders of European debt no longer believed they would be paid back their loans in real terms. A default through inflation was now the most likely outcome.

Therefore, it is impossible to permanently restore faith in Europe's debt and currency markets via their central bank; for a commitment to print an unlimited amount of money to purchase sovereign debt also serves to further erode faith in the currency that is underwriting the debt. Perhaps that is why Eurozone inflation is on its way to becoming a serious problem. Prices increased 2.2% YOY in December, up from a decline of .7% in July of 2009. But that is just a taste of what is to come in terms of inflation.

The growing threat of intractable inflation is not confined to Europe. China's growth rate in M2 was up 13.8% in December and inflation reached a 6-month high. Meanwhile, official inflation data in the U.S. appears quiescent. However, the truth is that the money supply as measured by MZM and M2 is soaring at an annualized growth rate of over 12%.

And now, Washington is floating the idea of having the Treasury mint a trillion dollar platinum coin. Few truly understand how devastating this would be to the dollar and our bond market in the long term. The constitution currently forbids the Fed from directly participating in U.S. debt auctions. The central bank is confined to buying debt in the secondary market through the banking system. However, by creating a trillion dollar coin the Treasury could deposit it at the Fed and then draw on its own account at will. The U.S. government would in effect circumvent the banking system and then be able to directly monetize its own debt.

This would be a watershed event for the dollar and our bond market. Perhaps it would be more appropriate if the Treasury issued a trillion dollar banana; because our nation would lose any credibility that is left in our currency overnight. A letter sent to President Obama on Friday by six U.S. Senators urged the Whitehouse to bypass Congress and raise the debt ceiling. This would lead to a long and nasty fight in the judicial system. Therefore, the trillion dollar coin is one way to avoid having to usurp the authority over the debt ceiling from Congress. Either way, one thing is for sure and that is the supply of dollars is set to increase significantly. In fact, the supply of fiat currencies in general is guaranteed to surge at an even faster pace going forward. That is not good news for the value of paper money or the sovereign debt it supports.

In the not too distant future the U.S. will face a collapse in our bond and currency market similar to what is happening in Europe. Endless increases in our borrowing limits and trillion dollar prints of dollars from the Fed (and now possibly even from the Treasury) will only hasten the demise of our economy. And the ultimate lesson yet to be learned on both sides of the Atlantic is that a bond and currency crisis cannot be solved through inflation.

 

Kamikaze BOJ Prepares to Launch More Zeros
January 8th 2013

It is an unfortunate truth that Keynesian counterfeiters with their Kamikaze monetary and fiscal policies have taken over the developed world. Politicians and central banks in the United States and Europe have decided to cement firmly in place their addictions to debt, inflation and artificially produced low interest rates. But Japan has now leapfrogged into the lead of those nations that believe prosperity can be brought about by loading up on government debt and increasing the number of zeros being printed by their central bank.

Shinzo Abe and the Liberal Democratic Party swept into power in mid-December by promising to boost inflation and destroy the value of the Yen. The new Prime Minister is trying to usurp the independence of the Band of Japan (BOJ) by dictating that the central bank provide an inflation target of at least 2% and also force them to expand their government bond-buying program. The reason for this is clear; Japan's debt has ballooned to over $12 trillion and is now 237% of their GDP.

So, what's a government and central bank to do? The answer of course is enacting yet another new fiscal stimulus package that will be monetized by the BOJ. Japan's central bank has already been buying corporate and government bonds in the scores of trillions of Yen. Then its board met on December 20th and decided to expand its program for the third time in four months. This additional 10 trillion Yen brings the current total of BOJ debt monetization to 101 trillion Yen! Of course, to "help" push things along on the spending side, the government is considering another 10 trillion Yen stimulus program.

The government believes their economic troubles emanate from stable prices and a currency that is too strong. Therefore, an all-out effort is underway to crumble the currency and boost inflation. This would be great news for the Japanese economy if it all hadn't been tried before and proven to fail miserably. In fact, the Yen has already lost 11% of its value in the past twelve months and is at its lowest level against the dollar since August of 2010. But that hasn't helped boost exports or manufacturing at all. Industrial production dropped 1.7% in November, which was the worst reading since the earthquake in March of 2011. That's because domestic prices rise in commensurate fashion with the decline of the currency. Hence, there was no benefit to manufacturing and exports due to a drop in the value of the Yen.

Japan has adopted the Keynesian mantra of, "The economy suffers from a lack of demand and government can and must supplant the private sector." However, the problem is that demand must be based on the prior production of goods and services, which allows an individual, corporation or government the ability to use their production for consumption. It cannot be generated artificially by printing money beforehand. If genuine growth and prosperity could come from government-induced demand, Cuba would be a global economic giant.

When a government perpetually tries to create demand by disseminating money that is printed by a central bank; all you get is a falling currency, faltering GDP, soaring debt levels and inflation-and eventually rising interest rates as well. Japan illustrates this point perfectly. Indeed, Japanese Government Bond yields have increased sharply in the last month in response to Mr. Abe's love affair with inflation. That could lead to disaster in short order as the country's debt service payments soar.

As stated before, one consequence of destroying your currency is to make those things priced in Yen rise in price. That also applies to equities. The Nikkei Dow closed up 23% on the year and has continued its increase so far in 2013. That's great for those fortunate to own hard assets, but pernicious for those in the middle class that must spend a greater portion of their income on food and energy. The result is a faltering middle class and an economy that is plagued by intractable debt and an unstable currency.

The failure of Japan to allow bankrupt institutions to fail, to let asset prices fall, to balance their budget and to embrace a strengthening Yen has helped turn their lost decade into the lost quarter century. And it is now etched in stone that the entire nation now faces a currency and bond market crisis that is not too far in the future.

 

Dysfunctional D.C. Leans on Fed’s Printing Press
December 26th 2012

It should now be clear to all Americans that our government is completely incapable of voluntarily reducing our fundamental problem of excess debt. The inability of Washington D.C. to address spending, even under the duress of a legal obligation to do so, is flagrantly obvious.

The sequestration, which is supposed to reduce our debt by $2.4 trillion over the next 10 years, is not the result of a curse brought to earth by an asteroid. It is a self-imposed act of congress to finally address our nation’s habit of raising the debt ceiling with as much concern as a thief cares about getting a credit line increase on a stolen Visa Card. Isn’t it ironic then that those same individuals who agreed on the sequestration a year ago are now doing back flips in order to undo their insufficient and feeble attempt at austerity.

The real issue here is the out of control spending on behalf of our elected leaders; and it can be proved. The deficit for November 2013 was $172 billion, which was up an incredible 25% from the level of last year. But, the reason for this significant increase in debt was not a lack of revenue. Government receipts were up $10 billion while outlays jumped by $44 billion. The truth is that the fiscal 2013 budget deficit is already up significantly from last year and it has nothing at all to do with a lack of revenue. Washington accepts the increased revenue with alacrity and uses it as a means to spend more instead of slowing down the rate of debt accumulation.

In addition, even if our leaders are indeed able to reduce the deficit by $2.4 trillion in the next decade, most of that proposed savings will be wiped out by increased debt service payments that are not currently incorporated into the rosy projections of the White House. Our “omniscient” leaders in D.C. predict that interest rates on the ten-year note will be just 5.3% by the year 2022. But if they are wrong on their base line projections; that is, if interest rates rise by just one point higher than predicted, $1.5 trillion of those proposed savings would be completely wiped away. That’s because the average amount of outstanding publicly traded debt will be around $15 trillion over the course of the next decade (it is currently $11.6 trillion). A one hundred basis point increase in the average interest rate paid would erase 62.5% of those hoped for savings.

However, the Fed will be buying more than $1 trillion worth of the anticipated trillion dollar deficits each year for the foreseeable future. That means by the year 2016 the Fed’s balance sheet will be have increased by nearly 100% and the amount of publicly traded debt will have soared by 200% since the start of the Great Recession in 2007. Therefore, it is highly likely that the average interest rate paid on government debt will be far higher than the 4.4% projected by the administration at the end of 2015, and the 5.3% going out a decade. After all, the surging supply of Treasury debt that is being monetized by the Fed should ensure inflation and interest rates rise well above their historical averages. That means the Ten-year note should rise well above its average rate of 7% going back 40 years. And that also means that deficits and debt will be significantly higher than anyone in D.C. expects. Given the above data, it is fairly certain that the U.S. government will be increasingly relying on the Federal Reserve to maintain the illusion of solvency in the future.

Indeed, most of the developed world finds itself in a similar situation. Central banks in Japan, Europe