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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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 and the United States have expressed their goal to aggressively seek a higher level of inflation. They operate within insolvent governments that need to have their central banks purchase most if not all of their debt. Given the fact that these governments are racing towards both bankruptcy and hyperinflation, it would be foolish to store your wealth in Yen, Euros or Dollars.
Physical gold and PM equities have suffered greatly of late due to the threat of American austerity. There have also been liquidations from a major hedge fund that owns a tremendous exposure to precious metals. However, these temporary factors are almost behind us and have offered investors a wonderful opportunity to acquire exposure to gold equities at incredibly low prices, especially in light of the incredibly-dangerous macroeconomic environment.
As expected, Ben Bernanke officially launched QE IV with his announcement last week of $85 billion dollars worth of unsterilized purchases of MBS and Treasuries. In unprecedented fashion, the Fed also tied the continuation of its zero interest rate policy and trillion dollars per annum balance sheet expansion to an unemployment rate that stays above 6.5%. Now, pegging free money and endless counterfeiting to a specific unemployment figure would be a brilliant idea if printing money actually had the ability to increase employment. But it does not.
The Fed recently celebrated the fourth anniversary of zero percent rates and massive expansion of its balance sheet. However, even after this incredibly accommodative monetary policy has been in effect since 2009, the labor condition in this country has yet to show significant improvement. Last month’s Non-Farm Payroll report showed that the labor force participation rate and employment to population ratio is still shrinking. Goods-producing jobs continue to be lost and middle aged individuals are giving up looking for work. This is the only reason why the unemployment rate is falling. I guess if all those people currently looking for work decide it’s a better idea to stay home and watch soap operas instead, the unemployment rate would then become zero.
But more of the Fed’s easy money won’t help the real problem because the issue isn’t the cost of money but rather the over-indebted condition of the U.S. government and private sector. Keeping the interest rate on Treasuries low only enables the government to go further into debt.
And consumers aren’t balking on buying more houses because mortgage rates are too high. The plain truth is this is a balance sheet recession and not one due to onerous interest rates. More of the Fed’s monetization may be able to bring down debt service payments a little bit further on consumer’s debt. However, it will also cause food and energy prices to be much higher than they would otherwise be. The damage done to the middle class will be much greater than any small benefit received from lower interest rates. Therefore, the net reduction in consumer’s purchasing power will serve to elevate the unemployment rate instead of bringing it lower.
Rather than aiding the economy and fixing the labor market, what the Bernanke Fed will succeed in doing is to ensure his unshrinkable balance sheet will not only destroy the economy but also drive the rate of inflation to unprecedented levels in this country.
Ben’s balance sheet was just $800 billion in 2007. It is now $2.9 trillion and is expected to grow to nearly $6 trillion by the end of 2015. A few more years of trillion dollar deficits that are completely monetized by the Fed should ensure that our government’s creditors will demand much more than 1.6% for a ten-year loan. The problem is that rising interest rates will cause the Fed to either rapidly and tremendously expand their money printing efforts, which could lead to hyperinflation; or begin to sell trillions of dollars worth of government debt at a time when bond yields are already rising. If yields at that time are rising due to the fact that our creditors have lost faith in our tax base and its ability to support our debt, just think how much higher yields will go once the bond market becomes aware that the Fed has become another massive seller.
This new Fed policy is incredibly dangerous and virtually guarantees our economy will suffer a severe depression in the near future. Bernanke should start shrinking his balance sheet and allow interest rates to normalize now. When the free market does it for him it will be too late.
The prevailing wisdom currently on Wall Street is that gold and commodity stocks will go nowhere next year because interest rates are about to rise in real terms. For instance, last week Goldman Sachs cut its 12-month gold-price forecast by 7.2%. The precious metal "is near an inflection point," according to the firm. And while the metal may rally slightly in 2013, a growing U.S. economy and a gradual rise in real interest rates may send investors towards other investments, their analysts said.
The consensus is that the global economy will rebound in 2013; causing central bankers in Europe and the U.S. to raise the cost of borrowing faster than what the rate of inflation is increasing. However, not only is the global economy not going to find its footing next year but central bankers are going to slam their gas pedals through the floor; sending interest rates yet lower in real terms.
In Euroland, ECB President Mario Draghi said this week that they discussed providing negative deposit rates (in other words, charging banks to hold money at the ECB) and that there was also "wide discussion" of a rate cut at their December meeting. The central bank also cut its growth estimate for next year, predicting the economy will contract by 0.3% in 2013. Why is Mr. Draghi so gloomy? Perhaps it is because Eurozone manufacturing shrank for the 10th consecutive month; Spain now has a record 4.9 million people unemployed and a youth unemployment rate of 50%; Greek unemployment jumped to 26% in September, which is up from 18.9% a year ago; and because the Eurozone unemployment rate hit a record 11.7% in October. That doesn't sound much like an environment where the ECB is about to take interest rates above the rate of inflation.
Turning to the Fed, operation twist is about to end in the U.S., which will cause Mr. Bernanke to conduct unsterilized purchases of MBS and Treasuries in the amount of $85 billion each month. Why is the Fed chairman ready to sabotage the U.S. dollar to an even greater degree next year than he did in 2012? Because the condition of labor in the United States is still abysmal. The November NFP report showed that this most crucial part of consumer's health is far from viability.
Despite a somewhat rosy top-line number of 146k net new jobs, the data underneath the headline tells Bernanke that his free-money interest rate policy must remain in effect for many years to come. And that new measures to boost money supply growth will be pursued.
First off, the goods-producing sector of the economy lost another 22k jobs. This shows that whatever job creation there was last month will result in the promotion of those sectors of the economy that encourage consumer's addictions to borrowing and spending; not from the sectors that increase production and real wealth. Secondly, the Labor Force Participation Rate fell to 63.6% in November, from 66% at the start of the Great Recession. The Participation Rate was also down from the November of 2011 level. Likewise, the Employment to Population Ration fell to 58.7%, from 62.7% in December of 2007. This number also showed no improvement from the year ago period.
Of course, some will say the fall in the number of people working and looking for work as a share of the non-institutionalized population is the result of aging demographics in the United States. However, those peak earners who are between 25 and 54 years old also saw their participation rate decline from 82.9% in 2007, to 81.1% today. This crucial number is also down from last year's reading of 81.3%. The bottom line here is people are leaving the workforce because they cannot find adequate employment opportunities; not because they have chosen to retire.
In November there were 2.5 million persons marginally attached to the labor force, which is essentially unchanged from a year earlier. These individuals were not included in the labor force because they had not searched for work in the 4 weeks preceding the survey. Also, there were 4.78 million people who have been out of work for at least 27 weeks in last month's survey. This is Bernanke's worst fear and will ensure the Fed will officially launch QE IV at the FOMC meeting next week.
If interest rates rise next year it will be because the free market is taking nominal rates higher in an effort to keep up with inflation. It will not be due to central banks getting ahead of money supply growth rates. Therefore, the primary reason behind the twelve-year boom in commodities will remain intact. Negative real interest rates caused the price of gold to increase from $250 per ounce in 2001, to $1,700 today. I expect real interest rates to fall next year, albeit at a lower rate of change than in the latter portion of the last decade, so don't expect gold to surge like it did in the 2000s. But rising prices, increasing money supply growth and falling real interest rates should be falling enough to push gold prices to new nominal highs in 2013; and that is why Goldman Sachs is completely wrong on their call.
Many investors still hope that the global economy will experience a significant rebound in 2013. I guess it is human nature to assume the optimistic position that our economic fate will turn to the upside with the new calendar. In fact, a Bloomberg poll of 862 global investors taken this month showed that 66 percent of respondents believe in a stabilizing or improving global economy, compared to just over 50 percent in September. The survey also indicated that the world economy is in its best shape in 18 months as China's prospects improve and the U.S. looks likely to avoid the Fiscal Cliff.
In sharp contrast, I believe the temporary illusion of global stabilization has come from a massive increase in public sector debt, artificially-produced low interest rates that can never be allowed to increase and central bankers that have taken their cue on how to conduct monetary policy from Gideon Gono (Governor of the Reserve Bank of Zimbabwe).
If the politicians and bureaucrats in Japan, Europe and U.S. allowed their private sectors to deleverage, if they did not interfere with the correction of asset prices, if they allowed insolvent institutions to go bankrupt, and if they did not abuse their currencies and interest rates; then they would indeed be on a sustainable and free-market based pathway to prosperity.
However, because they have the collective hubris to believe recessions can be expunged from the business cycle, what we do see is the empirical evidence of a government-induced mediocrity in the developed world, which will only lead to a severe downturn in the GDP in the near future.
If the current strategies deployed led to economic prosperity, then international lenders would not have to undertake yet another bailout for Greece. The nation already defaulted on €172 billion worth of Greek bonds, which represented 85.5% of the total €206 billion held by the private sector in the early part of 2012. However, just this week they again had to restructure their debt by cutting the interest rate on official Greek loans, extending the maturity of those loans from the EFSF bailout fund by 15 years to 30 years, and be granted a 10-year interest repayment deferral on those loans.
Turning to China, if government spending was the solution, then the Shanghai composite index would not be down 20% in 2012 and now be trading at a four-year low. Also, if central bank counterfeiting from the ECB was the answer, Spain's stock market would not be down 6% for the year. And if the U.S. was indeed rebounding after a multi-year recession, why is the S&P 500 down 4% since the end of this summer--especially in the light of the fact that it has not gained one point from the level it was five years ago?
If the global economy was about to make a turn to the upside, then industrial commodity prices would presage a rebound in growth. But instead copper prices are down from close to $4.00 per pound in February, to just $3.60 today. Oil prices were trading close to $100 a barrel in the summer and have sold off to just $88 today. If the global economy was about to make a significant move to the upside, why haven't industrial commodities and equity markets begun to price in that improvement-especially in consideration of the massive amount of liquidity that has been added by central banks?
The truth is that the Great Recession was the result of too much debt, rapid money supply growth, asset bubbles and artificial interest rates. Governments believe the economy can be remedied by placing all those conditions on steroids. They are wrong, and when falling real interest rates finally cause investors to demand a real rate of return on their holdings of government paper the game will be over.
In an effort to maintain the illusion of prosperity, politicians on both sides of isle will ensure that the Fiscal Cliff and Debt Ceiling in the U.S. will be avoided at all costs. Any retracement in government borrowing of the Fed's phony money will send the economy into a steep recession. That's because the main borrower of Bernanke-Bucks has been Uncle Sam. If our fiscal imbalances are suddenly and sharply reduced then the money supply would shrink, which would send asset prices and the economy tumbling. And then the mirages of economic stabilization and improvement would rapidly vanish away.
Therefore, the developed world will continue to be mired in stagflation, not only next year but indeed until those governments are finally forced into addressing the real underlying economic problems.
Nearly every key factor behind a bullish gold price is now currently in place save one. Once this single piece of uncertainty is removed, risk asset prices should soar.
First off, the global economy is accelerating to the downside and this is causing central banks to become the most dovish they have ever been in the entire history of fiat currencies. For example, the leader of Japan's LDP party, Shinzo Abe, called for the Bank of Japan (BOJ) to raise its year over year inflation goal to 2-3% and to engage in unlimited money printing until deflation is fully vanquished. He said if elected, he would forge an alliance with the BOJ to launch an all-out war on deflation and to attack the Yen—blaming a strong currency as the primary impediment to Japan's economic recovery. Mr. Abe also called for the BOJ’s policy rate to be cut below zero.
Not only are central banks tripping over themselves to destroy their currencies but gold should also be rising due to tensions in the Middle East that are the most explosive in many years. Car bombs are a daily occurrence once again in Iraq and last month alone 150 people were killed and 300 more wounded in the nation, according to the Iraqi Interior Ministry. Israel has now massively escalated its measures to make impotent Hamas, just as it also prepares for the growing likelihood of an all-out war with Iran come this spring. Civil unrest on this global scale is usually bearish for the global economy and quite bullish for the price of oil and gold.
Turning to the all-important U.S. central bank, Fed Chairman Ben Bernanke has all but officially announced that QE IV would be launched in January to combat the crumbling domestic economy. The Fed has communicated that $85 billion of purchases are most likely to occur in MBS and Treasuries each and every month starting in 2013. Bernanke feels compelled to deploy endless money printing because U.S. jobless claims surged 78k to 439k last week, just as the Philly Fed manufacturing survey showed a decline of 10.7% vs. an increase of 5.7% in the month prior. A faltering U.S. economy should be very dollar bearish and cause the yellow metal to move much higher.
All this money printing has already sent the monetary aggregate M2 soaring at a 12% annualized rate. Money supply growth of this nature is like rocket fuel for the price of precious metals.
On top of all this the Shanghai and Shenzhen stock exchanges are about to launch gold ETFs for their investors this December. Providing an easier way for citizens to own gold in China should be massively bullish for the metal.
So what’s the problem? There is only one; and it is something that should go away by January, at the very latest. The U.S. is currently going through a perfunctory pretense that we actually care about debt and deficits. In fact, the markets now fear that there is a significant chance that the 2013 fiscal deficit would be slashed by 70-90%. If such an unlikely scenario were to occur, most of the Fed’s money printing would lay fallow. That’s because for the broader monetary aggregates to increase they need some entity to borrow from banks. Since the private sector has been in a deleveraging mode for years, the only entity that has been borrowing with alacrity has been the Federal Government. If they were to stop borrowing money in a trenchant fashion the economy would temporarily take a nose dive along with most asset prices.
However, both republicans and democrats realize that being blamed for a recession is a fast ticket out of power. Therefore, once again our government will most likely punt on taking any serious measures towards balancing the budget by the end of the year; or at the latest in January of next year (once the Bush-era tax cuts actually do expire, it’s easier for congress to just reinstate most of them). After the charade in D.C. ends, look for all those bullish factors behind risk assets to flood the markets at once. And send the stock market higher in nominal terms and the gold market to record nominal highs next year.
The simple reason why governments never freely decide on fiscal responsibility is because fixing their well-entrenched problems of over borrowing and spending means that their already fragile economies would be temporarily thrown over a cliff.
America faces its own version of austerity come January. Tax hikes and spending cuts would cut $100's of billions off of the fiscal 2013 deficit, sending the already-anemic U.S. economy into a deflationary recession. With nearly $600 billion less debt for the Fed to monetize, the growth rate of the money supply would contract, which would send asset prices and most markets tumbling.
But the truth is that nothing of any substance will be done in regards to the deficit because if politicians, the MSM and Wall Street really wanted to cut the deficit they wouldn't be so alarmed about having the Sequestration go into effect. After all, the Fiscal Cliff is simply a combination of spending cuts and tax hikes that would dramatically lessen the rate of debt accumulation; and isn't that what we all supposedly want anyway? Of course, republicans prefer to raise revenues by lowering rates and eliminating loopholes; but the point is they still want to increase government's bounty-they just disagree on how to do it.
There would not be so much hysteria over the Fiscal Cliff if both parties actually held the belief that debt and deficits really matter. Therefore, it seems clear that austerity is something they can all agree on…only if it isn't happening under their watch.
And you can forget about a grand bargain getting done as well. There is no way the Senate and President Obama will agree on a long term deal to slash entitlements if House republicans can only assent on cutting tax rates and eliminating a few deductions on "the rich". They will instead punt on Austerity and all agree on staying drunk in order to delay the eventual hangover. It is blatantly and egregiously duplicitous for our government to claim that budgetary deficits and debt must soon be addressed, yet at the very same time panic about adopting measures that would address those imbalances now.
Even though austerity is the only real solution for our proclivity to over borrow and over spend, that scenario is untenable for the politicians. That is why fiscal austerity will be punted on and we will once again turn to the Fed to combat the anemic economy with unprecedented central bank intervention.
My guess is that there will be no significant reduction in borrowing and spending anywhere in the developed world in 2013. Once the U.S. officially backs away from the Cliff, commodity prices (especially gold) will soar. There will even be a huge relief rally in global markets due to the fact that governments have once again passed on austerity. Unfortunately, all that will be accomplished is to vastly increase the final collapse of fiat money and the debt that it supports.
It is a basic rule of human nature not to voluntarily self inflict pain upon ourselves. If there is any way to avoid the day of reckoning, even if it means the eventual catastrophe will be much worse if we delay, we always choose to hold reality in abeyance. This principle applies to countries as well because the notion of embracing austerity on a national level goes against the grain of our collective psyche.
But the United States faces a date with austerity regardless of whether it is voluntary or forced upon us. Our Q3 GDP report clearly illustrated that although growth is anemic (just 2%), inflation is creeping much higher. Despite the fact that we are in a revenue, earnings and capital goods recession; the rate of inflation doubled from 1.5% during Q2, to 3% in the current quarter. However, now the U.S. faces the Fiscal Cliff come January and that would throw the already fragile economy into a deep recession. The question is will our government voluntarily push the economy over the edge.
The truth is that the developed world faces a decision that is unbearably sharp and impossible to avoid. Either to drastically cut spending now in the hope of getting their debt to GDP ratios under control; or continue to borrow and spend until the market causes a full-blown currency and bond market crisis. The problem is that accepting austerity at this juncture would push already recessionary economies much deeper into the abyss. That’s because it will take some time before the private sector can absorb those individuals that formerly were employed by the government or relied on transfer payments for their consumption. And tax hikes steal money from the job creators and hand it over to government to be misallocated.
As the U.S. approaches the Fiscal Cliff, markets have already begun to price in its effects. The drop in government spending and increased tax revenue of around $600 billion in 2013 would cause most asset prices to fall. The reduction in government spending would also lead to a fall in money supply growth.
But austerity is something that individuals and governments have a long history of avoiding at all costs. It is my belief that the U.S. will back away from the cliff and decide to adopt a stopgap measure that extends the current tax rates and eliminates most spending cuts. The plan would then be to reach a grand bargain down the road where republicans and democrats agree on a combination of increased revenue and entitlement reform that cuts $4-6 trillion of additional debt over the next decade. However, if our government cannot agree on massive fiscal reform while there is the Fiscal Cliff hanging over its head, why will they agree down the road when no such sequestration exists?
Washington appears to be offering us two choices; trillion dollar deficits every year until we have a currency and bond market crisis or to go over the Fiscal Cliff in January. If D.C. cannot agree now to accept austerity, even after we have run up $16.2 trillion in debt, why should anyone believe they will reach an agreement in the future? Another problem is that even if we do actually cut around $5 trillion in projected deficits over the next decade, we will still be adding another $5 trillion in debt over the next ten years. That’s because these proposed cuts aren’t really cuts in existing debt but merely a reduction in the growth rate of new debt.
The truth is that austerity is unavoidable in the debt-laden developed world. Austerity is by its very nature both depressionary and deflationary. That is why it is never chosen voluntarily. It is simply much easier to continue to borrow and spend until your creditors finally cut you off. I fear that is the path of least resistance and we will see rapid growth in the money supply, a fall in the dollar and risk asset prices soar once the U.S. decides to reject the opportunity to voluntarily confront its debt addictions at this time.
There are two reasons why the price of gold has been under pressure in the last few days. One of them is legitimate; while the other is completely without grounds.
The U.S. Labor Department announced on Thursday that Initial Jobless Claims fell 30k for the week ending October 6th. The plunge took first-time claims for unemployment insurance to a four-year low. Despite the fact that this drop was mainly produced by one large state not properly reporting additional quarterly claims, the gold market took the data as a sign interest rates may soon have to rise. So I thought it would be a good time to explain that rising interest rates would not negatively affect the price of gold, as long as it is a market-based reaction to inflation; rather than the work of the central bank pushing rates positive in real terms.
The price of gold increased from $100 an ounce in 1976, to $850 an ounce by 1980. During that same time period the Ten year note yield increased from 7% to 12.5%. The reason why gold increased, despite the fact that nominal interest rates were rising, is because real interest rates were falling throughout that time frame. Bureau of Labor statistics shows that inflation as measured by the Consumer Price Index jumped from 6% in 1976 to 14% by early 1980. In addition, the Fed, under Arthur Burns and G. William Miller, kept the Funds rate far below inflation throughout their tenure; increasing the interbank lending rate from 5% in 1976, to just 10.5% by late ’79--just before Chairman Volcker took the helm.
Bernanke knows that the job market isn’t really improving anywhere close to the level that he believes would result in rising aggregate prices. Therefore, the gold market should not fear an increase in interest rates anytime soon stemming from better jobs data and the Fed. Any such increase in rates would merely be a reaction to an increase in the rate of inflation and not the result of the central bank. Thus, they would not be rising in real terms and pose no risk at all to the gold market. It is only when a central bank boosts interest rates above the rate of inflation that gold prices would start to retreat. And there just isn’t any hint of that from any central bank on planet earth at this time.
Gold prices have also soared in the last dozen years from $250 in 2001, to $1,760 per ounce today. Just like they did during the 1970’s, real interest rates are still falling and the central bank is keeping the funds rate well below inflation throughout this current period.
The important point here is investors in precious metals need to only be concerned with the direction of real interest rates. As long as the rate of inflation is rising faster than the increase in nominal yields, gold prices will remain in a bull market.
The second reason (and perhaps the only legitimate one) why gold prices are under pressure is because the looming Fiscal Cliff is almost upon us. The base case scenario at Pento Portfolio Strategies is that politicians of both parties will once again act in their own self interest, rather than that of the country, and avoid the drastic spending cuts contained in the Sequestration. A steep contraction in government spending would cause a serious recession to occur in the short term, but is absolutely essential for the long-term health of the country.
However, U.S. deficits have been habitually north of $1 trillion for the last four years. The Federal Reserve has already increased their balance sheet by trillions of dollars; and that money has been used by commercial banks to monetize government debts and increase the money supply. If we do indeed go over the fiscal cliff, annual deficits would be halved and gold prices are discounting the potential reduction in the growth rate of outstanding debt and the money supply.
Investors should ignore the “improvement” in jobs data and instead focus on the rapidly crumbling economic situation around the globe. However, fiscal austerity is deflationary in nature. If it is undertaken in the U.S., (even if by force) commodity prices and indeed most markets across the board would feel the pinch. It is still prudent to stay long precious metals, energy and agricultural commodities and their stocks at this juncture. However, purchasing some put protection on your investments may also be a prudent idea.
The gold market dropped nearly $20 an ounce shortly after the U.S. Non-farm Payroll report was released on Friday. The Labor Department reported that the unemployment rate dropped to 7.8%, from 8.1% in the month prior. Gold prices retreated on the fear that the Fed may decide to truncate its debt monetization schemes in the near future.
However, after digging a bit into the report investors in the yellow metal should find those fears without grounds. Friday's figures revealed that the underemployment rate--which includes those part-timers who would prefer a full-time position and also those people who desire to work but have given up looking - remained unchanged at 14.7%. In addition, only 114k jobs were added in the establishment survey; and the all-important manufacturing sector of the economy actually lost 16k jobs.
Not only was the actual data from the BLS not very impressive but the Fed is on record saying that the U.S. economy needs to experience a prolonged period of time where 250k jobs are added each month before the Fed would consider changing its monetary policy stance.
Rather than looking to take a step backwards; the Fed is hatching plans for QE IV, which will be an additional $45 of Mortgage Backed Securities and Treasury purchases beginning in January.
In fact, investors around the world are being forced into buying precious metals; and should consider holding sovereign debt the world's worst investment.
European Central Bank President Mario Draghi said on Thursday the institution was ready to fire its bazooka and begin purchasing bonds. Mr. Draghi said the ECB's bond-buying plan has already "helped to alleviate tensions over the past few weeks." And proclaimed the era of Outright Monetary Transactions in sovereign bond markets aimed "at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy" is about to begin.
Japanese investors are in the same sinking vessel as Europeans and Americans. Last Friday, the BOJ's policy board decided to maintain the size of its asset-purchase program, its main tool for monetary easing, at ¥80 trillion ($1.02 trillion) following a two-day meeting.
The meeting featured the unusual attendance of Japan's newly appointed economy minister, Seiji Maehara, on the second day of the session. He said, "I have a sense of crisis about the continued strength of the yen and Japan's inability to overcome deflation. I wanted to express this feeling through my attendance at the policy board meeting,"
With people like that in charge of your currency's purchasing power, investors in Yen denominated assets should cringe. Long notorious for urging the BOJ to take aggressive action against deflation, Mr. Maehara has said recently that the central bank should consider buying foreign bonds as a means of injecting more liquidity into the economy to help tackle falling prices. What Japan's economic minister is actually suggesting is that the BOJ not only dramatically increase the supply of Yen, but also directly manipulate the currency's value much lower by selling Yen and buying foreign currencies for the purpose of holding non-domestic debt.
Therefore, are the citizens of the United States, Europe and Japan encouraged to park their savings in sovereign debt while their central banks are the only buyers and the real rate of return is negative and falling?
There is a tremendous bubble being created in the fixed income markets of the developed world. Real interest rates are headed much further south and the value of those currencies is declining against other countries that display better monetary discipline.
Investors must own precious metals when nearly every other "risk-free" sovereign investment offers a negative return after adjusting for inflation. Since the bond market virtually guarantees investors will be a loser from the start, placing money in hard assets, which have a long history of keeping pace with inflation, is an easy choice.
Stock markets around the world continue to levitate despite the fact that the fundamentals behind the global economy continue to deteriorate.
U.S. second quarter GDP was significantly revised downward last week from the previously reported 1.7%, to just 1.3%. The paltry 1.3% reading on GDP followed a first quarter print that was already an anemic 2%. Also reported last week was the worsening state of consumer's income. Their take home pay (after taxes and inflation are considered) dropped 0.3% in August, as their savings rate fell to just 3.7%, from 4.1% during the prior month. Another worrisome report showed manufacturing activity in the Chicago region contracted for the first time in three years in the month of September, according to the MNI Chicago Report released on Friday.
But that weak and worsening economic data didn't stop investors from sending stocks higher. The Dow Jones Industrial Average climbed 4.3% and the S&P advanced 5.7% in the third quarter. However, any economic growth to support those moves was seriously lacking. The simple reason behind the ebullient stock market during last quarter was the Fed's persistent threat to soon launch a massive amount of debt monetization. Mr. Bernanke followed through on that threat by announcing an open-ended counterfeiting scheme on September 13th.
Turing to Europe, the situation is much the same. Spanish unemployment has reached 25% and the bank of Spain warned last week that the country is in a "deep recession", which will be its second in the last three years. Also, an audit of Spanish banks indicated that $76.3 billion of capital will be needed for their banks to ride out the next recession and that paved the way for the troubled nation to ask for an international bailout.
However, that negative and deteriorating news didn't stop Spain's IBEX 35 from climbing nearly 30% in the last two months! That's because Mr. Draghi promised to do "whatever it takes" to save the Euro on July 26th, which coincided perfectly with the turnaround in Spanish stocks and the drop in their 10 year note yield from 7.6%, to 5.9%.
Joining the Fed and the ECB's recent efforts to push stock prices higher was the People's Bank of China. The PBOC injected a net $57.9 billion into money markets last week, which was the largest in their history. The market's reaction was swift and profound, sending the Shanghai Composite up nearly 5% in just three trading days. The move higher was achieved despite the fact that manufacturing activity in China during September remained in contractionary territory for the 11th consecutive month and their GDP continues to falter.
The U.S. is headed over the fiscal cliff and into another recession but who cares? Investors can't sit in cash while the Fed is destroying the purchasing power of the dollar. Europe is in recession and its Southern nations are flirting with a depression; but it just doesn't seem to matter. You can't hold bonds when the ECB is rapidly inflating the Euro and is pushing bond real yields further into negative territory in real terms. China's growth rate is plunging and a substantial portion of their economy has been in recession for almost a year. However, it isn't enough to stop shares from turning higher. You can't hoard Renminbi if the PBOC is flooding the banking system with new money at a record pace.
Of course, this investing is being done out of desperation, in an effort to keep ahead of inflation; and in no way represents the hope that real growth will resume anytime soon. In fact, these counterfeiting efforts do serious damage to the economy.
But investors should never fight a central bank that has pledged to do everything in their power to prop up asset prices. A firm commitment from those that control the currency to systematically destroy its value renders investors with no choice but to plow money into precious metals, energy and agriculture.
The worldwide currency debasement war has now entered a new and more deadly phase. Central banks have escalated the combat plan to bring about the world's weakest currency for their individual countries. On the heels of the Federal Reserve and European Central Bank's promises of unlimited counterfeiting forever, the Bank of Japan announced last week that it would expand its purchase of Japanese Government Bonds (and other assets including equities) by 10 trillion Yen. This brings the latest round of BOJ intervention to a total of 80 trillion Yen!
The sad fact is that the developed world's central banks are in a desperate battle of one-upmanship. The ill-founded goal is to wreck their currency's value in relationship to other fiat currencies in order to boost manufacturing and stimulate economic growth. But once again these central bankers have their economics backwards.
A weak currency that is caused by printing money cannot create a more competitive market for a country's exports because it increases the cost of goods sold in terms of the domestic currency. Central banks reduce the value of their currency by lowering interest rates and boosting the money supply. This causes aggregate prices to rise, especially on manufactured goods that are a key component of exports. While it is true that foreign currencies will have a more favorable exchange rate, the price of domestic goods and services will have increased in commensurate fashion-thus, offsetting the change in currency valuations. Therefore, there is no improvement in the balance of trade and no improvement in economic growth from competitive currency devaluation.
For example, the U.S. dollar peaked at 160 on the Dollar Index back in 1985--the USD Index is comprised from a basket of our 6 largest trading partners. This index has lost 50% of its value since that time and stands at just 79 today. According to the economics of today's central bankers, this should have engendered a U.S. manufacturing renaissance, a huge trade surplus and a vibrant economy. However, the U.S. economy has been mired in anemic growth for years. The trade deficit has been a chronic problem for decades and was $559 billion last year alone. And manufacturing as a percentage of the economy has dropped from 18% in 1985, to just 12% today.
You just cannot ignore the fact that governments and central banks are engaged in a global currency war. But we already know who the losers are in this battle; they will be the middle classes and the economies of the developed world. There will be no sustained economic growth until they make peace with their currencies and put aside the notion that prosperity can come from inflation.
The foundation for strong economic growth comes from having competitive tax rates, limited regulations, attractive labor costs, stable interest rates, a low debt to GDP ratio, price stability and a sound currency. By actively destroying a currencies purchasing power, money printers work against all those principles. Until those in charge of fiat currencies reach that epiphany, the only winners will be those that can afford to place a significant portion of their investments in hard assets.
Last week, Fed Chairman Ben Bernanke announced that the central bank would launch an unprecedented form of quantitative easing. This "new and improved" iteration of money printing will be without limit and duration. The Fed Head launched QE III ($40 billion of MBS purchases every month) on September 13th and stated that it will remain in effect until the labor market "improves substantially." He also promised that, "The Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved…"
In other words the Fed will continue to counterfeit money until there is a substantial decline in the unemployment rate. But there are two major problems with this measure. The first is interest rates have been at record lows for the last four years and the money supply (as measured by M2) is up over 6% from twelve months prior. Therefore, onerous interest rates cannot be the cause of our high unemployment rate and the money supply is already growing well above productivity and labor growth. The other major problem with his plan is that the unemployment rate doesn't fall when the dollar is devalued, the middle class gets dissolved and the inflation rate is rising.
The first round of Quantitative Easing began in November of 2008. At that time the unemployment rate in the U.S. was 6.8%. The second round of QE began in November of 2010 and ended by July of 2011. However, after printing a total of $2 trillion and taking interest rates to virtually zero percent, the unemployment rate had risen to 9.1%.
After four years of money printing and interest rate manipulations, the economy still lost 16k goods-producing jobs and 368k individuals became so despondent looking for work that they dropped out of the labor force last month alone. And the unemployment rate has been above 8% for 43 continuous months. Mr. Bernanke must believe that $2 trillion dollars worth of counterfeiting isn't quite enough and 0% interest rates are just too high to create job growth, so he's just going to have to do a lot more of the same. But by undertaking QE III the Fed is tacitly admitting that QEs 1 & 2 simply didn't work.
Here is why printing money can never lead to economic prosperity. The only way a nation can increase its GDP is to grow the labor force and increase the productivity of its workers. But the only "tool" a central bank has is the ability to dilute the currency's purchasing power by creating inflation. Central Bank credit creation for the purpose of purchasing bank assets lowers the value of the currency and reduces the level of real interest rates. Interest rates soon become negative in real terms and consumers lose purchasing power by holding fixed income investments.
Investors are then forced to find an alternative currency that has intrinsic value and cannot be devalued by government. Commodities fill that role perfectly and prices rise, sending food and energy costs much higher. The increased cost of those non-discretionary items reduces the discretionary purchases for the middle class. The net effect of this is more and more of middle class incomes must be used to purchase the basics of existence. Therefore, job losses occur in the consumer discretionary portion of the economy.
The inflation created by a central bank also causes interest rates to become unstable. Savers cannot accurately determine the future cost of money and investment activity declines in favor of consumption. Without having adequate savings, investment in capital goods like machinery and tools wanes and the productivity of the economy slows dramatically.
The result is a chronically weak economy with anemic job growth. This condition can be found not only in the U.S. but in Europe and Japan as well. These stagflationary economies are the direct result of onerous government debts, which are being monetized by their central banks.
I predicted that QEs I & II would not work and I also predicted back in January that QE III would occur in the second half of 2012. I now predict that QE III will fail as well, causing the unemployment rate to rise along with the rate of inflation. In fact, I believe the unemployment rate will increase sharply over time. That will force Mr. Bernanke to choose which mandate (full employment or stable prices) takes precedence. I believe he will choose the former. That means this round of quantitative counterfeiting will last as long as he is Chairman of the Fed.
What the Fed has accomplished is enable Washington to amass $6 trillion of new debt since the Great Recession began in December of 2007. They have not only prevented an economic recovery from occurring but and have catapulted the U.S. towards a currency and bond market crisis in the next few years.
Anemic economic data in the U.S., Europe and in emerging markets has virtually guaranteed that the Fed will launch QE III on September 13th. Two perfect examples of America’s structurally-weak economy could be found last week in the Institute for Supply Management Manufacturing Survey and the Non-Farm Payroll report for August.
The ISM survey came in at 49.6, which was the lowest level since July 2009, indicating the very industry that was once credited for engendering an economic recovery is now back in recession. The employment component of the survey contained the lowest reading since November of 2009 and the new orders component dropped to 47.1, which was the third consecutive monthly decline. However and perhaps most importantly, the prices paid index jumped 14.5 percentage points to 54. This survey clearly states that the U.S. is headed for a more severe slowdown than what Wall Street is anticipating. But it will also be accompanied by rising aggregate prices.
Also highlighting the faltering economy was last Friday’s unemployment report, which left little doubts that the chronically sub-par employment condition is getting even worse. Not only were there only 96k net new jobs created but nearly one third of those jobs were in the food service sector. The all-important goods producing sector continues to operate on life support and actually managed to shed 16k jobs; despite the belief that we are in fourth year of recover. But the most disturbing part of the report was that 368k Americans became so despondent looking for employment that they gave up and left the work force; sending the labor force participation rate to 63.5%, the lowest level since 1981.
The European recession, which continues to steepen, has already caused the ECB’s Mario Draghi to promise to purchase unlimited quantities of bonds with duration of 1-3 years on the secondary market. Mr. Draghi plans to “sterilize” these purchases by auctioning one-week term deposits to banks. But there are two problems with this form of sterilization. The first is there is no guarantee that private banks will hand over all of their newly printed money back to the ECB. Instead, they may choose to make loans to the private sector and receive a higher return, causing a rapid increase in money supply growth. In fact, recent term deposits have yielded just 0.01% and the ECB has stopped paying interest on excess reserves, so there just isn’t much incentive to park a tremendous amount of cash at the ECB. And the second problem is that offering a one-week term deposit only removes money from the private banking system for seven days. It is not the same as selling a long-term bond to the bank. Therefore, the sterilization done by the ECB will only be temporary at best.
The Federal Reserve under Ben Bernanke will make no such pretension towards sterilization. He simply wants banks to lend in spades and for the money supply to grow substantially. The Fed will most likely announce on September 13th a program to purchase a fixed dollar amount of Treasuries and Mortgage Backed Securities until the unemployment rate falls below 7%. He may also lower the interest paid on excess reserves.
However, the only problem with ECB and Fed money printing is that it has been tried for the last five years and hasn’t worked. The unemployment rate in the U.S. has been above 8% for 43 consecutive months and EU (17) unemployment, now reaching 11.2%, continues to set Euro-era records with each new release.
In truth, a central bank has only one tool; and that is to systematically erode the confidence of holding the currency by increasing its supply. The ECB launched its plans for further money printing last Thursday and the Fed will officially announce their plans to launch QE III this coming Thursday. But these are just counterfeiting cruises to nowhere.
Central bank interventions are the reason why the desperately needed deleveraging process was cut short. They have acted as enablers for their governments to run up massive debts. They have brought about never-ending recessions. They have caused energy and food prices to soar. They have eroded the incentive to save and invest and caused productivity rates to crumble. And they are the primary culprit behind faltering global growth.
No central bank has ever been able to restore solvency or create prosperity for any country. All they have ever served to accomplish is to wipe out the currency and middle class. These new central bank interventions are unprecedented in nature and will have a dramatic affect on your investments and the global economy.
If the August Non-farm Payroll report produces a number of less than 100k jobs, the chances of QE III being announced on September 13th are close to 100%. However, if the number is north of 100k the odds drop, but are still about 80% on more Fed money printing.
The truth is that the worsening global economy is going to force the hands of both the Fed and ECB. For example, China's exports to EU (17) dropped 16.2% in July, as sales to Italy plunged 26.6% from a year earlier. The stumbling world economy has sent prices for base metals like iron ore falling 33% since July, which is the lowest level since October 2009. And now the nucleus of Europe, Germany, is starting to split. German unemployment increased five straight months in August to reach 2.9 million. Factory orders fell 7.8% in June YOY as manufacturing output contracted further in August. Finally, EU (17) unemployment hit a Euro-era record 11.3% in July, as U.S. initial jobless claims and the unemployment rate have started to creep back up.
But listen up all you lovers of the Phillips Curve and inflation atheists; Spain's unemployment rate has just reached another Euro-era high of 25.1% in July. However, inflation is headed straight up, rising from 1.8% in June, to 2.7% in August. But this is just the beginning of rising unemployment and inflation. Just wait until the ECB and Fed launch their attack on their currencies in September.
The European Central Bank and Federal Reserve are both about to announce this very month an incredible assault on the Euro and the dollar. The European Union said on August 31st that it proposes to grant the ECB sole authority to grant all banking licenses. This means the ECB would be allowed to make the European Stabilization Mechanism a bank-if sanctioned by the German courts on September 12th. That would allow them an unfettered and unlimited ability to purchase PIIGS' debt and is exactly what Mario Draghi meant when he said he would do "whatever it takes to save the Euro."
Not to be outdone, Fed Chairman Bernanke gave a speech on the same day indicating that open-ended quantitative easing will most likely be announced on September 13th. Fed Presidents Eric Rosengren and John Williams spelled out what open-ended QE means. The Fed would print about $50 billion per month of newly created money until the unemployment rate and nominal GDP reach targets levels set by the central bank.
Incredibly, Mr. Bernanke said in his speech at Jackson Hole, WY that previous QEs have provided "meaningful support" for the economic recovery. He then quickly contradicted himself by saying that the recovery was "tepid" and that the economy was "far from satisfactory." He also said, "The costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant." He continued, "…the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor-market conditions in a context of price stability." Mr. Bernanke actually believes he has provided the economy with price stability, despite the fact that oil prices have gone from $147 to $33 and back to $100 per barrel all under his watch--precisely due to Fed manipulations.
Therefore, the Fed also believes their attack on the dollar has helped the economic recovery and that it has been conducted with little to no negative consequences. Of course, to believe that you first have to ignore our rising unemployment rate and also fail to recognize the destruction of the middle class that has occurred since 2008. And incredibly, Bernanke also believes the $2 trillion worth of counterfeiting hasn't quite been enough to bring about economic prosperity, so now he's going have to do a lot more.
The saddest part of all is that the Fed and ECB don't realize their infatuation with inflation, artificial low rates and debt monetization has allowed the U.S. and Europe the ability to borrow way too much money. Their debt to GDP ratios have increased to the point that these nations now stand on the brink of insolvency. And now these central banks will embark on an unprecedented money printing spree that will eventually cause investors to eschew their currencies and bonds. Therefore, they have managed to turn what would have been a severe recession in 2008, into the current depression in Southern Europe; and a currency and bond market crisis in the U.S. circa 2015.
It looks like fiat currencies will get flushed in September. The only good news here is that the failed global experiment in counterfeit currencies may be quickly coming to an end. In the interim, investors that have exposure to energy and precious metal commodities will find sanctuary.
The European Central Bank and the Federal Reserve have both telegraphed that another round of currency depreciation is in the offing. The ECB’s Mario Draghi has pledged to do “whatever it takes” to save the Euro currency by setting specific targets for Italian and Spanish bond yields. And the Bernanke Fed has stated that addition monetary stimulation is warranted soon unless there is a “substantial and sustainable strengthening in the pace of the economic recovery.” Fed Presidents Charles Evans and Eric Rosengren have both recently indicated what action would be taken by saying that the U.S. central bank needs to expand its balance sheet until more favorable targets are reached on the unemployment rate and nominal GDP.
But there is little doubt, unfortunately, that both the European and American economies continue to falter. A composite index of Europe’s manufacturing and service sectors contracted for the seventh straight month is August. Meanwhile, U.S. capital goods orders fell 3.4% in July, which was the largest decline since November 20011 and the fourth decline in the last five months. That can hardly be misconstrued as evidence of a substantial or sustainable economic recovery. Even the four-week moving average of initial jobless claims rose 3,750 last week as the unemployment rate in the U.S. continues to rise. In addition, EU 17’s unemployment rate now stands at a Euro-era record 11.2%.
Therefore, there is now little doubt that more central bank money printing is coming in September. They are playing a game of poker with the markets but aren’t very good at hiding their cards. Promises and threats of more monetary intervention have already caused commodity and equity prices to rise in anticipation. The 24 raw materials in the S&P GSCI are up 21% since June 21st and have just entered new bull market. Gold prices have increased over $100 an ounce and oil prices have soared 25% since mid-June. Even the S&P 500 index has risen 10% since the June low and the Spanish IBEX has soared 21% since July 25th.
The problem now is that unless the official announcements of quantitative easing from the ECB and Fed are surprisingly massive, much of the move in economically sensitive commodities and equities may have already been priced in. And after we receive the September decisions on monetary policy from Mario Draghi and Ben Bernanke, there isn’t much to carry those prices higher until the U.S. presidential election is concluded. However, what could weigh on markets between then and November is the continued political paralysis in Washington over how to reduce America’s out of control deficits and the likelihood of $200 per barrel oil resulting from an Israeli attack on Iran’s nuclear facilities.
Therefore, investors should pay close attention to what the ECB does on September 6th and what the Fed does on September 13th. Unless the QE plans are “significant and sustainable”, equity and industrial commodity prices could be in for a sharp decline. However, gold and oil ETFs should provide the best protection if war breaks out in the Middle East and/or if central banks decide to launch a “significant and sustainable” attack on fiat currencies.
Global central banks have promised to pump an unprecedented amount of money into the system. They are trying to mollify the effects from a global contraction in GDP and the growing likelihood of a war between Israel and Iran.
Bloomberg recently reported that Israeli Prime Minister Benjamin Netanyahu told U.S. Defense Secretary Leon Panetta on August 1st that “time is running out” for a peaceful solution to Iran’s atomic program. The Tel Aviv-based newspaper Haaretz also reported on August the 10th that Netanyahu and Israeli Defense Minister Ehud Barak are considering bombing Iran’s nuclear facilities before the presidential elections in the U.S. In addition, Shlomo Brom, a former Israeli army commander said the nation is now actively planning civil-defense measures including implementing a text messaging system to alert the public to missile attacks, mass distribution of gas masks for their population and bomb-shelter drills for students returning to the class room, the newspaper Yedloth Ahronoth reported on August 15th.
A war in the Middle East would send oil prices soaring towards $200 per barrel, which would immediately usher in a severe worldwide recession. Central bankers are preparing now to help ease the pain at the pump. Unfortunately, their strategy to lower oil prices is to massively depreciate their currencies. Therefore, that will only further exacerbate the problem by sending energy prices even higher.
But even if another war in the Middle East can be avoided, the global economy continues to suffer and that will cause further central bank intervention. U.S. regional manufacturing surveys released this week indicate a significant deterioration in economic activity is now occurring. The Empire State Manufacturing Survey dropped 13 points and fell into negative territory for the first time since October 2011. And the Philly Fed Survey came in at -7.1 for August, which was the fourth negative reading in a row.
Meanwhile, S&P 500 companies are reporting Year over Year revenue growth that is barely positive and is predicted to post a negative 0.7% in the third quarter. China’s industrial production has now contracted for seven quarters in a row, and Japanese GDP fell sharply to 1.4% in Q2 from 5.5% in the first quarter. Europe is faring even worse as Italian GDP dropped 2.5% YOY and their public debt jumped to a record 2 trillion Euros. French GDP growth came in at zero and German GDP growth fell from 0.5% in Q1 to just 0.3% in the current quarter.
Additionally, unemployment rates in Europe and the U.S. continue to climb. Portugal’s unemployment rate hit a Euro-era record 15% and Spain’s unemployment rate rose to 25%. The Federal Reserve has a mandate to bring down our 8.3% unemployment rate and the European Central Bank feels that the rising number of those without work is a deflationary threat, which goes against their mandate of providing stable prices as well.
The stock markets in Europe and the U.S. have been rising on the promise of more central bank easing and European bond yields have come down in anticipation of those ECB purchases. “Help” has been guaranteed by ECB head Mario Draghi in the form of giving the European Stability Mechanism a banking license to purchase insolvent government debt. And Boston Fed President Eric Rosengren is urging the U.S. central bank to commit to an unprecedented amount of money printing.
A growing possibility of war in Iran and the worsening economies in Europe and the U.S. have caused central banks to prepare investors for another round of money printing. The time has now arrived for the Fed and ECB to either follow through on their threats or to sit back and watch as equity shares plummet and bond yields in Europe soar. If central banks launch the assault on their currencies, I expect gold and energy prices to increase sharply. In that case precious metal and energy shares should fare the best. However, in the unlikely event that the month of September ends without any action on the part of the ECB and Fed, I would expect a significant retracement in all global markets and especially in commodity prices.
There is just far too much attention being paid to the so called Fiscal Cliff occurring at the end of this year. The expiration of the “Bush era” tax cuts and forced spending reductions taking place because of the Sequestration, really doesn’t amount to much more than a fiscal speed bump. In fact, less government spending is one of the pathways to prosperity; rather than becoming some make-believe economic catastrophe. And although raising tax rates isn’t an optimal solution, there could still be a small benefit if there was a resulting increase in revenue, which then served to reduce annual deficits and began to address our long-term fiscal imbalances.
However, there is indeed a real fiscal cliff that the United States is racing towards. It’s the very same cliff that Europe has already dived over. That cliff is based on the collapse of our debt and dollar markets, resulting from the lost faith on the part of international investors. And that loss of faith is being greatly facilitated by our Federal Reserve.
The Fed has been on an avowed inflation quest since 2008. They have sought inflation by systematically seeking to destroy the value of the dollar. By already printing trillions of dollars and now threatening to print even more, Mr. Bernanke has not only crumbled our currency but has also ruined the purchasing power of the middle class. But the worst part of the central banks’ assault on our nation is the fact that Bernanke has been a tremendous enabler of the U.S. government’s fiscal irresponsibility. He has duped our leaders into believing they can borrow an unlimited amount of money at nearly zero cost indefinitely.
I wrote this ominous warning back in May of 2010:
"However, a temporary reprieve from significantly higher yields has been given courtesy of Europe. Investors are fleeing Greek debt and the Euro currency in favor of the U.S. dollar and our bond market. But this is a temporary phenomenon and in no way bails out America from its own fiscal transgressions. In just a few years our publically traded debt will reach nearly $15 trillion. If interest rates just rise to their historic averages, the interest on our debt (depending on the level of economic growth and tax receipts) will absorb anywhere from 30-50% of total Federal revenue. If we indeed reach that point, massive monetization of the debt may be deployed by the Fed in a vain effort to keep rates from spiraling out of control."
Back in 2010 I calculated that U.S. publicly traded debt would become unmanageable by 2015. We are moving ever closer to fulfilling that prediction, as our publicly trade debt has just soared past $11 trillion. In fact, since the recession began in December 2007, the amount of publicly traded U.S. debt has increased by 117%! Since the Fed has managed to temporarily and artificially manipulate interest rates lower throughout that increase of debt, the government believes there is no rush to change its borrowing and spending addiction. However, there is a limit to how much a country can borrow with impunity. If you debate that point just ask the Greeks, Spanish, Portuguese, Irish and Italians.
But now Boston Fed president, Eric Rosengren, has just predicted our central bank will not only cease paying interest on excess reserves, but will also commit to an open-ended form of counterfeiting. He believes QE III should be results orientated in that the Fed should obligate itself to continue to print money until the unemployment rate and nominal GDP hit their--yet to be named--specified targets.
The only problem with that is boosting nominal GDP requires boosting inflation; and rising inflation serves to raise the unemployment rate, not bring it down. So there is a conflict that the Fed is completely unaware of or refuses to acknowledge.
History has proven that no matter where it is tried, massive central bank intervention to control interest rates and rescue the economy increases the number of those who are unemployed. That tactic is failing miserably now in Europe and has utterly failed here in the U.S.
With central banks now acting in unison to garner complete control of interest rates, the only mechanism available that will eventually force them to stop piling on more debt is the repudiation of fiat currencies that back those bonds on the part of the free market.
Central banks across the globe are about to launch a coordinated effort to boost inflation. And Pento Portfolio Strategies has now nearly fully prepared our clients for a global and unprecedented attack against deflation. You would be wise to prepare accordingly.
The developed world’s central banks are now foolishly preparing for a full assault on their respective currencies in an attempt to lower unemployment rates. Spurring these central bankers into action is persistently anemic markets and employment data, which they believe can be rectified by creating inflation.
U.S. jobs data showed that the Non-farm payroll report for July produced 163k jobs. That sounds ok at first glance. However, the Household Survey conflicted with the Establishment Survey, in that it concluded 195k net individuals actually lost their jobs last month; and that the unemployment rate ticked higher to 8.3%. Americans continue to leave the workforce—150k left last month—while our unemployment rate has now been above 8% for the last 41 months. That stubbornly high and rising unemployment rate will likely cause Mr. Bernanke to announce QE III in September.
Taking a look over in recession-ravaged Europe, the unemployment rate in Spain rose to 24.6% in the second quarter of 2012, which was an all-time high since records were kept starting in 1976. That has already caused Mr. Draghi to promise an unprecedented and unlimited bond buying scheme that will necessitate hundreds of billions in freshly printed Euros--just for starters.
Adding to the fears of weak growth and increased joblessness are the depressed stock markets around the globe. The Shanghai Composite Index is down 13% in the last 3 months. The Nikkei Dow has shed 15% in the last 4 months. And Spain’s IBEX has plunged 21% in just 5 months.
So Bernanke and Draghi have threatened to unload a massive debt monetization and inflation strategy to get people back to work. That all sounds great and wonderful, except the total disregard for a currency’s purchasing power is one of the reasons behind those long unemployment lines.
If one doesn’t know their history, you might be duped into believing money printing has a chance to reduce unemployment. In fact, all central bankers need to do is open their eyes and see what is going on around them to understand their folly.
Spain’s unemployment rate, which has soared from 9% in 2008, to just below 25% today, hasn’t stopped inflation from rising. Spanish inflation rose 2.2% YOY in July, and that was up from 1.8% in the month prior. That’s not runaway inflation by any means. However, it is certainly not deflation either. According to the philosophy of today’s central bankers, having one quarter of your workforce in perpetual siesta should bring about massive deflation. Which, of course, must be fought with the full force of the printing press. But all that accomplishes is to bring rising prices along with the misery of being unemployed. The saddest part is that the ECB launched their LTROs in December 2011 and March 2012. Therefore, the full inflationary impact from these programs is only just beginning to be realized.
The history of the U.S. shows the same results. Our inflation rate reached its apex in 1980 at 13.5%. According to those who place too much faith in counterfeiting, that should have brought with it full employment. But the unemployment rate was a lofty 7.2% at that time and reached 10.2% within the next two years.
The truth is that destroying the purchasing power of your currency serves to increase the unemployment rate. That’s because it erodes the impetus to save and invest, robs the middle class of its standard of living and leaves the economy in ruins. Economic growth comes from stable interest rates, low inflation and a sound currency. Persistent money printing erodes all of the basic principles of a strong Economy.
What you eventually end up with is a chronically weak currency, intractable inflation, onerous tax rates, a sovereign debt crisis and a depressionary economy. That always leads to civil unrest. Therefore, the allocation in your portfolio towards some ownership of gold has now become mandatory.
It is obvious to me that the world of economics has now fully entered the Twilight Zone. As evidence, last week, European Central Bank Head Mario Draghi pledged to quote, "Do whatever it takes preserve the Euro. And believe me, it will be enough." In this upside down world of phony Keynesian Economics, doing "whatever it takes to preserve the Euro” apparently now means promising to dilute the purchasing power of the currency into oblivion.
The ECB plans to use their hoard of freshly-minted counterfeit money to purchase the insolvent debt of bankrupt nations. Incredibly, the ECB’s dedication to create unlimited inflation actually served to send bond yields much lower. The Italian 10 year note plunged 77 bps and the Spanish 10 year note dropped by 88 bps just days following the announcement. What’s more, the Euro unbelievably rallied to a three-week high.
Sane individuals realize that the ebullient reaction from Southern European currency and bond markets can only be temporary at best. True economic principles are as immutable as those that exist in mathematics and science. One of those principles is that a central bank cannot pursue a massive inflationary policy without sending its currency and bond market crashing in the long term.
"To the extent that the size of the sovereign premia (borrowing costs) hampers the functioning of the monetary policy transmission channel, they come within our mandate,” Draghi also said at an investment conference in London. By saying that, the ECB president has unwittingly committed to endless money printing. Which would if executed to its fullest extent, send Europe into an inflationary death spiral. That is, a situation where there is no longer a private market for a country’s debt at current yields and the central bank becomes the predominant buyer. Therefore, they must continuously and massively print money in an effort to stop yields from rising. Otherwise, debt service payments would bankrupt the nation and cause a severe depression. However, those very same hyperinflationary actions of the central bank force borrowing costs to surge despite those efforts to artificially manipulate rates lower. Thus, the economic destruction occurs regardless, albeit with greatly increased intensity.
Not to be outdone by their European counterpart, the Wall Street Journal reported last week that the Fed would soon act to spur America’s faltering economic growth. Friday’s anemic 1.5% GDP number only served to underscore that notion. In fact, NY Senator Chuck Schumer scolded Mr. Bernanke recently saying, "Get to work Mr. Chairman.” Apparently, Mr. Schumer doesn’t think four years of zero percent interest rates, a promise to keep them at zero until at least the end of 2014 and printing $2 trillion, doesn’t amount to doing much of anything and it is time for Mr. Bernanke to do something really extraordinary.
Joining Mr. Schumer was former Vice-Chair of the Fed Alan Blinder, who wrote in the Journal that the central bank should not only consider stop paying interest on excess reserves but should also charge banks interest on reserves that they don’t loan out. That action would undoubtedly lead to an explosion of money supply growth and rising prices.
It is now becoming blatantly apparent that the central banks of the developed world are becoming desperate in their pursuit to fight deflation. And despite what the perennial deflationist contend, a central bank can always create inflation when they so choose. All they need is a firm commitment to destroy the value of the currency and have a government that is compliant towards that goal. That situation is quickly coming into fruition in Japan, Europe and the United States.
In preparing your portfolio to prosper during rapidly rising inflation you must also try to get the timing correct. The time to gear away from deflation is approaching quickly. Having some exposure to precious metals and writing covered calls against the position is currently a good strategy. Then, you must be ready to deploy a good proportion of your assets in the precious metal, energy and agricultural sectors once the Fed and the ECB follow through on their threats to take even greater steps to destroy their currencies. From all available evidence, that day is now fast approaching.
Could it be that world governments and central banks are now taking drastic measures to re-inflate their economies because they don’t believe their own economic statistics? For example, China reported that GDP growth came in at 7.6% last quarter. That’s slower growth, but still not so bad. However, China’s electricity consumption has slowed much faster than growth in official GDP (electricity generation was unchanged in June from a year earlier at 393.4 billion kilowatt-hours), when they normally move in tandem. Turning to the U.S., the Labor Department announced last week that initial jobless claims fell 26k to 350k. Sounds great…but wait. Digging into the unadjusted data, there was actually an increase of 69,971 claims for the week—an increase of 19% from the week prior. Now that’s some seasonal adjustment!
It is really any wonder why global governments and central banks are starting to panic? As I indicated in last week’s commentary on King World News, the European Central Bank decided to lower its deposit rate it pays to banks to 0%. While some foolishly believed this move would have no effect on money supply growth, we just received empirical evidence of how banks behave when the interest on their reserves are cut to nothing. Last week the ECB recently reported that overnight deposits parked at the central bank plunged by the most on record, or €484 billion in just one session. It now seems that my theory that banks would deploy their reserves was proven correct in just a matter of days.
The truth is that most global central banks are now acting in a concerted and unprecedented effort to battle deflation. South Korea cut interest rates by 25 bps and Brazil cut rates 50 bps to a record low last week; joining China, Europe, England and Japan in an aggressive attempt to raise asset prices. Not only have these central banks massively increased liquidity, but they are now moving towards taking measures to punish banks that do not do their part in expanding the money supply.
While it is true that banks don’t depend on a tremendous level of reserves to make new loans, it is imperative not to ignore the increase in the level of their excess reserves. These reserves came into existence when the central banks purchased assets from banks. A bank cannot afford to have a significant portion of its assets, which used to be productive and earning interest, to then become latent for an extended period of time.
However, the key point here is that while the Bernanke Fed has sat on hold, other central banks are cutting rates, reducing reserve requirements, buying equities and ceasing to pay interest on excess reserves. That has caused the U.S. dollar to rise 12% in the past year. This factor alone has stoked Bernanke’s deflation phobia to an unbearable degree.
I believe the cyclical period of deflation that I warned about several months ago is now close to an end. The Fed feels foolishly compelled to stop the rise of the U.S. dollar and will soon opt to follow the lead from the ECB and stop paying interest on excess reserves. That move will not increase bank lending to the private sector, as much as it will force banks into purchasing even more sovereign debt. If they Fed does indeed go down that road, I would expect to see U.S money supply growth increase significantly, causing gold and commodity prices to soar and the dollar tank. I would also expect to witness the global economy sink ever further into the stagflationary abyss.
Spanish and Italian bond yields have now risen back up to the level they were before last week's EU Summit. We also learned last Friday that U.S. job growth remains anemic, producing just 80k net new jobs in June. The global manufacturing index dropped to 48.9, for the first time since 2009. And emerging market economies have seen their growth rates tumble, as the European economy sinks further into recession. ;
It isn't much of a surprise to learn that central banks in China, Britain, Europe and America have indicated that more money printing is just around the corner.
In fact, we have recently witnessed the People's Bank of China cut their one-year lending rate by 31 bps to 6 percent. The European Central Bank cut rates 25 bps, to .75 percent and dropped their deposit rate to 0 percent. And the Bank of England restarted their bond purchase program just two months after ending the previous program, which indicates the central bank will buy another 50 billion pounds of government debt.
Last week's Non-farm payroll report in the U.S. virtually guarantees the Fed will take action to compel commercial banks into expanding loan output within the next few months. It would be unrealistic to believe Ben Bernanke would watch U.S. inflation rates fall, the major averages significantly decline, employment growth stagnate; and do nothing to increase the money supply--especially while his foreign counterparts are aggressively easing monetary policy and trying to lower the value of their currencies.
As I predicted as far back as June of 2010, the Fed will soon follow the strategy of ceasing to pay interest on excess reserves. Since October 2008, the Fed has been paying interest (25 bps) on commercial bank deposits held with the central bank. But because of Bernanke's fears of deflation, he will eventually opt to do whatever it takes to get the money supply to increase. With rates already at zero percent and the Fed's balance sheet already at an unprecedented and intractable level, the next logical step in Bernanke's mind is to remove the impetus on the part of banks to keep their excess reserves laying fallow at the Fed. Heck, he may even charge interest on these deposits in order to guarantee that banks will find a way to get that money out the door.
The move would be much more politically tenable than to increase the Fed's balance sheet yet further, most likely because people don't understand the inflationary impact it would have. Ceasing to pay interest on excess reserves would allow the Fed to lower the value of the dollar and vastly increase the amount of loan creation, without the Fed having to create one new dollar.
If commercial banks stop getting paid to keep their money dormant at the Fed, they will surely find somebody to make a loan to. They may even start shoving loans out through the drive-up window with a lollipop. Banks need to make money on their deposits (liabilities). If banks no longer get paid by the Fed, they will be forced to take a chance on loans to consumers, at the exact time when they should be getting rid of their existing debt. But it has already been made very clear to them that the government stands ready to bail out banks. So in reality, they don't have to worry very much at all about once again making loans to people that can't pay them back.
Commercial banks currently hold $1.42 trillion worth of excess reserves with the central bank. If that money were to be suddenly released, it could through the fractional reserve system, have the potential to increase the money supply by north of $15 trillion! As silly as that sounds, I still hear prominent economists like Jeremy Siegel call for just such action. If they get their wish, watch for the gold market to explode higher in price as the dollar sinks into the abyss.
Plunging ISM manufacturing data in the U.S. forebodes a GDP growth rate of just about 1%. And crumbling global PMI manufacturing data indicates worldwide growth is retreating to just 2%. There is a deepening recession in the EU (17) countries, while emerging market economic growth has collapsed. It isn't much of a surprise to learn that central banks in China, Britain, Europe and America have indicated that more money printing is just around the corner.
In fact, we have recently witnessed the People's Bank of China cut their one-year lending rate by 31 bps to 6%. The European Central Bank cut rates 25 bps to .75% and dropped the deposit rate to 0%. And the Bank of England restarted their bond purchase program just two months after ending the previous program, which indicates the central bank to buy another 50 billion pounds of government debt. Global central banks' love affair with counterfeiting is now without question and beyond precedent. But one has to wonder how effective more money printing will be when interest rates are already at or near rock bottom.
A central bank's stock and trade is to engage in a legalized form of counterfeiting. But counterfeiting doesn't do a very good job of encouraging businesses into expanding the amount of goods and services available for purchase; especially if the process has been well advertised. Bernanke believes in embracing Glasnost at the Fed. He wants everyone to know and understand the motives behind every action at the central bank. However, if everyone is aware that a massive round of counterfeiting is underway, it makes no sense for the economy to hire new workers or increase productivity. It is much easier to simply raise prices. If the newly created money isn't backed by anything and does not represent any increase in goods and services in the economy, rising prices will result.
If I show up at the grocery store to buy gallons of milk with counterfeit money and I tell the manager that the bills came from my printing press located in my home's basement, he will call the police…not call his suppliers to have them ramp up the milk production supply chain. However, it is illegal not to accept a central bank's money. Therefore, prices increase because the market has lost faith in the currency's purchasing power. Unfortunately, the Fed is working very hard to destroy the global confidence in holding the world's reserve currency. But it now seems Bernanke isn't alone in his quest to hold the title of counterfeiter in chief.
However, when a central bank prints money there are two sides to the equation. On the positive side, money printing, when done on the margin, lowers interest rates and reduces borrowing costs in the economy. That provides debt service relief to borrowers and can encourage people to take on even more debt-which isn't such a good idea but can boost short-term growth. On the negative side of the equation, savers are punished and rising prices erode the purchasing power of the middle and lower classes. That's because they see the newly created money last…if they do at all. When an economy is in a balance sheet recession-as the developed world finds itself today--the economy must deleverage and will not take on much more debt regardless of how low the cost of money falls. If interest rates are already at zero percent, there can be no further relief on debt service payments that can be attained by more money printing.
It is clear that governments need to allow the deflationary deleveraging process to finally run its course, rather than continue to artificially prop up the economy by expanding public debt and having the central bank buy it all up.
More QE at that point only exacerbates the negative side of the ledger by putting further pressure on the middle class. Real GDP will contract as inflation takes off. That is what I expect to occur if the ECB and Fed recommence monetizing public debt. Asset prices will rise but the economy will sink further into the stagflationary morass.
In the past few days there appeared to have been a huge victory scored by Europe's three Italian Super-Marios. But appearances can be deceiving.
Mario Balotelli scored two goals for Italy's Azzurri, in a resounding victory against the Germans during Thursday's Euro 2012 semi-final Football game. But that victory was shot-lived, as the Italian national team was beaten 4-0 this Sunday by Spain.
Italy's Prime Minister, Mario Monti, stared down his German counterpart last week at the E.U. Summit and demanded that there be no austerity strings attached to a 500 billion Euro ($630 billion) bailout fund, which he insisted must also be allowed to purchase Italian bonds directly.
And ECB chief, Mario Draghi, hailed the decisions coming out of Brussels saying, "The future possibility of using both the European Stabilization Mechanism (ESM) and the European Financial Stability Facility (EFSF) for direct capitalization of the banks, which was something that the ECB had advocated for some time, is another good result." According to the ECB, the other "good result" is not having those loans pass through PIIGS' budgets first, which would have exacerbated their debt burdens.
Allowing the ESM and EFSF the ability to directly purchase Italian and Spanish debt will temporarily bring yields down from their previously dangerous levels. That will hold in abeyance any imminent fear of Euro dissolution and place a bid under the currency and bond market. It is worth noting that the rise in Europe's debt and currency market would be greatly enhanced if any of the stabilization funds were given bank status, which would allow them to lever up their balance sheets and also be eligible to sell its assets to the ECB. That would vastly multiply the 500 billion Euro's worth of buying power many times over and that is exactly what I believe the EU will eventually end up doing.
However, it does not solve any of Europe's problems. It does not purge any of their debt burdens and does little to nothing in the way of boosting GDP growth. Neither does it eliminate the eventual need for deleveraging to occur.
In fact, in the long term it makes things much worse. First off, the $630 billion dollars in bailout money isn't enough to keep PIIGS countries out of the public debt market for very long and will need to be expanded in the not too distant future. Secondly, if the debt monetization strategy is deployed and if it occurs in the size and duration needed to keep sovereign yields from spiking to record highs, it will produce an unprecedented dose of stagflation throughout Europe. Therefore, at best this buys Europe a few weeks reprieve until rates begin to rise and markets begin to fall once again.
Mario Balotelli and his teammates failed to secure the UEFA cup for Italy. It is also assured that the EU Summit meeting will not produce a lasting victory for Mario Monti or Mario Draghi. The problems that plague Europe remain and will most likely intensify.
For now the biggest winners will be gold and gold mining shares. A falling dollar and rising Euro will reverse much of the damage done to the precious metals sector during 2012. Of course, down the road the gold market will most likely need to see Bernanke follow through on his threat to launch QE III in order to resume its bull market. Since the debt of Europe and the U.S. is only going to increase in both nominal terms and in terms of GDP, their economies will continue to deteriorate. The behavioral history of central bankers in Europe and America has clearly illustrated that massive debt monetization will be inevitable. Therefore, a new nominal high in the price of gold in Euros and dollars is an eventuality as well.
The global economy continues to falter and the pace of that slowdown is picking up. Recent data showed that German consumer confidence dropped the most since 1998, as Italian confidence dropped to an all-time record low. The level of Spain's non-performing loans reached the highest since 1994. And Chinese consumer loan demand fell to the lowest since 2004, as their PMI continues to drop further below the line of expansion. To round things out, U.S. job openings fell by 325k, the most since September 2008. Meanwhile, the Philadelphia PMI fell the most in nearly a year and despite record low borrowing costs, Existing Home sales fell 1.5% in May.
Despite the prediction of Wall Street shills, Europe's funk is starting to affect the bottom line of U.S. multi-national corporations. A great example of this came from Proctor and Gamble. The global consumer goods company cut their revenue and earnings estimates for the second time in the last two months, blaming the slowdown in emerging markets, the recession in Europe and the negative impact from a rising U.S. dollar.
The plain truth is that the developed world is either flirting with or is in recession, while emerging market growth has been cut in half. And it now seems that since America brought down Europe in 2008 by exporting our credit and housing crisis, Europe is now returning the favor through a sovereign debt crisis.
The Europeans are hoping to solve their problems by performing a balance sheet game of three card monte. Where debt laden nations that can no longer afford to borrow money in the open market, instead make loans to entities called the EFSF and ESM, and then borrow that same money back. News out of Europe this week was that the ESM (once it is established) may be funded with as much as 400-500 billion Euros for the purpose of buying PIIGS debt. This amounts to only about 16% of Spanish and Italian outstanding public debt. Meanwhile, the exact funding sources for these entities are still up in the air.
Sadly, Europe has been placed on the life support of their governments that need to borrow and print money in order to keep interest rates from rising and their economies from imploding. Of course, borrowing and printing money is the bane of stable interest rates and a sound economy. So, it will surely backfire with extreme severity in the long term.
We now have the condition where worldwide financial markets are pining for printing presses to once again be fired up simultaneously across the globe. However, central bankers are reticent to accommodate their desire because counterfeiting more money when borrowing costs are already near zero percent is counterproductive. More money printing will not cause fallow resources to be utilized, nor will it encourage productivity enhancements. All it will do is put a floor under equity values as it sends commodity prices soaring. The trade off will be to place further pressure on the middle class, as their purchasing power and living standards will resume their decline.
The Fed is moving towards QE III, but will need to see any one of the following three conditions to be met before embarking on further monetary dilution: the unemployment rate climb back to 8.5%, from the current 8.2%; the S&P 500 falling below 1,200, from the current level of 1,330; or the YOY increase in CPI to fall below 1 percent, from the 1.7% of today.
In the interim, global markets and economies will continue to be pulled lower by the gravitational force associated with a deleveraging deflationary depression. Gold and other precious metals will continue to tread water until the full monetary assault begins from the ECB and the Fed. However, as I've stated before, gold mining shares have already priced in Armageddon in the metal price. And as such, are worthy of at least holding a small position ahead of what could be a moon shot in value if Bernanke and Draghi head back to the helicopters soon.
We now live in a phony economic world where central bankers rule without check. Any hint of weakening data, which is actually a sign of reality and healing returning to the economy, is quickly met with the promise of more disastrous money printing. Last week we saw U.S. factory orders down and initial jobless claims rise. In Europe, we saw the Spanish bank bailout fall flat on its face and interest rates spike in Spain and Italy. Therefore, in predictable fashion, financial markets soared on the premise that the ECB and Fed must imminently ride to the rescue once again.
Meanwhile, most Main Stream Economists are auditioning for a role with the Weather Channel by blaming the persistently weak economic data on a warmer than typical winter. However, in truth the faltering global economy is resulting from a massive accumulation of debt that has led to a recession/depression in Europe. The same situation will inevitably cause a recession in the U.S., which will continue to cause a reduction in the growth rate of GDP in emerging markets.
But an endless increase in central banks' balance sheets can never be the answer to the malaise we find ourselves in, nor will there be any bailout coming for Europe other than the viability that can eventually arrive out of a cathartic depression.
Don't look for Germany to bailout Europe either. The country will never abdicate its sovereignty to profligate nations and assume the average borrowing costs of southern Europe on their debt. The U.S. shouldn't advise Germany to adopt fiscal unity in Europe unless Treasury Secretary Geithner also thinks it's a good idea to allow Greece the authority to issue T-Bills. Unless they are given complete control of the PIIGS spending and taxing authority, the Germans will most likely abandon their parenting role in Europe in due course.
The only real solution for insolvent Europe is to explicitly default on the debt to a level that brings PIIGS countries to a debt to GDP ratio below 60%. Then to pass balanced budget amendments and adopt tax and regulation reforms that makes them competitive with the rest of the world. Also, they need to adhere to the other strictures of the Maastricht treaty and not fall into the temptation of abandoning the Euro. Their economies will suffer a short depression, but this plan is the least painful option.
Having Greece return to the Drachma and defaulting on their debt through devaluation and money printing is a much worse option. Many are proposing that Greece now leave the Euro and inflate their way out of debt; just like Argentina did during 2002. However, this ignores the fact that the Argentines first defaulted on $100 billion of their external debt before removing their currency's peg to the U.S. dollar. Even though the Peso lost about 75% of its value and caused a brief bout with high inflation, the Argentine central bank did not have to monetize its debt. Therefore, the amount of new money printed was greatly reduced and resulted in a quick rebound in the economy.
In sharp contrast, the Europeans, Japanese and Americans still cling to the idea that inflation is the answer. PIIGS countries are pursuing an inflationary default that will increase borrowing costs and lead to a depression that will be far worse than if they simply admitted their insolvency and defaulted outright. Devaluing your currency to pay foreign creditors leads to hyperinflation and complete economic chaos. Paying off your debt by printing money was tried in Hungary during 1946 and Germany in 1923, but it resulted in complete devastation and hyperinflation.
If the Eurozone economies persist in the belief that the ECB can restore solvency to bankrupt nations, the Euro could fall back to parity with the dollar within the next 16 months. And if such central bank arrogance persists, the Euro could eventually go the way of the Hungarian Pengo.
Our central bank suffers from the same hubris as its European counterpart. Bernanke believes a deflationary recession must be avoided at all costs and that prosperity can be found in a printing press. The U.S. already has a higher debt to GDP ratio than EU (17) and is growing that debt at an unsustainable 8% of GDP per annum. Therefore, if America doesn't remove her addictions to borrowing and printing money, our own sovereign debt and currency crisis can't be more than a few years away.
It was announced this weekend that Spain will receive $125 billion (100 billion Euros) to recapitalize their banking system. The money for the bailout will be channeled through the Fund for Orderly Bank Restructuring (FROB), whose funds count towards public debt.
Nobody really knows exactly where this money will come from or what the consequence will be from bailing out banks by increasing European sovereign debt levels. However, the current view among global financial markets is that Europe can solve its problems by applying the same elixir as the U.S. did during our credit crisis back in 2008.
Namely, the European Union now claims that by ring-fencing their banking system, starting with Spain, the European debt crisis will simply disappear. By adopting this philosophy, politicians have illustrated their complete lack of understanding regarding the true structure of the problem.
Regardless of how successful the bank bailout will become, it ignores the difference between the American credit crisis of 2008 and the current debt crisis over in Europe. The U.S. housing and credit crisis was primarily a banking problem caused by eroding real estate related assets that rendered many banks insolvent.
Therefore, all that needed to be done was: Have the government borrow money to inject capital into banks, for the Fed to liquefy the financial system, to increase the level of deposit insurance, to guarantee bank debt and interbank lending and then to repeal the mark-to-market account rule that required bank assets to be valued at their current market price. Problem solved. Except that we expedited the U.S. a few years closer to a complete currency and bond market collapse … but that's a commentary for another day.
The basic belief now held on both sides of the Atlantic is that if you can fix the banks, you've solved all of the problems. But the U.S. enjoyed a debt to GDP ratio of just 60% at the start of our credit crisis - a level that would have even met the qualifications of the Maastricht Treaty. And it owned the world's reserve currency as well.
At that time, the U.S. was able to borrow the money needed to recapitalize the banks. That allowed the U.S. a few more years before having to address the unsustainable level of aggregate debt. It basically amounted to a balance sheet shell game where the private sector's bank debt was dumped onto the public sector, which now has a debt to GDP ratio of over 100%. So I guess we shouldn't try that trick again.
Turning to Europe today, their gross debt is just about 90% of GDP and the euro isn't used as the world's reserve currency. The onerous level of public sector debt was already high enough to send bond markets in Southern Europe and Ireland into full revolt.
So here's the big difference; U.S. financial institutions were insolvent due to rapidly-depreciating real estate related assets. But European banks are insolvent in part because they own the bad debt of insolvent European nations. If Europe's sovereigns are already insolvent because they owe too much money, how can they go further into debt to bail out their banking system?
Even if they are willing and able to borrow more money, their debt to GDP ratios would soar even higher and cause further downgrades of their debt. Therefore, sovereign bond prices would decline much lower and cause Europe's banks to fall further into insolvency.
The truth is that the only entity outside of China that can bail out Europe is the ECB. That, I believe, is the eventual "solution" that will be applied to Europe's mess. Of course, the inflationary default on European debt will wreak havoc on their economies, bond markets and currency.
So there is simply no magic bullet or elixir that can save Europe from a tremendous amount of pain - and you can add Japan and America into that mix as well. The market rallied last week in anticipation of some banking solution in Europe - or at least the re-entry of massive central bank intervention. All we have right now is an insufficient bailout of certain Spanish banks, which will do little to address spiking debt service payments on European bonds and nothing to bring down debt to GDP ratios of other European nations.
However, once this latest "solution" fails as well, all eyes will turn back toward Mario Draghi and his printing press to finally attempt to inflate the debt away.
After the euphoria from the Spanish bailout ends, look for sovereign bond yields to once again rise, along with credit default swaps on that debt. Also, look for the dollar to carry on rising against the euro, and for global markets to continue lower.
Most investors and market pundits continue to misdiagnose the reason behind the worldwide economic malaise. The underlying problem isn’t "uncertainty” or any other platitudes Wall Street and politicians like to offer. The truth is that massive sovereign debt defaults (if central banks allow them to be written down honestly) are very deflationary in nature.
Debt defaults destroy the assets of non-bank investors and also wipe out the capital of financial institutions. Without adequate capital, these banks are unable to make new loans and expand the money supply, causing bubbles to burst.
For a good while Wall Street was holding on to the ridiculous idea that the U.S. and China would be spared from a meltdown of the second largest economy on the planet. However, last week’s data should have put a dagger through the heart of that notion....
The Non-farm Payroll report showed that the U.S. produced just 69k jobs in May, while the unemployment rate rose to 8.2%. However, the most alarming part of the report was that America lost 15k jobs in the all-important goods-producing sector. GDP posted an anemic 1.9% growth rate and home prices continue to fall—down 2% YOY. China’s PMI fell sharply in May, dropping to 50.4, down from 53.3 in the prior month. And Eurozone PMI came out at an alarming 45.1 in the same month, which is well below the line of economic expansion.
Global markets are sounding the alarm of rapidly intensifying deflation. Commodity prices such as oil and copper are in free fall, while equity prices are hurting as well. Japan’s Nikkei Dow lost 10% in May alone, which was its worst monthly loss in two years? But Japan isn’t alone. The Chinese Shanghai composite is down nearly 20%, Spain’s IBEX is down nearly 50%, Italian stocks fell 45% and Greece is down over 60% from the year ago period.
The only market yet to succumb to the carnage is the U.S., whose averages are roughly unchanged for the year. However, the S&P 500 has lost nearly 10% over the last 30 days, and is now in full catch up mode with the rest of the world.
It is simply undeniable that the global economy is closely interconnected. Emerging markets depend on Europe to support their export driven economies and the U.S. depends on foreign economies to support the earnings of S&P 500 companies -- forty percent of S&P revenue and earnings are derived from overseas.
In truth, the real reason why global markets are melting down is because the recession in the Eurozone is quickly turning into a deflationary depression.
For example, take a look at the direction Portugal is headed. This country had negative GDP growth and a 10% unemployment rate in 2010. At that time their 5 year note was just 3%. Now their unemployment rate is 15% and GDP has been down for 6 straight quarters. Their economy cannot possibly survive now that the 5 year note has been in the 15% range for the last year!
The carnage all began when Irish and Southern European banks became insolvent due to non-performing real estate assets. Then the sovereigns borrowed so much money, in order to bail out the banks, that their economies have become insolvent. Now banks find themselves insolvent once again … this time because they own the debt of bankrupt countries that were shoved down their throat by the ECB’s LTROs.
So we now have a situation where insolvent nations are trying to bail out insolvent banks by proposing to borrow more money, which will cause the countries to become even more insolvent. Then, of course, banks are asked to lower their country’s borrowing costs by buying more of the debt issued from insolvent nations. Doesn’t that sound like it will work out well?
If you can believe it, that is the proposed magic bullet to save Europe.
It’s simply a game of counterfeiting chicken. Central Bankers have been on a money printing hiatus, pretending and hoping that the global economic bubbles didn’t need their money printing to keep them inflated. However, each and every worsening piece of economic data brings us closer to the eventuality of more central bank intervention. That is the reason why gold soared $65 per ounce on Friday. Gold is now signaling the helicopters may be just over the horizon.
As most of you already know, I have for years been in the vanguard warning about the inflationary policies pursued by global governments and central banks. However, we now face a hiatus of monetary intervention and that has once again brought about the fear of deflation—which is the natural countervailing force to inflation.
The value of any currency is what the market perceives its value to be. Even though there may not be an actual reduction in the supply or that currency, the market will price in the effects of a decrease in the second derivative of money supply growth and the possible eventuality of deflation; if market forces are allowed to operate.
In the U.S. for example, during the late summer and early fall of 2008, M3 was growing at a 10-15% annual rate. It wasn’t until the beginning of 2009 that money supply growth rates began to decline rapidly. And they didn’t actually turn negative until the fall of 2009. Money supply growth rates bottomed out in May of 2010 at a -9%.
However, markets first began to price in the decline in money supply growth during the summer of 2008. Oil prices began to fall from $147 in July of 2008, down to $33 per barrel by early 2009. The S&P 500 went into free-fall starting in September of 2008 and bottomed out in March of 2009—falling almost 50% in six months.
The point here is that you don’t need deflation—a reduction in the outstanding supply of money—to have markets react to a decrease in the rate of money supply growth and to then anticipate the eventual deflation. This is what has already happened to the gold mining sector.
Today we find that M3 is still rising at a 3% annual rate, but that is down from the 6% annual rate of growth at the start of 2012. Therefore, commodities prices have reacted to the slowdown in money supply growth and the direction towards deflation.
Investors need to understand that gold mining stocks have already discounted a severe dose of deflation, which in my view has a very low likelihood of actually coming to fruition. Remember, central banks may be on a counterfeiting holiday but they have a history of taking very short vacations.
Just as oil and equity values declined in 2008, in the anticipation of a much stronger dollar, the gold mining shares have now retreated to a level that forebodes massive sovereign defaults in Europe, Japan and quite possibly even in the U.S.. Since a deflationary depression and a tremendous reduction in gold prices have already been priced into gold stocks, the odds strongly favor a rally at this juncture. But, it should be made clear that mining shares will still need the support of central banks to embark on a new and sustainable secular bull market.
We now live in a world where deflation has become public enemy number one. In this current economic environment, governments seek a condition of perpetual inflation in order to maintain the illusion of prosperity in the developed world. But in reality, deflation is the free-market approach to rectify a secular period of superfluous money supply growth, debt accumulation and asset price appreciation.
In an effort to boost the earnings of private banks and to facilitate sovereign government's largesse, central banks have a well documented history of rapidly expanding the supply of fiat currencies and manipulating interest rates lower. This creates increasing debt levels and rising asset prices.
As recently as July 2008, the U.S. Fed (with the help of commercial banks) had produced YOY Consumer Price Inflation of 5.5% and Producer Price Inflation of 9.8%. In the Eurozone, the ECB produced consumer inflation over 4% and The PBOC (People's Bank of China) boosted inflation north of 8% for Chinese consumers.
Once central bankers are finally forced to confront the inflation they created, they throttle back on the printing press. But the return trip to a more normalized economy brings with it the bursting of debt and asset bubbles.
After the credit crisis set in and the healing aspects of deflation began to take hold, central banks rapidly expanded the supply of base money in an effort to quickly erode the purchasing power of their currencies and bring real estate prices higher. For example, real estate prices in Spain are already down over 30% and are expected to drop a further 12-14% in 2012. The ECB has printed over one trillion Euros to date; in an effort to weaken their currency, elevate home prices and bring solvency back to the European banks.
The problem with the addiction to money printing is that once a central bank starts, it can't stop without dire, albeit in the long-term healthy, economic consequences. And the longer an economy stays addicted to inflation, the harder the eventual debt deflation will become. As a result, central banks are now walking the economy on a very thin tightrope between inflation and deflation.
Once they finally step away from expanding the money supply, deflation rapidly takes hold. However, it then takes an ever-increasing amount of new money creation, on the part of the central bank, to pull the economy away from falling asset prices.
Another example of the roller coaster ride provided by central banks can be found in the price of oil. Oil prices had been historically around the $25 per barrel range throughout the decades of the 80's and 90's. Then, beginning in the early part of the last decade, oil prices started to soar and eventually shot up to $147 by the summer of 2008.
In the midst of the deflationary credit crisis, it fell to $33 per barrel by the start of 2009. Of course, the Fed had already embarked on their quest to eventually print $2 trillion to fight deflation, which helped send oil back to $114 per barrel by 2011.
However, because the Fed and ECB have both proclaimed that they are on hold from debt monetization and currency debasement, the same monetary environment that led to the pronounced deflation that occurred during fall of 2008 has arrived once again.
Now, some will say that a severe recession accompanied by sharp deflation can't occur because banks are currently well capitalized. It is true that the deflationary recession was caused by banks that had previously loaned themselves and the economy into insolvency. However, today the problem is much worse. We now have entire nations which have become insolvent. It would be very difficult to argue that having a banking crisis is better than enduring a sovereign debt crisis, especially since much of the assets banks hold is sovereign debt.
Therefore, we see that oil prices have already fallen 18%, from $110 a barrel in February of this year to $91 today. Copper prices have dropped 11%, from 3.90 per pound in April to $3.50 per pound today. And equity prices have started to decline, just as they did at the beginning of the Great Credit Crisis.
Japan's Nikkei Index has declined nearly 11% in the last month, while the S&P 500 has lost 7% since the beginning of May. The Spanish IBEX has tumbled 7.6% in the last 30 days and is now down 37% during the past year!
These price adjustments are absolutely essential for the long-term health of the global economy, but I doubt the central banks will sit idle much longer.
The plain truth is that the current debt levels, carried by the developed world, demand a period of massive deleveraging to occur. A healthy and cathartic period of deflation is needed; where asset prices fall, money supply shrinks and debt levels are reduced to a level that can be supported by the free market. This is the only viable answer for various nations struggling with solvency.
However, the return journey from rampant inflation and asset bubbles always carries insolvency and defaults along for the ride. Defaulting on debt is deflationary in nature and restructuring your liabilities is the only choice when you owe more money than you can pay back.
The prevalent idea among heads of state and central banks is that a country can borrow and print more money in order to eliminate the problems caused by too much debt and inflation. But more inflation can never be the cure for rising prices and piling on more debt can't solve a condition of insolvency.
Global investors are now being violently whipsawed by the decisions of central banks, as they switch between inflationary and deflationary policies. The choice governments now face is to allow a deflationary depression to finally purge the worldwide economy of its imbalances; or try to levitate real estate, equity and bond prices by printing massive quantities of their currencies.
It is vitally important for your financial well-being to be able to determine which path central banks are currently pursuing. For the moment, they have allowed the market forces of deflation to take hold. However, past history clearly signals to investors that it is only a matter of time before economic conditions deteriorate to the point where governments return to their inexorable pursuit of inflation. The point here is to understand where we are in the cycle between inflation and deflation and then to invest accordingly.
The prevailing view amongst Keynesians is that the austerity measures being taken in Europe to prevent a complete currency and bond market collapse is the cause of their current recession. But blaming a recession on the idea that an insolvent government was finally forced into reducing its debt is like blaming a morning hangover on the fact that you eventually had to stop drinking the night before.
There is now a huge debate over whether the developed world's sovereigns should embrace austerity or increase government spending in an effort to boost demand and avoid a full-blown economic meltdown. Former U.S. Secretary of Labor and current professor of public policy at the University of California, Robert Reich, recently wrote a commentary titled, "We Should Not Imitate the Austerity of Europe." In it, Mr. Reich contends we should simply; "Blame [the recession] on austerity economics - the bizarre view that economic slowdowns result from excessive debt, so government should cut spending" He continued, "A large debt with faster growth is preferable to a smaller debt sitting atop no growth at all. And it's infinitely better than a smaller debt on top of a contracting economy."
But Mr. Reich and those like him who vilify austerity measures are ignoring the reality that investors in periphery European sovereign debt had already declared those markets to be insolvent. Sharply rising bond yields in southern Europe and Ireland were a clear signal that their debt to GDP ratios had eclipsed the level in which investors believed the tax base could support the debt. Once sovereign debt has risen to a level that it cannot be paid back, by definition, the country must default through hyperinflation or restructuring.
However, in the unlikely scenario that the bond market actually has it wrong, a dramatic reduction in government spending gives sovereigns their only fighting chance before admitting defeat and pursuing a default strategy.
If these governments can quickly balance their budgets and lower the level of nominal debt outstanding; it gives them a chance to restore investors' confidence in the bond market, bolsters confidence in holding the Euro and offers the hope that the private sector can rapidly supplant the erstwhile reliance on public sector spending.
Keynesians must realize that it was the high level of government spending supported by a compliant central bank that initially caused the debt to GDP ratios to skyrocket to the point where governments were deemed insolvent. These governments already tried over borrowing and spending and it didn't work. How is it possible to believe that adding even more public sector debt, most of which is printed, can fix the problem? Public sector spending doesn't grow an economy; it just adds to the debt and thus, increases the debt to GDP ratio. Yet more government spending, or investment as they like to call it, guarantees the bond market will be correct in judging Europe sovereigns bankrupt. Additional public borrowing not only increases debt but steals more money from the private sector that would otherwise be used to pare down onerous household debt levels or invest in the private sector-the only viable part of the economy that can support growth. It would also cause the ECB to print more money and create more inflation; resulting in a further reduction of economic growth and the standard of living.
The sad truth is that austerity is coming to Europe regardless of whether it is voluntary, or because the international bond market forces it upon them. Pursuing voluntary austerity measures gives Europe, and indeed the developed world, there only chance before defaulting on the debt. Indeed, Japan and the U.S. now have a better opportunity than Europe to make austerity measures work. That's because both their bond markets are currently quiescent; despite that fact that both of their debt to GDP ratios are far worse than in the Eurozone--EU (17) debt to GDP is 87%, while the U.S. has 103% and Japan has 230% public debt to GDP ratio. But the bottom line is that austerity is the market-based mechanism to countervail decades of profligate government profligacy.
Forcing down a few more drinks to delay a hangover isn't a very good strategy. Mr. Reich and the rest of the Keynesians should acknowledge that it is impossible for individuals, or a nation, to stay drunk forever.
Two lovers of the notion that inflation can cure everything that ails an economy recently squared off in a battle over who adores counterfeiting the most. Paul Krugman, who probably has a statue of Al Capone at his bedside, chided Ben Bernanke in a New York Times Magazine article for his unwillingness to raise the Fed's inflation target in order to reduce the unemployment rate. The recipient of the Nobel Prize in economics penned an article titled "Earth to Ben Bernanke" on April 24th. In it he encouraged Bernanke to embrace the idea that more money printing can save the world by writing, "Higher expected inflation would aid an economy."
Bernanke addressed Krugman's comments at last week's FOMC press conference. His dovish response directed towards Krugman's commentary was, "The question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly faster reduction in the unemployment rate.the view of the committee is that that would be very reckless." While it is commendable that Bernanke doesn't publicly admit he wants to send inflation higher than it already is; the question remains why he believes that higher inflation can cause even the slightest reduction in unemployment.
What strikes me the most is that neither the Nobel Prize winner nor the Chairman of the Federal Reserve had the sagacity to completely repudiate the idea that inflation can in any way reduce the unemployment rate. Even a cursory look at the data throughout economic history proves that inflation is a destroyer of jobs. All they would have to do is to look at the most salient periods of inflation that occurred over the last 40 years and see how negatively it affected the unemployment rate.
From 1971 (the year Nixon broke the gold window) through 1974, the annual percentage change on the Consumer Price Index (CPI) increased from 4.4% to 11.0%. According to Krugman and Bernanke, this should have sent the unemployment rate crashing. However, the unemployment rate increased from 6.1% at the end of 1971 to 7.2% in 1974. And since the unemployment rate is a lagging indicator, that figure increased even further to 8.2% in December of 1975.
In 1977 the CPI was 6.5% and it shot all the way up to 13.5% in 1980. Just as it did in the early part of the decade, the unemployment rate increased yet again to 7.2% in 1980 and hit 10.8% by the end of 1982! Finally, the other salient increase in the rate of inflation occurred between 1986 and 1990. The annual percentage change of inflation in '86 was 1.9;, that shot up to 5.4% in 1990. The unemployment rate started that period at 6.6% and climbed to 7.3% at the end of 1991.
Therefore, I have to ask our dear Fed Chairman and Nobel Prize winner where the evidence is that inflation causes people to find work. In reality, it's the exact opposite that occurs. Inflation robs the middle class of their purchasing power and sends them onto the government dole. Inflation also destroys investment in an economy because savers have no idea what interest rate is necessary to charge in order to profitably lend out their money over an extended period of time. And inflation causes tremendous economic imbalances, as capital is diverted into ephemeral asset bubbles instead of being allocated in a more viable manner.
If Krugman and Bernanke were correct in believing inflation has a positive influence on the workforce, Zimbabwe and Argentina would both be paragons of how to achieve full employment. The truth is that a high unemployment rate is the simply the result of a weak economy. And an economy can suffer through a recession while experiencing either inflation or deflation. But when an economy experiences a significant increase in the rate of inflation, it nearly always ends up with an unemployment rate that goes along for the ride. We can only hope that central bankers in the developed world assent to that principle very soon. Unfortunately, the ECB, BOJ and Fed continue to believe a positive rate of inflation must be maintained at all costs. That is one of the reasons why a high rate of unemployment has now become a structural condition in most of the developed world.
I would have thought that the decoupling myth between global economies would have been completely discredited after the events of this past credit crisis unfolded. Back in 2007 and early 2008, investors were very slowly coming to the realization that the U.S. centered real estate crisis was going to dramatically affect our domestic economy.
However, the prevailing view at the time was that the global economy -- especially emerging markets -- would be almost totally immune from any such slowdown. But the truth was that emerging market economies took America’s financial crisis directly on the chin, causing the Shanghai Composite Index to drop 70% in just one year.
Now investors are being told that the worsening sovereign debt crisis in Europe will leave the U.S. economy unscathed. The reason for the perma-bulls’ optimism is based on the fact that America doesn’t have a strong manufacturing base. In fact, manufacturing now represents just 10% of our once diversified and vibrant economy. Wall Street is now hoping that since we don’t make many things to export to Europe, our GDP won’t suffer a significant decline at all.
What investors have conveniently overlooked is the fact that 40% of S&P500 earnings are derived from foreign economies. And the seventeen countries that make up the Eurozone have collapsed into recession. That wouldn’t be so bad if EU (17) wasn’t the second biggest economy on the planet. Recent data points illustrate that the worsening recession in Europe will continue to bring down global GDP.
Credit Default Swap prices on 15 western European countries shot up 26% in the last month and Spanish banks now have over 8% of loans that are non-performing -- an 18 year high. European banks are keeping their governments afloat by loaning them money, which they in turn borrowed from the ECB. That cannot be a viable or sustainable situation. Many European economies will suffer massive inflation and sovereign default -- just as was the case in Greece -- within the next two years.
But don’t rely on China to supplant falling demand from the Eurozone economies. China’s economy is still driven by exports, which represent about 40% of their GDP. The problem here is that China’s largest customers are the U.S., Japan and Europe. The U.S. is mired in stagflation, while Japan’s growth is anemic at best and the E.U. is in recession.
The global slowdown will put further pressure on the U.S. economy and the earnings of multi-national corporations. Downward pressure on the U.S. economy is already becoming apparent. Data on home sales, industrial production, jobless claims and regional manufacturing surveys have all recently disappointed. U.S. productivity has fallen from 4% during 2010, to just 0.4% during all of 2011. S&P500 earnings growth has already plummeted from 14% during 2011, to just a 3% annualized rate in Q1 2012.
The fact is that we have a global economy that is intricately intertwined. And at this juncture there is no such thing as decoupling. Because of this, it is my view that equity markets will fall significantly this summer, as earnings fall and PE ratios contract. That will be the primary catalyst that brings global central banks back into play.
The Fed, ECB and BOJ will most likely launch further quantitative easing later this year in an effort to combat falling stock prices.
The three primary factors that determine the interest rate level a nation must pay to service its debt in the long term are; the currency, inflation and credit risks of holding the sovereign debt. All three of those factors are very closely interrelated. Even though the central bank can exercise tremendous influence in the short run, the free market ultimately decides whether or not the nation has the ability to adequately finance its obligations and how high interest rates will go. An extremely high debt to GDP ratio, which elevates the country’s credit risk, inevitably leads to massive money printing by the central bank. That directly causes the nation’s currency to fall while it also increases the rate of inflation.
It is true that a country never has to pay back all of its outstanding debt. However, it is imperative that investors in the nation’s sovereign debt always maintain the confidence that it has the ability to do so. History has proven that once the debt to GDP ratio reaches circa 100%, economic growth seizes to a halt. The problem being that the debt continues to accumulate without a commensurate increase in the tax base. Once the tax base can no longer adequately support the debt, interest rates rise sharply.
Europe’s southern periphery, along with Ireland, has hit the interest rate wall. International investors have abandoned their faith in those bond markets and the countries have now been placed on the life support of the European Central Bank. Without continuous intervention of the ECB into the bond market yields will inexorably rise.
The U.S. faces a similar fate in the very near future. Our debt is a staggering 700% of income. And our annual deficit is over 50% of Federal revenue. Just imagine if your annual salary was 100k and you owed the bank a whopping 700k. Then go tell your banker that you are adding 50k each year—half of your entire salary--to your accumulated level of debt. After your bankers picked themselves off the floor, they would summarily cut up your credit cards and remove any and all existing lines of future credit. Our gross debt is $15.6 trillion and that is supported by just $2.3 trillion of revenue. And we are adding well over a trillion dollars each year to the gross debt. Our international creditors will soon have no choice but to cut up our credit cards and send interest rates skyrocketing higher.
When bond yields began to soar towards dangerous levels in Europe back in late 2011 and early 2012, the ECB made available over a trillion Euros in low-interest loans to bailout insolvent banks and countries. Banks used the money to plug capital holes in their balance sheets and to buy newly issued debt of the EU nations. That caused Ten-year yields in Spain and Italy to quickly retreat back under 5% from their previous level of around 7% just a few months prior. But now that there isn’t any new money being printed on the part of the ECB and yields are quickly headed back towards 6% in both countries. There just isn’t enough private sector interest in buying insolvent European debt at the current low level of interest offered.
The sad truth is that Europe, Japan and the U.S. have such an onerous amount of debt outstanding that the hope of continued solvency rests completely on the perpetual condition of interest rates that are kept ridiculously low. It isn’t so much a mystery as to why the Fed, ECB and BOJ are working overtime to keep interest rates from rising. If rates were allowed to rise to a level that could bring in the support of the free market, the vastly increased borrowing costs would cause the economy to falter and deficits to skyrocket. This would eventually lead to an explicit default on the debt.
But the key point here is that continuous and massive money printing by any central bank eventually causes hyperinflation, which mandates yields to rise much higher anyway. It is at that point where the country enters into an inflationary death spiral. The more money they print, the higher rates go to compensate for the runaway inflation. The higher rates go the worse economic growth and the debt to GDP ratio becomes. That puts further pressure on rates to rise and the central bank to then increase the amount of debt monetization…and so the deadly cycle repeats and intensifies.
The bottom line is that Europe, Japan and the U.S. will eventually undergo a massive debt restructuring the likes of which history has never before witnessed. Such a default will either take the form of outright principal reduction or the central bank to set a course for intractable inflation. History illustrates that the inflation route is always tried first.
The MSM is busy promulgating the idea that the Great Recession is a fast-fading memory and that it's now clear sailing for the global economy. But the true numbers belie that notion. One of the supposedly good news items that are being celebrated in the U.S. was found in the ISM Manufacturing Survey released this week. It increased to 53.4 in March, from a level of 52.4 in the prior month. However, the somewhat better news on manufacturing came on the back of a U.S. consumer that has fully reverted to their borrowing and consuming ways.
Spending increased by 0.8% in February, the most in seven months but incomes only increased by 0.2%. More importantly, real disposable income declined by 0.1%, which was the third such decrease in the last four months. As a consequence, the savings rate fell out of bed to 3.7% from 4.3%, which was the lowest level since August 2009. Therefore, the small rebound in manufacturing and huge increase in spending by the consumer is ersatz and unsustainable in nature. The problem is that consumer debt has now started to increase once again at a time when it desperately needs to contract.
The Europeans have taken a small step towards addressing their problems. They are trying desperately to embrace fiscal austerity, but in the meantime have also been dealt a huge dose of monetary madness from the ECB. The consequence of taking only a half-hearted dose of the appropriate medicine for your economy won't fix the problem. Evidence for this fact was displayed from the Eurozone manufacturing PMI released this week. It fell to 47.7 in March; declining in Spain, France and even Germany. But perhaps most troubling was that the unemployment rate in the Euro-zone rose in February to 10.8%, the highest level in nearly 15 years. However, household inflation in the Eurozone was 2.6% in March, which is well above the ECB's 2% target rate. By only addressing their fiscal imbalances, Europeans will have to battle a recession that is accompanied by inflation instead of having the amelioration provided from falling prices.
In contrast to Europe, the U.S. hasn't gone one inch towards fixing the crumbling foundation of our fiscal imbalances. And both the Fed and the ECB cling to the belief that borrowing and printing money is the best path to prosperity. What Messrs Bernanke and Draghi don't know or refuse to acknowledge is that this is a balance sheet recession in America and Europe. Therefore, creating copious amounts of new money will not increase productivity or grow the labor force. It will, however, continue to provide a tremendous headwind to the economy due to rising inflation.
Interest rates have been at rock bottom for the last three years. They were taken to zero percent by printing money (inflation) and not by a superfluous amount of savings evident in the economy. Therefore, these low rates have both a moderately positive and extremely negative effect for GDP. Low interest rates do provide some temporary relief on debt service payments. That's great for the heavily debt-laden consumer and government.while they last. But those same artificial low rates punish savers while destroying the purchasing power of the dollar. Since interest rates are already at near zero, there will not be any further relief on debt service from continuing to print money. There will instead be a pernicious increase in the level of inflation and rate of currency destruction.
The Fed's next meeting will be at the end of April and the following meeting won't be until June. Traders are anxiously waiting for more QE, while the economy braces for yet more stagflation. If Mr. Bernanke takes a pass this month on further QE, commodity prices and the stock market will hopefully undergo a healthy pullback. However, if the Fed prepares to launch another round of quantitative counterfeiting, the gold market will take off like a rocket, while the economy sinks further into the stagflation abyss.
The prevailing notion among the main stream media and economists is that interest rates are rising because of improving economic growth. But like many of the readily accepted tenets of today's world of popular finance, this too has its basis in fallacy.
Interest rates have increased by nearly 40 basis points on the Ten year note since the first week of March and that is being offered as proof that the economy has healed and GDP growth is about to accelerate. But in truth, the recent spike in Treasury bond yields is only the result of a temporary ebbing in the fear trade that brought about panic selling in Euro denominated debt, which had previously caused U.S. Treasury prices to soar.
The head of the European Central Bank, Mario Draghi, just finished printing over a trillion Euros in an effort to calm the bond market. This new liquidity predictably found its way into distressed Eurozone debt and has mollified bond investors; for the moment. Since a Greek exit from the Euro in no longer perceived an imminent threat, investors have sold their recent purchases of U.S. Treasuries and piled back into Eurozone sovereign debt. For example, the yield on the Italian 10 year note took a rollercoaster ride above 7% at the start of this year, before plunging south of 5% by the beginning of March.
However, in contrast to what passes for the economic wisdom of today, an increase in the rate of sovereign bond yields would be a function of deterioration in their credit, currency and inflation risks. But it would never be because of an increase in the prospects for growth. An economy that is experiencing a healthy growth spurt would experience a reduction in all three of those factors that would cause bond yields to rise. Strong GDP growth-which results from increased productivity--serves to improve credit risk, due to a bolstered tax base, while it also lowers the rate of inflation by increasing the amount of goods and services available for purchase. Therefore, it also tends to boost the currency's exchange rate as well.
Economic growth that is also accompanied by a sound monetary policy tends to lower the rate of inflation and thus increases the real rate of interest. But it does this without increasing nominal interest rates. It instead serves to provide a higher real rate of return on sovereign debt ownership.
This is precisely what occurred in the U.S. during the early 1980's. After Fed Chairman Paul Volcker fought and won the battle against inflation, economic growth exploded while the stock market soared in value. And nominal bond prices began to fall, not rise. At the start of the 1908's, GDP fell by 0.3%, the Ten year note was 12% and the rate of inflation was 14%. Therefore, real interest rates were a negative 2% at the start of that decade. But by 1984 GDP had accelerated to 7.2% in that year. However, the nominal Ten year note fell to 11% and inflation had plummeted down to 4%. In this classic example that illustrates clearly how growth isn't inflationary; real interest rates soared by 9 percentage points to yield a positive 7% return on sovereign debt! In a healthy economy; stocks, bond prices and the currency should all rise together as nominal yields fall and real interest rates rise. The simple truth is that the rate of inflation should fall faster than the rate nominal yields decrease.
However, what the Fed, ECB and BOJ are doing now provides a prescription for soaring nominal interest rates in the not too distant future. These central banks are violating all three conditions that lead to low and stable interest rates for the long term. By massively increasing the money supply, they have caused inflation to rise and reduced the purchasing power of their currencies. And by creating superfluous money and credit, the central banks have given the cover needed for their respective governments to run up an overwhelming amount of debt. The currency, credit and inflation risk of owning those three sovereign debt markets has soared. Therefore, they have created the perfect conditions for a collapse of their bond markets.
Central bankers believe they have more power and influence over the yield curve than what they indeed posses. The fact is they can only control interest rates for a relatively short period of time. By not allowing interest rates to function freely, the Fed, ECB and BOJ are facing the eventuality of a bond market debacle that will also crush their currencies and stock markets. Recent history has proven that these central banks will fight the ensuing run-up in yields with QEs III, IV and V in an effort to postpone the pain. This failure to acknowledge reality will cause the eventual collapse to become significantly more acute.
Please don't believe the hype that the American economy is healing. While it is true that some data is showing improvement, the true fundamentals of the economy continue to erode.
America's trade deficit hit $52.6 billion in January. That's the highest level since October of 2008 and is clear evidence that we have fully reverted back to our under production, under saving and overconsumption habits with alacrity.
The nation's debt has now eclipsed 100% of our GDP, after 13 straight quarters of paying down debt households have now started to releverage their balance sheets and total non-financial debt is at a record 250% of GDP. The sad truth is that the U.S. economy is more addicted to debt than at any other time in history.
But most importantly, please don't believe the lie that the Fed's money printing is laying fallow at the central bank and that inflation isn't harming the American middle class and the economy. Consumer prices rose 0.4% in the month of February alone and year over year increases in food and gas prices are 5% and 12% respectively. Money supply growth is up 10% in the past 12 months and banks are now buying U.S. Treasuries with reckless abandon.
Commercial banks have purchased $78.2 billion in Treasury and Agency debt in January and February of 2012. That's already more than the entire amount of purchases made in all of 2011 and is on track to add nearly ½ trillion dollars of government debt to commercial banks' balance sheets. The Fed buys these Treasuries from banks and that enables them to buy more debt from the government. Using that process, the Fed is able to monetize both existing and newly issued Treasury debt. Since the government gets the money first and distributes it into the economy, the money supply increases without any direct benefit of capital goods creation.
Making this situation even worse is the Fed's promise to keep interest rates on hold for another three years. Banks can either keep their newly created credit at the Fed earning .25% or give a three year loan to the government and earn .57% at the current interest rate. Since Bernanke has assured them that there is little risk of rates going up on the short end of the yield curve for at least the next 36 months, banks have made the intelligent choice to earn the extra yield and buy 3 year notes.
That is a big win for the banks because they can earn an extra 32 basis points on their money. And it's a major score for the government because they have a ready buyer for their debt. However, it's a big loss for the middle class, as they see their cost of living soar due to the relentless increase in money supply.
So there you have it! The American economy isn't healing at all. What we have accomplished is to further cement our addictions to debt, over consumption and inflation. Those very same conditions were the progenitors of the Great Recession beginning in December of 2007. Oil prices are soaring above $100 a barrel, inflation is rising and households are still soaked in debt…sound familiar? Only now the nation's sovereign debt is at a record level and the country is careening towards insolvency. The only thing holding the economy together is the Fed's promise of free money forever. That shouldn't be misconstrued as a viable and healthy economy.
Back in early 2011, I was one of the few economists to warn that global GDP growth would slow dramatically in the near future and that the emerging market economies would not be immune from that upcoming contraction. My prediction was based on the premise that the then incipient sovereign debt crisis in the developed world would cause the export-driven BRIC economies to stall. We now know that the Japanese economy is contracting, while Europe’s GDP is falling off a cliff. And just last week we received more concrete evidence that emerging market economies are starting to feel the pinch from the developed world’s debt crisis.
Brazil cut interest rates by ¾ percentage point after reporting that their GDP growth during 2011 dropped to 2.7%, down from 7.5% in the prior year. China lowered their GDP forecast to 7.5% in 2012, from the reported 9.2% in 2011. The Indian economy grew at its slowest pace in more than two years at the end of 2011, as high inflation and Euro-zone insolvency put downward pressure on the economy. Russia’s GDP grew by 4.2% in 2011, and is predicted by S&P to drop down to 3.5% this year. And the United Nations predicts that global GDP will only increase by a paltry 0.5% in all of 2012.
The McDonald’s corporation corroborated the global slowdown in growth when they announced their earnings report for Q4 last week. The company missed their fourth quarter revenue target and warned about its Q1 operating income due to, according to the company’s press release, "…commodity and labor cost pressures, particularly in the U.S.” But the company also noted that the main cause of their revenue shortfall for their last quarter was a sharp falloff in sales from Europe, Asia, the Middle East and Africa.
Can it really be any wonder why this is occurring? Moronic central bankers across the globe persist in believing that economic prosperity can be brought about by printing more money. They also cling to the specious argument that inflation can’t occur when growth is anemic. That gives them plenty of impetus to step up their monetary madness; even in the face of rising prices.
But in reality, all you end up getting is a serious dose of global stagflation, which only continues to increase in intensity. It is my view that the worldwide slowdown in GDP will cause further iterations of QE to occur within two quarters, not only in the U.S. but around the world.
However, since these rounds of quantitative counterfeiting resemble birth pangs in nature—in that they are occurring more frequently and with greater intensity—I anticipate the rate of inflation to increase rapidly across the globe during 2012. As such, I would continue to avoid consumer discretionary stocks and increase your exposure to precious metals and oil investments on any pullbacks.
Everything I’ve been warning about regarding the fallout from global central bankers’ love affair with inflation is coming to fruition. Consumers are once again dealing with the fact that the cost of filling up their gas tank is eating a significant portion of their disposable income. The price of a barrel of oil is now soaring above $100 a barrel; just as it always has done when the Fed has gone on one of their counterfeiting sprees. And it’s not just dollars that have been eroding in value because the price of oil in Euros is now at a record high. The sad truth is that with each iteration of QE, either in the U.S. or around the globe, it has sent oil prices skyrocketing, inflation rising and the economy into the tank.
But our nation’s Treasury Secretary continues to display how very little he understands about markets and the economy. Timothy Geithner said last week that there is "no quick fix” to higher oil prices and that there’s no easy solution for spiraling energy prices. What he does recommend is a long-term approach, "…to encourage Americans to be more efficient in how they use energy." My guess is what Mr. Geithner means by "encouraging Americans to be more efficient” is to make sure our economic growth is anemic.
In contrast to what Geithner believes, there are two things he, the Fed and the Obama administration could do today to bring oil prices down below $75 per barrel in less than 30 days. First, is to raise the Fed Funds rate to 1% and repeal Bernanke’s pledge to keep interest rates at zero until the end of 2014. The second is for the president to proclaim that the U.S. does not support, in any way, a preemptive military attack on Iran. These two simple measures would dramatically strengthen the dollar, backing out at least $25 from the crumbling currency premium; and removing the $15 war premium built into the price of oil.
But seeing as neither of those things is likely to happen, we can look to recent history for what we can expect from soaring oil prices. In the summer of 2008, oil prices hit an all-time record high of $147 per barrel and gas prices hit a record $4.16 per gallon. This helped send the global economy into the Great Recession. Then in Q1 of 2011, QEII sent oil prices back to $114 per barrel and gas back above $4 a gallon. Predictably, U.S. GDP once again plummeted, falling from 2.3% in Q4 2010, to 0.4% in the following quarter. Today, oil prices are back to $110 per barrel and gas prices are surging back to $4 per gallon. Expect a slowdown in the economy similar to what occurred every other time gas prices hovered around the $4 level. We received a taste of that slowdown with the release of the Durable Goods and ISM manufacturing report. Orders for U.S. durable goods fell in January by the most in three years and capital goods expenditures, less aircraft and defense fell 4.5%. And the Institute for Supply Management’s factory index fell to 52.4 in February from 54.1 a month earlier.
The main reason why oil prices are rising is the same reason why food and import prices are soaring as well. Paper currencies across the world are losing their purchasing power against real assets that cannot be increased by fiat. Of course, the Pollyannas on Wall Street will tell you that oil is rising because of a rebounding economy. However, the facts are that gasoline demand is down 6% YOY, while oil inventories are at a six month high. If the global economy was indeed recovering why is the demand for gas at the pump falling? In reality, the global economy is very weak and the U.S. is very far removed from a sustainable recovery.
Japanese GDP dropped 2.3% in Q4 and the European Union is in recession, with last quarter’s GDP falling 0.3%. And Greece has entered into a depression with GDP down 7% last quarter and falling sharply. Emerging market economies will be hard pressed to keep up their ebullient growth rates when the developed world’s demand for foreign made goods is collapsing.
Meanwhile, the U.S. continues to run trillion dollar annual deficits and the unemployment rate is 8.3%. Inflation is destroying the nation’s desire to save and invest, as the economy is suffering through a protracted period of stagflation. But perhaps the worst situation of all is that the Fed’s free-money policy has set the economy up for the biggest interest rate shock in history. It’s really not much of a mystery why investors have fled to gold and oil as an alternative to owning paper, which can only offer a negative return after inflation.
It is a sad situation when everything the man in charge of our central bank professes to understand about inflation is wrong. Mr. Bernanke does not know what causes inflation, how to accurately measure inflation or the real damage inflation does to an economy. He, like most central bankers around the globe, persists in conflating inflation with growth. The sad truth is that our Federal Reserve believes growth can be engendered from creating more inflation.
However, in reality economic growth comes from productivity enhancements and a growing labor force. Those two factors are the only way an economy can expand its output. Historically speaking, the total of labor force and productivity growth has averaged about a 3% increase per annum in the U.S. Therefore, any increase in money supply growth that is greater than 3% leads to rising aggregate prices.
That’s why money supply growth should never be greater than the sum of labor force growth + productivity growth. Any increase greater than that only serves to limit labor force growth and productivity. Since Bernanke doesn’t understand that simply economic maxim, he persists in his quest to destroy the value of the dollar. Perhaps that’s why the Fed Head has decided to keep interest rates at zero percent for at least six years, despite the fact that the growth in the money supply is already north of 10%.
Maybe Bernanke believes that a replay of the entire productivity gains from the industrial and technology revolutions will both simultaneously occur in 2012. Or perhaps he feels that the millions of unemployed individuals laid off after the collapse of the credit bubble will all be re-hired this year. What he also fails to understand is that consumers are in a deleveraging mode because their debt as a percentage of income is, historically speaking, extremely high. So regardless of how much money Bernanke counterfeits into existence, it won’t lead to more job growth or capital creation…just more inflation.
There is little doubt that global economic growth is faltering. Most of the developed world is mired in an incipient recession. Japanese GDP fell at an annual rate of 2.3% in Q4. Eurozone GDP dropped 0.3% last quarter and Greece is in a depression—GDP falling 7% as of their latest measurement. U.S. GDP is still a mildly positive 2.8%, according to the Bureau of Economic Analysis. But that’s because they measured inflation in the fourth quarter at a .4% annualized rate. If inflation was reported more accurately by our government, the U.S. would also produce an extremely weak GDP figure.
But this is the age of a very dangerous global phenomenon; where central bankers view the market forces of deflation as public enemy number one and inflation as the panacea for anemic growth.
To that end, the Bank of Japan just added 10 trillion Yen last week to their 20 trillion bond buying program and adopted a minimum inflation target, much like that of the U.S. Federal Reserve. The European Central Bank is deploying their Long Term Refinancing Operation (LTRO) parts one and two. This counterfeiting scheme offers banks unlimited funds for at least three years to go out and monetized Eurozone debt. The first iteration of the LTRO dumped nearly 500 billion Euros into the economy. The second attack on the Euro currency will be launched on February 29th. And, of course, our Fed has printed $2 trillion dollars of new credit for banks to purchase U.S. Treasuries.
There is an all out assault on the part of global central banks to destroy their currencies in an effort to allow their respective governments to continue the practice of running humongous deficits. In fact, the developed world’s central bankers are faced with the choice of either massively monetizing Sovereign debt or to sit back and watch a deflationary depression crush global growth. Since they have so blatantly chosen to ignite inflation, it would be wise to own the correct hedges against your burning paper currencies.
They always tell you no one rings a bell when a market top or bottom is reached. But a bell is now ringing for the end of the thirty-year bull market in U.S. debt. And ironically, the bell ringer is our very own U.S. Treasury Department!
The U.S. Treasury Borrowing Advisory Committee, which brings together dealers and Treasury officials, met last week in a closed meeting at the Hays Adams Hotel. The committee members unanimously agreed that the Treasury should start permitting negative interest rate bids for T-bills. In other words, newly issued T-bills from the Treasury would offer investors a guaranteed negative return if held to maturity. The mania behind the U.S. debt market has reached such incredible proportions that investors are now willing to lend money to the government at a loss; right from the start of their investment. This is a clear signal that the bond market can't get any more overcrowded and can't get any more overpriced.
Of course, many in the MSM contend there is justification for today's ridiculously low bond yields and that a bubble in U.S. debt is impossible. But those are some of the same individuals who claimed back in 2006 that home prices could never decline on a national level and any talk of a bubble in real estate was nonsense. These are also the same people who assured investors in the year 2000 that prices of internet stocks were fairly priced because they should be valued based upon the number of eyeballs that viewed a webpage.
But we can easily see the future of U.S. Treasuries from viewing what is occurring in Portugal and Greece today. Portugal and Greece were able to borrow tremendous amounts of money because they converted their domestic currencies to the Euro and therefore, had the German balance sheet behind them. If these two countries had to borrow in Escudo's and Drachma's instead, yields would have increased much earlier, forcing a reconciliation of the debt years before a major crisis occurred. Therefore, their current debt to GDP ratios would be much more manageable. But now their bond bubbles have burst. The yield on the Portuguese 10 year was 5% a year and a half ago; today it is 15%. Greek 10 year bonds yielded 5% two and a half years ago; today they are 34%! The bottom line is that these counties were able to borrow more money than their economy was able to sustain because their interest rates were kept artificially low.
Likewise, the U.S. was and still is able to borrow a tremendous amount of money-far more that can be sustained by its income and revenue-because interest rates have been artificially low for far too long. Not only has the Fed pegged interest rates at zero percent since December 2008, but the U.S. dollar has been the world's reserve currency for decades. These two factors combined have deceived the U.S. into believing it can add about 8% of GDP to its debt each year. And since the end of 2007, the amount of publicly traded debt has increased by nearly $6 trillion; that's over 100 percent!
New Treasury issuance will be inexorably north of $1 trillion for at least the next decade to come. Along with that increasing debt supply, there is tremendous inflationary pressure coming from the expansion of the Fed's balance sheet and a Fed Funds rate that will end up being at zero percent for at least six years in total. Those two factors alone paint a very ugly picture for the direction of bond prices.
Manias can last a very long time and become more extended than reason should allow. But wise investors should prepare now for the upcoming interest rate shock and continue to accumulate anti-dollar investments. Once the bond bubble explodes here as it did in Southern Europe it will destroy the dollar along with it. That's because the sellers of U.S. debt will be forced to abandon dollar based holdings completely. That will mark the end of the U.S. dollar as the world's reserve currency and the restoration of gold as the global store of wealth.
The Fed has indicated that quantitative easing part three has commenced. As a part of the Fed's own version of glasnost, Bernanke has sought to lift the veil on the sausage making behind the decisions reached by the FOMC. To that end, our central bank has disclosed they now have an inflation goal of at least two percent. Therefore, the plain and sad truth is that the Bernanke Fed has now provided the holders of U.S. dollars a target rate for its destruction.
The Fed's preferred metric of inflation is the Personal Consumption Expenditures Price Index (PCEPI). This index is now trending lower, falling to 0.8% in the fourth quarter, compared with an increase of 2.0% in Q3. Excluding food and energy prices, the core rate increased 1.0% in the fourth quarter, compared with an increase of 1.8% in the third.
The Fed's January statement Bernanke acknowledged this by saying, "Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable." And in Bernanke's press conference, the chairman said that his inflation target may have to be breached until the unemployment rate falls significantly further saying, ".I think there are good reasons, from a dual mandate perspective, to have inflation greater than 2%."
Since the Fed believes that inflation is headed further south and is now well below their inflation target on a core measurement, it seems logical to anticipate that Bernanke will take immediate action to defend that two percent inflation target. The Fed Funds rate is already at zero percent, so the only way the Fed can lower real interest rates is to increase the rate of inflation. They do this by creating more credit and purchasing more assets from banks. Therefore, I expect a gradual increase in the size of the Fed's balance sheet over the next few months.
It should be noted that the PCEPI is the most benign measurement of inflation the government compiles and is currently trailing the real rate of inflation experienced by consumers by about five percent.
Of course, the idea that the "stewards" of our currency would set a minimum rate for its collapse is abhorrent. It's sort of like the Department of Homeland Security setting a quota for the number of terrorist attacks each year. Not only did Mr. Bernanke opt for an inflation target but he also pushed out the timeframe for the first rate hike until the end of 2014. The Fed is completely convinced that without an inexorably rising rate of inflation, there won't be enough money made available to finance our rapidly increasing national debt. So we are stuck with a perpetually reducing standard of living and a middle class that is rising fast on the endangered species list.
Before the Great Recession began in December of 2007, the M2 money stock was $7.40 trillion and the monetary base stood at around $800 billion. Therefore, the ratio between M2 and the monetary base was about 9:1. But now, thanks to Bernanke and his comrades at the Federal Reserve, the monetary base now stands at $2.7 trillion. The increase in the monetary base-which is also known as high powered money-was a direct result of the Fed's desire to take interest rates to zero percent and to vastly increase banks' ability to increase the supply of money and create inflation.
However, the Bernanke Fed has put this country in an unprecedented and extremely precarious position. Banks now have the ability to expand the money supply to over $24 trillion based upon the pre-recession level of lending. If you thought the inflation-led housing boom and credit crisis was bad just think what bubbles can now be created by expanding the M2 money supply from its current $9.75 trillion to well over $24 trillion!
Of course, the Fed and their apologists will be quick to explain that they will reduce the monetary base and raise interest rates once banks begin to aggressively push loans out the door and the money supply begins to grow rapidly. But what if the Fed is forced into a similar battle with that of European Central Bank? The European money supply is about to surge, as the ECB provides trillions of Euros in additional credit for banks to purchase distressed sovereign debt in an attempt to bring yields down. Likewise, our central bank has already given banks the fuel to expand the dollar supply by over $14 trillion. Such an increase in money supply will not come from loans made to commerce and industry, but rather to the U.S. Federal government. In addition, since our addictions to debt and inflation have become so entrenched in the economy, any attempt to significantly increase interest rates will remand the economy back into the middle of an economic crisis. Not only would the government find debt service impossible but the value of all real estate related investments would plummet. The result being that the Great Recession would turn into the Greater Depression.
More importantly, an increase in interest rates would render the Fed
incapable of removing enough money from the economy for years to come.
That's because a tremendous amount of their assets (such as the $852 billion
in Mortgage Backed Securities) would have fallen so much in value that they
will not have anything left to sell to banks. Therefore, the American
economy is most likely facing a protracted and difficult battle with rapidly
rising prices and a lower standard of living.
The plain fact is that the Fed is both unwilling and unable to fight
inflation. They are trapped. Interest rates will significantly increase
regardless of whether the Fed does it voluntarily or if the market does it
for them. And it is at that time that our true condition of insolvency will
Standard and Poor's has been greatly vilified for their call to lower the U.S. credit rating to AA+ from AAA. The evidence, naysayers point to, for their justification of excoriating S&P is the performance of Treasuries since the downgrade occurred. Indeed, U.S. debt yields have fallen and the dollar has increased in the five months after being stripped of AAA.
In fact, foreigners increased their holdings of Treasuries in Q3 by $17.2 billion and now own nearly 50% of our marketable debt. And 60% of their currency reserves are in U.S. dollars. So there are no signs of panic yet.
The prevailing wisdom of today now yields to the conclusion that getting your debt downgraded automatically renders a boost to your currency and bond prices. Therefore, why worry? Their comfort is ridiculously based upon the notion that the U.S. has a printing press and can create unlimited amounts of inflation. Therefore, interest rates will never rise and debt service won't ever be a problem.
I think that's also what the government of Hungary believed after WWII. They had a printing press also and it was used to pay debts accumulated during the war. But their daily rate of inflation hit a global record of over 200%. I wonder if the mortgage rates in Hungary were low back in 1946?
I, of course, strongly applaud S&P for attempting to shed a light on our pernicious debt problem. The U.S. government seems completely inept at taking even the smallest baby step towards lowering our annual shortfall in revenue over spending-let alone paying off the debt.
Recent examples of the paralysis in Washington include; the debt ceiling debate, Simpson Bowles Committee and the payroll tax holiday extension. Time after time D.C. manages to decide to increase the debt without cutting spending.
Our debt now exceeds the total GDP, and the annual deficits pile on an additional $1.3 trillion each year to that accumulated debt. Our publicly traded debt has increased 100% in the last 5 years!!! What is even worse is that our debt as a percentage of revenue is exploding. Back in 1971, the national debt was 218% of revenue. In the year 2000, the debt as a percentage of revenue had grown to 280%. Today, it has skyrocketed to 700% of revenue.and if you think that is worth panicking over you are absolutely correct. Yet those ethnocentric politicians and Wall Street Banksters still believe the credit rating agency had no basis to downgrade the U.S.
The bad news is the worst is yet to come. Just wait until interest rates start to rise. The average yield on U.S. debt is near 1% today. It was 6.5% in the year 2000. But given our record level of debt and Fed-led money creation, yields on Treasuries could and should go much higher than at any other point in U.S. history. Just imagine the economic instability that will arise when yields start to soar on corporate, consumer and government debt.
So much has been written and spoken about the pristine state of corporate balance sheets. Wall Street gurus love to parrot the fact that corporations hold a record level of cash. But it is also true that those same corporations now hold a record $7.6 trillion in debt. The facts are that households, corporations and government now hold a record level of debt. And the total of that debt as a percentage of GDP is, historically speaking, extremely high and close to its record set just a few years ago. These artificial and temporary low interest rates won't last. Inflation and massive debt supply will force rates higher. Then, the economy will falter as the percentage of debt to GDP soars. Just imagine what would happen to the real estate market if mortgage rates went back to 8%, if corporations had to pay double digits to refinance their debt and if the Federal government had to roll over its $10.5 trillion in debt at 7% instead of paying 2%.
That's the reason why I believe if there is any criticism to be placed on Standard and Poor's it should be that their rating of U.S. debt is still too high; and that the downgrade came way too late.
The original parameters used to construct the European Monetary Union were
set up by the Maastricht Treaty of 1992. The Treaty on European Union
contained strict limits on debt and deficits. In particular, deficits were
not to exceed 3% of GDP and gross public debt was to be south of 60% of
total output. Today, not even Germany can claim to have held true to those
strictures. In fact, all but a few countries in the EU have egregiously
violated the Treaty's mandates.
However, we are now being told that a new Maastricht Treaty-let's call it Maastricht Light-is to be adopted by those permanently-profligate Western European Nations. The European Summit meeting held last week proposed a blueprint for member nations to curb deficits and also to bolster the bailout fund. In other words, this time is different and now they really mean it!
But there are some significant problems with this latest solution. For starters, how will violators be sanctioned and what enforcement mechanisms can there be? For example, if the new plan is to throw out transgressors of this new treaty then what is the excuse for not starting now? More importantly, how can a country already having a debt to GDP ratio north of 100% pare down their debt to a viable level? In order to become a member in good standing in this new frugal club of nations; Portugal, Italy, Ireland, Greece Spain and perhaps even France and Germany, must first default on a significant portion of their debt.
But the act of defaulting in trillions of Euros worth of debt will lead to a depression in the Eurozone, if not the entire globe. Therefore, I expect the new name for this agreement coming from the European Summit meeting should be called Maastricht Light. But this new treaty will be much shorter in duration and profoundly less effective than the first.
In the interim, global markets continue to be held hostage by the ECB and its (UN)/willingness to massively monetize Eurozone debt. The covariance of most assets is currently extremely high because of debt levels that are also near their apogee. Last week we received further confirmation that the economy just isn't deleveraging.
The Flow of Funds report, put out by the Federal Reserve, showed that Total Non-financial debt is at 250% of GDP.
That's the same level it was in Q3 2010 and also in 2009. Due to the precarious level of debt in the developed world, the direction of the dollar continues to dictate the direction of markets. Whenever the ECB communicates clues to the markets that it may buy-up insolvent EU (17) debt, the dollar drops, as most asset prices rise. And whenever ECB President Mario Draghi steps away from that eventuality, the dollar rises and global asset prices fall.
It appears, from his statement released last Thursday that Mr. Draghi is currently a bit reticent to bring back the good old days of Weimar Germany. But sadly, he is a politician like all central bankers and sooner or later will succumb to the pressure engendered by a depression. Much like our own Treasury Secretary Hank Paulson acquiesced to borrowing and printing trillions of dollars after facing the collapse of the entire U.S. banking system, which was brought about by the imminent insolvency of AIG.
Investors should be aware that gold and other commodities will experience extreme volatility in 2012--even more than what was witnessed in 2011. However, the timing for the next move to new highs will hang on the ECB's deployment of its ultimate plan of massive monetization of unsterilized European debt.
Last week many Wall Street investors were duped into believing the European debt crisis was well on the way to being solved. That's because six central banks led by the Federal Reserve made it cheaper for foreign banks to borrow dollars in case of emergencies. Stocks and commodities rallied as the U.S. dollar fell in the belief that the Fed was somehow committing to purchasing huge quantities of European debt. But last week's move was only symbolic in nature and very short on substance. Making dollars less expensive to borrow over in Europe does nothing in the way of lowering debt service expenses or reducing the debt levels of fiscally challenged nations.
However, in reality this week could be the most important and volatile seven days in all of 2011. The European Central Bank will most likely make a crucial decision as to whether or not they will monetize massive quantities of insolvent European debt without sterilizing those purchases. ECB head Mario Draghi has already lowered the interbank lending rate one quarter point in his first few days in office. Now he is expected to take interest rates down to 1% after next week's meeting. And in addition, if the European Summit meeting next week yields an acceptance to broad-based austerity measures, the ECB may finally assent to purchasing PIIGS' debt in unlimited quantities and duration.
That action will temporarily send sovereign debt yields lower and the Euro currency higher. And the major averages will celebrate the Pyrrhic victory. However, if the ECB holds the line on interest rates and refuses to monetize distressed debt the crisis will intensify greatly. In the latter case, bank failures will ensue and European money supply growth rates will plunge. Meanwhile, commodities prices will fall along with equity values across the globe. A deep recession would result from the eventual default of over two trillion Euros in debt.
In contrast, a sharp recession would be the best option to pursue as it would allow insolvent debt to finally be written down. A straight forward default on debt would be a much better option than defaulting through inflation. By the ECB keeping a strong and stable Euro, banks and nations would be able to slowly recover after a truncated period of distress.
Unfortunately, what is more likely to occur instead is central bank intervention the likes of which we haven't seen since the end of WWI. But what Wall Street egregiously misunderstands is that central banks are
incapable of solving the bankruptcy of Europe by printing money. Creating inflation on a massive scale will crush GDP growth while eventually sending interest rates spiraling out of control. The only winners in that case will be those that own inflation hedged portfolios--especially those who own gold in the European currency. Pay very close attention to what happens in Europe next week. Your portfolio depends on it!
Europe is providing the U.S. with a serious warning; to cut your deficits as soon as possible or face skyrocketing debt service payments and insolvency. So I was hoping given this valuable lesson currently being taught us, our government would now be making huge strides towards fixing America's fiscal
However, this week we received further confirmation that it is impossible for our leaders in government to cut even one penny of our debt. Whether it is Simpson Bowles or the Gang of Six or the Super Committee; it just doesn't seem to matter.the folks in D.C. are completely addicted to debt and inflation. The Super Committee failed to find $1.2 trillion to cut in cumulative deficits over the next 10 years. So let's break this down a bit and see how odious these people really are.
The cuts weren't going to even start until fiscal 2013; but still no agreement. The cuts were going to be backend loaded; but nobody could agree to make the cuts. The "cuts" aren't even really cuts at all because they are simply a reduction in the amount of debt we will accrue in the next decade; but that didn't seem to matter.
To be specific, the Super Committee was supposed to limit the accumulated deficits to be run up in the next decade to a staggering $8.8 trillion. So even if they were successful, we would still have added $8.8 trillion in deficits to our $15 trillion in debt that is already in the bag. So we are still light years away from reducing the nominal level of debt or even reducing the level of debt to GDP.
But of course, since the laws of economics don't apply to the U.S., we don't have to worry about debt.correct? Isn't that what those in D.C. must truly believe. Well the U.S. needs to take a look at what happened in Germany this week. We just may have witnessed the nucleus of Europe split. Germany failed to get bids for 35% of the 10-year bonds offered for sale today, sending its borrowing costs higher. Not having bids for 35% of your action means that the auction has failed. With interest rates now rising in Germany, how will they also be able to stop rates in Spain and Italy form soaring? Higher interest rates in Germany may push the Bundesbank and the ECB over the inflation edge, causing Mario Draghi to rapidly ramp up the Euro printing presses. It is either assent to printing trillions of Euros or watch the Eurozone crumble into the dustbin of history. Given that horrific scenario, I expect the ECB to follow the pattern of all previous central banks and pursue an inflationary bailout with alacrity."
Many investors continue to overlook the profound ramifications of having the largest economy on the planet fall into a steep recession. EU 27, which has a GDP north of $16 trillion, is the largest export destination of some of the world's fastest growing economies. Bloomberg reported last week that Chinese exports rose at the slowest pace in almost two years in the month of October as the deepening debt crisis crimped demand. A sharp decline in the European economy means slower growth in emerging markets, which has implications for U.S. corporate earnings and bond prices as well. Remember how the fall of 2008 so very clearly illustrated the interconnectivity of the global economy. Can there really be any safe haven country when the GDP of the developed world is on the precipice of a sharp decline? The truth is that Europe, and quite possibly Japan and the U.S., face a recession in 2012 due to a full-blown bond market crisis.
But the mechanics behind what is occurring is actually very simple to understand. And once you grasp the fundamental dynamics behind what causes a sovereign default, investors can reach a very clear conclusion as to what action they need to take. History is replete with examples that indicate once a nation reaches a debt to GDP ratio of between 90-100%, two pernicious conditions begin to appear. First, International bond investors start to become concerned that the tax base cannot support the amount of debt outstanding. This concern is precisely because economic growth rates screech to a halt, as most of the available capital is diverted from the private sector to the government. And secondly, it is at this point that interest rates begin to climb inexorably....
Two recent examples of this can be found in Greece and in Italy. Neither country is growing and their debt to GDP ratios have soared well above 100%, and their bond markets are now in full revolt. The sad fact is that their debt levels have become so intractable that both bond markets have now been placed on the life support of the European Central Bank. However, regardless of central bank intervention, interest rates eventually rise to a level in which most of the country's tax revenue must be used to service the interest payments on the debt. It is at this point where investors fears become a mathematical reality and the country finds paying down the principal of the debt an impossibility.
Sadly, at this juncture only two default options exist. The country can admit their insolvency and default on the debt outright-which is the smartest route to take. The other option-and the one that all fiat currencies take-is to monetize the debt. However, this default by means of inflation doesn't solve the problem, it only extends and exacerbates the default process.
It is very likely that an inflation-led default will be deployed first in Europe and then later in this decade in the U.S. Therefore, it makes sense to avail yourself of the best protection against the ravages of a crumbling currency. That is why gold and gold equities are a buy, especially when you are fortunate enough to get a pullback.
The latest round of optimism on display late last week from Wall Street was based upon the supposed resolution-once again-of all Europe's problems. However, the sad truth is the move upward only brought the S&P500 near the unchanged mark on the year in nominal terms and much lower when adjusted for inflation.
What was the cause for this optimism you ask? It was the speculation that an epiphany had been reached on the part of the European Central Bank that they would arm themselves with a bazooka to purchase all of the PIIGS distressed sovereign debt. Under its Securities Markets Program (SMP), the ECB has already bought billions of Euros worth of government bonds issued by Italy, Spain and other troubled euro area economies. It now seems very likely that the new ECB head, Mario Draghi, is going to borrow Hank Paulson's bazooka, which was first deployed to rescue FNM and FRE. But years after Secretary Paulson fired his bazooka, those formerly thought of as "safe "investments are now trading at just pennies a share. And just last week the government-or more appropriately the taxpayer-was forced to throw an additional $7.8 billion at the GSEs for the last quarter's losses. That was on top of the $169 billion they have already spent to rescue the black holes known as Fannie and Freddie since 2008.
Nice bazooka Hank! You see, the problem with arming any government with a bazooka is that they are guaranteed to have the need to fire it. Mario Draghi is making the same mistake as our former Treasury Secretary did during our financial crisis. Paulson believed that the problem with the GSEs was a lack of confidence. The thought process was that if he threatened to buy all of the GSE obligations, he would never have to actually do it. However, the truth was that the FNM and FRE owned or guaranteed mortgages that were worthless. Offering to buy these garbage investments did nothing in the way of solving the problem of people owning homes that they couldn't afford. Similarly, Draghi now believes that the problem with European debt is fear, not one of insolvency.
And just like Hank, Mario will soon learn that offering to purchase an unlimited amount of Italian debt does nothing in the way of bringing down the debt to GDP ratio. In fact, it has the exact opposite effect. It encourages more profligate spending, just as it also lowers the growth of the economy by creating inflation. What's even worse is that yields on Italian debt will reach much higher levels in the longer term. That's because the purchasers of sovereign debt have now become aware that their principal will be repaid with a rapidly depreciating currency. Therefore, the yield they will require in the future must reflect the decision to use inflation as a means of paying off debt.
What is unfortunately assured is that several countries in Europe are facing a recession due to their overwhelming level of debt. One of the consequences of having a debt to GDP ratio over 100% is that the economy ceases to grow. But to make matters even worse, the ECB has decided to deploy their arsenal against rising bond yields. Therefore, the significant downturn in the economy will be also be accompanied by a high rate of inflation.
The situation in Greece, and perhaps soon to be in other countries, is not that different from an individual that is using nearly all of his or her income to pay the minimum interest payment on their credit cards. Once the C.C. Company gets wind of that, they are likely to pull in all lines of credit because the chance of getting their principal back has become nil. However, unlike an individual, a country with a fiat currency can counterfeit as much currency as they please. But that is a temporary solution at best.
For now the yield on the Italian 10 year note has declined from 7.3% on Wednesday the 9th to 6.5% on Friday. But the ECB has a very short window in which they can create inflation to bring down bond yields. That's because the main determinants of how much it costs a country to borrow money in the international markets are the credit, currency and inflation risks of their debt. In pulling out his inflation bazooka, Mr Draghi is rapidly increasing all three risks and much higher yields are virtually guaranteed in the near future
Of course, not to be outdone Mr. Bernanke and his cadre of counterfeiters at the Fed have sent oil prices back to $100 a barrel, M2 up 10% YOY and the Misery Index to a 28 year high. The threat of yet more quantitative easing has sent many commodity prices rising and gold in shouting distance of its record nominal high. With central bankers around the globe consistently coming up with plans to destroy paper currencies, can someone justify a reason not to buy more gold and gold stocks!
Even though the Misery Index in the U.S. has now hit a 28-year high, the Fed is still mulling over new ideas on how to create yet more inflation. The Misery Index-which is simply the sum of the unemployment plus the rate of consumer price inflation--rose to 13.0. It wasn't Ben Bernanke this time squawking about the virtues of money printing. It was one of the Counterfeiter in Chief's minions, Fed Governor Dan Tarullo, who stated in a speech last week; "I believe we should move back up toward the top of the list of options the large-scale purchase of additional MBS." Buying more mortgage securities will only ensure that the money supply expands faster as the value of the dollar crumbles expeditiously against the stuff you and I consume.
But it's not only the U.S. that is working diligently on sending the Misery
Index close to all-time highs. The European Central Bank is steadily
acquiescing into the practice of monetizing most of Europe's debt. As the
continent sinks slowly into a debt-fueled recession, the ECB has been brought more and more to the fore. This isn't any surprise to this writer, as the notion of a bailout coming from leveraging up already insolvent
nations was absurd from the start. The buyer of Europe's bankrupt debt has to be their central bank.
Back on the home front, the talk about large scale purchases of Mortgage
securities by the Fed sounds like Quantitative Easing part 3 is just around
the corner. Is it really any wonder why the price of gold is so hard to
knock down? Mr. Tarullo is in complete accord with his boss in believing that the resolution of this economic malaise is to bring down the cost of money. But the truth is that interest rates have never been lower; and yet
the economy is still dying. And the act of creating more inflation won't revive the economy or raise the living standards of most Americans. It will just continue to crush savers and create further devastating imbalances in the economy. It may come as a shock to the Fed, but the reasons why consumers aren't able to buy houses are because their level of debt is too high, unemployment rates remain elevated and the price of homes is still out of line with average incomes. By pursuing a policy of dollar destruction, the Fed will only ensure that the eventual level of interest rates will rise inexorably, as inflation destroys whatever real growth is left in the economy.
Bernanke's "Operation Twist" has succeeded in sending yields on longer duration maturities to record lows. But what is now being lauded as a success by the interest manipulators at the Federal Reserve will very soon prove to be this country's Waterloo.
The problem is that America's addiction to artificially-produced low interest rates is becoming permanently cemented into the economy. By definition, artificially-low interest rates cannot last forever. Once debt supply and inflation pressures overwhelm the Treasury market, as they inevitably must, yields will soar. If you doubt that fact, ask the Greeks if a poor economy or the ECB is capable of holding down yields forever. The interest rate on their two-year note is now above a staggering 70%.
Much like the Greeks, we Americans have been duped into believing we could borrow much more money than we could ever pay back. If Greece never stopped using the Drachma, their interest rates would have surged much sooner and prevented the buildup of their onerous level of debt. It was the fact that the Greeks had the cover of the Euro which tricked the world into believing they could run a debt to GDP level above 100% with impunity. Likewise, the U.S. has used the benevolent cover of having the world's reserve currency to run-up $15 trillion in Gross Debt. Without that reserve currency status, interest rates would have skyrocketed and forced deleveraging upon our country.
However, by the time it comes for the US to face the reality of a free-market based cost of money, the U.S. banking system and indeed the entire government will have become completely dependent on the continuation of nearly free money to maintain solvency.
America's teaser rate and adjustable rate mortgage on her $15 trillion debt will most likely expire within a few short years. An insolvent banking system and an insolvent government will be the result of believing we can and should borrow more than $1 trillion above what we raise in revenue each and every year; simply because the cost of financing is so low.
The "solution" to European and American insolvency is always sought from the printing press. Is it really any wonder why gold is still up $260 an ounce YTD. This is why the gold bears and those who have given up on the gold market will be extremely disappointed in the weeks and months ahead.