It wasn’t too long ago that the stock market was busy celebrating a “great” September jobs report. There were 248k net new jobs created and the unemployment rate dropped to 5.9 percent. Janet Yellen, Ben Bernanke and the rest of Washington D.C.’s central planners deemed it a great time to take a Keynesian victory lap, basking in the delusion that they now have proved you actually can print and borrow your way to prosperity.
And, because of their success, the Fed would be able to raise interest rates without any damage to the economy.
But while crossing the finish line they discovered they were on the wrong track. U.S. stocks have dropped for the third consecutive week and have erased all the gains for the year. The market’s anxiety stems from the global economic slowdown (that includes the United States). Industrial commodity prices, most notably oil, are tumbling and sovereign debt yields are plunging—asset prices around the world have begun to collapse.
Ever since the late 1980’s, the Fed has viewed itself as the savior for the stock market; this is affectionately referred to on Wall Street as the Fed put. Like a fireman standing ready to put out a major fire brewing in the economy’s kitchen, the central bank has stood ready to bail out any of the markets bad behaviors—most of which were first derived from the Fed’s provision of artificially-low interest rates to begin with.
But, today’s Fed isn’t merely waiting for a fire to start, it is using a flame thrower to light the stove. It has stopped relying strictly on overnight repos to manage short-term rates and providing liquidity on the margin; but instead has now put the responsibility of the worldwide economy squarely on its shoulders.
This is why former Fed Governor Laurence Meyer recently complained that too-low inflation, “is getting to be a real issue again,” With inflation at 1.5 percent according to the Fed’s preferred index, Meyer believes FOMC policy makers aren’t likely to raise interest rates, even if the economy approaches full employment—what Keynesians believe causes inflation.
And taking this a step further, John Williams, president of the San Francisco Fed, said in a recent interview with Reuters that the first line of defense at the central bank would be to telegraph that U.S. rates would stay near zero for longer than mid-2015. Then, if inflation isn’t really hollowing out the middle class fast enough, Mr. Williams suggests the Fed should be open to another round of asset purchases. Even so called Fed Hawks, like St. Louis President James Bullard, are now suggesting that the current quantitative easing program should be extended.
It has become clear that the Fed is no longer just tinkering on the edges of the economy, it is now micromanaging every economic data point and, most importantly, each tick of the stock market.
This over-engaged Fed has created an overwhelming sense of investor complacency—an entitlement that asset prices will always go up and bond yields will always stay low.
All central bank intervention comes with a price. The upside of lowering interest rates is that it lowers debt service costs. The down side is it encourages more gluttonous debt consumption. That is why the U.S. National debt has risen from $9.2 trillion, to $17.9 trillion, since the beginning of the great recession. This is also why total Global debt has soared by over $40 trillion, since the start of the Great Recession. Stated differently, total global debt has leaped from 176 percent of GDP in 2008, to 212 percent by the end of last year. The truth is there has been no deleveraging at all since the financial crisis; but rather a dramatic re-leveraging of the global economy.
Rising rates are not the current problem. Despite the fact that the biggest buyer (the Fed) is nearly out of the picture, yields are falling because deflation is pervading across the globe. However, the ending of our central bank’s massive QE programs is acting like a defacto tightening of rates.
The fact is that debt levels have increased to such a lofty level that zero percent interest rates are not enough to keep the current stock market bubble afloat. If you don’t agree with this, take a look over in Europe. Central Bank head Mario Draghi is having difficulty getting a genuine QE program going and there has been no increase in the ECB’s balance sheet. Despite the negative nominal interest rate environment in Europe all stock indices are down on the year; with the German DAX down 11% in 2014.
U.S. markets fell around 15% after QEs 1 and 2 ended. That’s because asset bubbles have risen to the extent that they now rely on perpetual central bank money creation to survive. Investors need to be reminded that the stock market did not bottom from the panic selloff experienced during the height of the great recession until QE1 was expanded to $1.55 trillion in March of 2009. Each time QE ended the stock market fell apart. Only this time the end of QE III finds the market more than 40% higher than it was at the end of QE II. In addition, the end of this round of money printing coincides with the majority of developed and emerging market economies at or near a recession. And, the Fed isn’t just ending QE but is planning to raise interest rates in the next few months.
Bond yields and industrial commodities have already tumbled in price; and now real estate and stock prices have also begun to plummet. I believe that stocks have entered into a significant bear market.
Without having the ability to further lower interest rates, it will take another massive and protracted QE program to pull equities out of this tailspin. To keep the bubble growing we will see a promise from the Fed that QE won’t end until inflation has become permanently entrenched in the economy.
It looks like yet another Fed prediction has failed to materialize and another of its strategies has been thwarted. The sad truth is that the Fed’s plan to raise interest rates next year will not come to fruition. In sharp contrast, the new plan will be called QE infinity.
The International Monetary Fund (IMF) has downgraded its global growth forecast for both this year and next, highlighting among other things, the threat of weakening demand in the Eurozone and a slide into deflation. This comes after consumer price growth in the euro zone slipped again in September, coming in at just 0.3 percent.
There’s absolutely no sign of growth in the Euro region. France is stagnant, Italy is back in recession, and even the German economy, once the pillar of the Eurozone, shrank in the second quarter. German industrial output fell by 4 percent in August, with the worse-than-expected drop coming a day after the country's industrial orders had their largest monthly decline since the global financial crisis in 2009.
The United Kingdom isn’t fairing any better, as manufacturing output for August grew just 0.1 per cent, down from 0.3 per cent in July.
And then of course we have Japan, whose industrial production shrank 1.5 percent month-on-month in August and spending among Japanese households fell a steeper-than-expected 4.7 percent.
Life in the emerging markets isn’t faring much better. Adding to the world-wide misery is Russia. Russia is suffering from its involvement in the Ukraine, resulting with both U.S. and European Union imposed sanctions. Investors are now frantically pulling money out of the country. Demand for dollars and euros is growing among Russian companies locked out of western debt markets as they contend with $54.7 billion of debt repayments in the next three months; leaving the rubble under severe pressure. All this is exacerbated by the plunge in oil prices to their lowest level in more than two years--threatening to tilt the $2 trillion Russian economy further towards recession.
Moving to the other side of the globe, we have Latin American economies that are also in, or teetering on recession. Brazil’s economy, post-world cup, is on life support, its one hope being that President Rousseff, the Marxist and former guerilla, doesn’t win the election. A win for her seems likely, even though Brazil’s economy is officially in recession. The second quarter’s GDP took a huge downturn, contracting 0.6 percent from the first quarter.
Chile’s manufacturing output fell 4.9 percent in August, as policy makers cut their growth forecast for the 4th consecutive quarter. And, it may finally be time to cry for Argentina, as tougher controls on trade and the currency market are exacerbating economic imbalances that were already dizzied from the nation’s July default. Economists now predict the first full-year recession in Latin America's No. 3 economy in over a decade.
And then of course we have China, the former darling of global growth. Its industrial production growth slowed sharply in August to its lowest level for more than five years. In addition to this, house prices have fallen for five consecutive months. This could be a result of China's large debt-to-GDP ratio, which stands at 217 percent. The Chinese government continues to add to their debt load by fruitlessly attempting to stimulate the economy through endless construction projects. But all they have produced are more unoccupied cities, instead of balanced and sustainable growth.
The fact is that economies all over the world are in, or near a recession. However, Wall Street’s greed and hubris is trying to convince investors to believe U.S. growth will be immune from the global malaise and leave the earnings of multinational corporations unaffected.
But why would the growth rate of earnings and the US economy be better than virtually every other country on the planet? Linear-thinking economists are extrapolating the Q2 GDP rebound from the negative first quarter as a sustainable trend. But a temporary bounce from a sharply negative 1st quarter should not be viewed as a permanent growth trajectory. The entire planet is suffering from anemic growth due to a tremendous debt albatross. That includes the United States.
To think Q3’s earnings won’t be disappointing, investors have to believe that; weak and faltering global growth, a surging U.S. dollar, the Fed ending a $1.7 trillion QE III program, and the specter of rising interest rates in 2015, will be great news for multinational corporate earnings.
The United States is part of a global economy and does not operate on an economic island. Now that the Fed’s QE programs are ending, global deflation is starting to take over. Equities, bond yields, commodities and home prices are all starting to roll over. Look for these factors to negatively impact S&P 500 earnings in significant fashion this quarter.
Under the stewardship of Shinzo Abe, the nation of Japan has become a global leader in debt, currency devaluation and inflation. Unfortunately for the Japanese, Abenomics is also leading Japan into a hyperinflationary depression, as the first of his three arrows has shot right through the yen and put a gaping hole in the wallets of every Japanese citizen.
The Bank of Japan (BOJ) has placed all its chips on the bet that inflation will cure all the nation’s economic problems. Making deflation public enemy number one is rather convenient when your country's public debt to GDP is the highest in the world. In order to end deflation, the central bank has purchased 70% of all newly-issued Japanese Government Bonds. All this money printing is intended to get prices rising, and it has been very successful. Japan's consumer prices rose 3.1 percent in August from a year earlier. Prices for fuel, light and water rose 6.4 percent on the year. But as real wages continue to fall, the bull’s eye appears to be directed on destroying the Japanese middle class.
In the nonsensical world of Abenomics--where inflation is viewed to be the progenitor of growth--the 3.1% CPI reading is deemed to be insufficient. This is because the core rate of 1.1 percent was far shy of the 2% read they are aiming for. So, as expected, there are calls coming from the lobotomized economic experts in Japan for yet more money printing from the BOJ.
Japan’s “experiment” with Abenomics would be much more interesting if we didn’t already know how it all ends. This so called experiment of massive debt monetization has already been tried in countries such as Weimar Germany and, more recently, in Zimbabwe; with disastrous results. The misguided policy of using inflation to create growth is predictably causing asset bubbles in JGBs and stocks. The BOJ is tirelessly printing money to monetize nearly all of the Japanese government’s enormous debt load and also to buy stocks. This has ballooned its equity portfolio alone to be an estimated 7 trillion yen ($63.6 billion). However, all this has done nothing to boost real GDP, balance trade or boost real wages. In fact, Industrial production shrank 1.5 percent month-on-month in August and spending among Japanese households fell a steeper-than-expected 4.7 percent.
The Japanese economy has reached the point of no return. The BOJ will continue to print yen until the citizens of Japan, unable to take any more pain from intractable inflation, insist on a change of course. The real solution for Japan will be to explicitly default on its monstrous debt.
The major beneficiary of Abenomics has been the value of the U.S. dollar. But this will not be the case for very much longer. There currently appears to be a trenchant divergence between the monetary policies of the BOJ, and that of the Fed. The market has become convinced that the Fed will soon be raising interest rates, while the BOJ continues to reckless print money. This has caused a large increase in the value of dollar vis-à-vis the Yen.
The dollar is going higher because of the misperception that the U.S. economy is strengthening. Markets are also convinced that the Fed will have a graceful exit from QE and a smooth transition to interest rate mean reversion. But this could not be further from the truth. The US economy is still highly susceptible to even slight interest rate hikes. This is why Q1 GDP was a negative 2.1 percent. The 10-year note went from 1.6% in May, to 3% by the end of 2013. Keynesians blamed snow for the negative first quarter, but the truth is that our over-indebted economy falls apart once debt service costs increase—even from such low levels.
As the Fed exits QE and prepares the market for rate hikes, we see the Case-Shiller home price index fell 0.5% in July, the biggest drop since November 2011 and the third month in a row of such declines. The Russell 2000 is down 12% from its March highs, and half of the NASDAQ is in a bear market. Commodity prices are crumbling as the economic data is weakens. Pending home sales, the ISM Manufacturing Index, Construction Spending and Factory Orders all recently came in worse than expected.
QE’s purpose was to boost real estate, equity and bond prices. After six years of successfully re-inflating assets, the Fed has duped itself and the markets into believing it can exit monetary manipulations with impunity. Therefore, get ready for the resumption of plummeting asset prices like we experienced in 2008.
But remember, central banks’ number one fear is deflation. The Fed under Chairperson Janet Yellen is certainly not the exception, and she will do whatever is necessary to curtail the dollar’s strength. This is why the Fed will not be aggressively hiking rates in 2015; and could even start another round of QE in the near future.
Much like the BOJ, our central bank firmly believes that inflation can somehow lead to prosperity. After asset bubbles crumble and the Fed re-engages, the true anemic state of the dollar will be revealed.
Most importantly, it is crucial to understand that the intrinsic value of the dollar is not rising. Real interest rates in the United States are still very much negative and the money supply is growing far faster than real GDP. Therefore, the dollar is only rising if measured against those countries whose central banks are actively trying to depreciate their currencies. And the U.S. Fed is about to rejoin in that effort.
Japanese citizens—if they have any discretionary investment income left—should be aggressively selling their paper money and buying gold. And it won’t be long before all holders of fiat currencies are forced to do the same.
Wall Street came to a halt recently, as Chinese e-commerce giant Alibaba made its Initial Public Offering debut. The media became myopically focused over this so-called “historic event” and by its celebrity founder Jack Ma. By the time the closing bell had rung, the hype and fanfare propelled Alibaba up 36 percent on its first day of trading and caused the world’s largest IPO to display a market cap worth $231 billion. The investing public seems to have forgotten the dangers associated with disregarding valuation metrics—Alibaba is trading at a Price to Book value ratio north of 27!
This hysteria is scarily reminiscent of the late 1990’s, where an over-hyped stock market soared to new heights fueled by an accommodative Federal Reserve. Today, just as in 1999, a vastly superfluous money supply is finding its way into the pockets of any flimsy business model, with stock valuations that far outstrip the book value or potential profits.
During the peak of the late 90’s tech bubble, the Price/Earnings ratio of the Nasdaq 100 was far in excess of 200. This confirmed investors were willing to pay very high prices for stocks, due to their delusional expectations of earnings growth. The problem, which is now easily acknowledged by using hindsight, was these companies never had the potential to reach the valuations ascribed to them—all they had was eyeballs. But a central-bank manipulated increase in the money supply does strange things to investors, it ails them with a condition Alan Greenspan referred to as “irrational exuberance.”
Today we see that same type of irrational exuberance, as investors fall over themselves to buy stock of a Chinese internet company, despite the fact the communist government of China retains total control over that country’s internet. If China’s Premier Li Keqiang decides to pull the plug on the company, it will become worthless overnight. However, while Alibaba does have revenue and earnings, the gross overvaluation of the enterprise echoes the tech bubble with frightening similarity.
But Alibaba is not even the best example of this current Fed-induced social media frenzy. The paragon of “irrational exuberance” would have to be the social media app called YO. What is the intellectual property behind this life-changing technology you ask? Brace yourselves; it just sends friends the thought provoking message “Yo,” Yo was developed in eight hours and was launched on April Fool’s Day of 2014. As idiotic as this idea may sound, it has a valuation of $10 million. The actual meaning behind the word “Yo” is subject to interpretation. And not even its founder, Mr. Arbel, whom I imagine is “Yoing” all the way to the bank, is willing to provide Webster’s with a definition. Some presume its code for “hey”, which I am sure will be the next app to raise millions of dollars very soon as well. But, more than likely the significance of this word really is, “Yo, this market is a bubble; get out now!”
But it’s not just irrational investments, such as Yo, and overhyped IPO’s, that are signaling a top to this market. There are technical indicators in the market that are also setting off loud warning bells. The breadth of the market is troubling to say the least, with nearly 50 percent of stocks in the NASDAQ down more than 20 percent from their peak in the last 12 months. Additionally, more than 40 percent have fallen that much in the Russell 2000 Index. In fact, the Russell 2000 index of smaller companies is now down over 4 percent on the year, and has in technical terms reached a “death cross”. A death cross occurs when a stock or index's 50-day moving average trend line dips below its 200-day moving average; and is a sign momentum is fading.
It’s clear as the Federal Reserve reins in its economic stimulus plans that the appetite for risk is narrowing. QE III totals $1.7 trillion worth of Treasury and Mortgage Backed Security purchases and this program ends in October. And the Fed’s massive money printing scheme, which resulted in record-low interest rates for the last 6 years, has manifested in stock, real estate and bond bubbles occurring all at the same time.
After a Fed-induced five-year rally in stocks, which added almost $16 trillion to equity values, it’s been three years since investors saw a 10 percent decline in the S&P 500. But we are starting to see the early anecdotal and technical signs that this market has gotten too frothy and a significant pullback is imminent. With the total market cap of stocks as a percentage of the economy at 117%, its highest point since the dot.com bust and far above its level reached in 2007, the toboggan ride down can’t be too far off. Perhaps those who haven’t gotten out in time will yell this as their portfolios plunge, “Yo, I should have known better.”
A wise saying goes like this; "Those who do not remember history are condemned to repeat it." So ask yourself; what is the fate of those who seem to have absolutely no recollection of events that happened just a few years ago?
We are nearing the end of 2014, and to the debt markets, it is almost as if the 2008 economic collapse never happened. It appears that borrowers and lenders are suffering from a severe case of collective amnesia. Yes, consumer debt levels took a slight breather in 2009-10. But today, total consumer credit in the U.S. has risen by 22 percent over the past three years, and at this point 56 percent of all Americans have a subprime credit rating.
By the end of 2014, total U.S. credit card debt is expected to rise by $54.8 billion and average household credit card debt will surpass the $7,000 mark, reaching levels not witnessed since the end of 2010. Adding to these disturbing figures is student loan debt that is at a nationwide all-time record of $1.2 trillion, which is an 84 percent jump since the Great Recession of 2008. Almost 19 percent of student loan borrowers owe more than $50,000, according to a report published recently by the Federal Reserve. Only 6 percent of borrowers had that much debt in 2001. Student loan debt now outstrips credit card and auto loan debt in America. And speaking of auto loan debt, during the first quarter of this year, the size of the average vehicle loan soared to a new all-time record high of $27,612. Five years ago, that number was just $24,174.
The financial crisis of 2008 was born out of a romance between the US consumers' insatiable desire to spend and financial institutions' voracious desire to issue debt, which compelled them to lend money regardless of the other party's ability to make payments. In 2008, this dysfunctional relationship ended badly and both parties swore each other off. But, with the Fed in the background playing the violin, recent data shows today, these two lovebirds can't stay away from each other.
Unfortunately, todays mounting debt isn't limited to the US consumer, Bank of America is forecasting about $110 billion of collateralized loan obligations for 2014, as volume is on pace for a record year. CLO's are used to finance small and medium size businesses. And CLO issuance in total, is on pace to surpass the record $93 billion raised in the U.S. during 2007.
Adding fuel to the debt fire is the aggressively growing Junk bond market. Junk bond yields have fallen to the 5-6 percent range. This has caused fund managers, still insisting on a 10%+ return, to buy on leverage in order to increase the yield on their capital investment. Citigroup, displaying a pre-2008 mindset, has even calculated that leveraging junk bonds at 2.3X is a better trade than leveraging US Treasuries at 8.1X.
All these data points prove that we, as a nation of borrowers, have learned nothing from 2008. In fact, things have gotten worse as our own Federal Government, lulled by record low interest rates, has massively stepped up its own passion for debt, taking Federal Debt levels up from $9.2 trillion, at the start of 2008, to $17.8 trillion today. But the tease is that with record low interest rates, they are actually paying less today to service that debt then they were 6 years ago.
This is in part because the Treasury insists on financing debt at the shortest duration possible. In fact, about 80 percent of the government's $12.8 trillion publicly traded debt is financed with shorter-term Bills and Notes. And thanks to the Fed's ZIRP and Treasury's short-term thinking, the average interest rate on the government's marketable debt was less than 2 percent last year. Compare that to the 6.6 percent level in January of 2000, when interest rates were still below their forty-year average.
It's clear that simply reinforcing bad behavior of the past has left few to learn from previous transgressions. The past six years of record low interest rates, should have given borrowers a reprieve; an opportunity to refinance debt and get their financial house in order. Instead, it has predictably lured, first the public, and now private sector borrowers, to pile on more debt. Indeed, the aggregate level of U.S. debt now stands at a record $57 trillion! That figure is up nearly $7 trillion from the Great Recession.
Therefore, those investors who believe the Fed can seamlessly transition from 6 years of ZIRP and $3.7 trillion in QE should re-read the above data. An aggressive Fed will immediately cause our overleveraged and asset bubble-driven economy to collapse. It's just a shame the Dole of Doves at the Fed never learned from previous mistakes-even those made just a few years ago.
This is why the Federal Reserve will not be raising rates anytime soon. And why Ms. Yellen kept the language in last week's FOMC statement regarding, "considerable time" between the end of QE and the first rate hike.
Those investors piling into the U.S. dollar based on a hawkish Fed are making a big mistake. Our central bank wants to create an environment of perpetual inflation. And will not end its policy of providing negative real interest rates until thoroughly successful.
Since the Greenspan era, history has taught us that our dovish Fed exists to accommodate government borrowing. This truth is becoming more immutable as debt levels inexorably increase. Unfortunately, this codependent relationship has now caused the latest iteration of a stock market bubble to become the most dangerous of them all.
Wall Street powerhouse Goldman Sachs has recently reiterated its negative view on gold, which it has held for the past year. However, it is now doubling down on this view and advising clients to actually go short the metal. Jeff Currie, head of commodity research at Goldman noted "Our target is really driven by the view that we think that the Fed will ultimately be the dominate force here and put more downward pressure [on prices]".
While I am in agreement with Goldman that the Fed will be the dominant force behind the price of gold, I believe the central bank will soon be back into the QE business, rather than raising interest rates and crushing the dollar price of gold.
Since Nixon closed the gold window in 1971, gold has made an impressive move upward from its fixed price of $32 an ounce, to where it sits now around $1,250. But few seem to grasp what actually causes gold to move higher. An increase in the gold prices occurs when the market becomes convinced that a currency will lose its purchasing power due to central bank-induced money supply growth and real interest rates that have been forced into negative territory. And nothing convinces a market more of a rising gold price than when debt and deficits explode.
But while the parabolic move higher in gold from 2009 to 2011 did contain a period of low nominal interest rates, real rates did not fall. And, the surging gold price was not accompanied by a growing money supply either. In fact, the growth rate of M3 plummeted during 2009 thru 2010—it wasn’t until 2011 that the money supply rebounded. So what would explain the steady move in gold from $800 to $1,900 per ounce during that time period? The gold price simply got ahead of itself because the market feared that out of control deficits would force the Federal Reserve into an unending cycle of debt monetization, which would engender a protracted period of negative real interest rates, booming money supply growth and inflation.
However, those fears were temporarily ameliorated by the reduction of Federal Budget deficits starting in 2011. This is because the Fed was, ironically, able to temporarily re-engineer asset bubbles, while sending borrowing costs lower, causing revenues to increase and expenditures to decrease. Annual deficits fell from $1.3 trillion in 2011, to $500 billion today. Adding to the gold market’s recent woes is the specious belief held by U.S. dollar bulls that the Fed will be aggressively raising interest rates while the rest of the world is cutting rates. This is the explanation to why gold and gold mining shares have suffered mightily during the past three years.
Today, the equity and bond markets have positioned themselves for the best outcomes of all possible scenarios. These markets are assured that the Fed can painlessly exit QE in October and real interest rates will rise with no ill effects on the economy. The pervasive belief being that US bonds, stocks and dollars will be the sole beacons of economic hope in an otherwise slumping worldwide economy; and, having complete faith that budget deficits will continue to shrink.
I don’t buy any of it, and here are the reasons:
Last week we learned that mortgage applications plunged to a 14 year low. This is because home prices are still so unaffordable that just a slight tick higher in interest rates is enough to stall both potential home buyers and borrowers looking to refinance their loans. This confirms that after six years of unprecedented Fed manipulation of markets, our economy has become hypersensitive to the slightest interest rate blip. It also supports my contention that the rise in rates which occurred during the second half of 2013, was much more influential on the first quarter’s negative 2.1 percent GDP print than what can be attributed to snow. Our economy is not anywhere near strong enough to sustain growth during a rising interest rate environment. And is why the Fed won’t venture very far into this game.
Furthermore, economies in Europe and Japan are in recession, while the once mighty emerging market economies are flailing. As their respective Central Banks frantically print money, the US dollar is soaring due to the belief that the US economy will remain unscathed from a global economic slowdown. But, the belief that the U.S. economy will stand alone on a pristine island, while Europe and Japan sinks into the sea, is just as preposterous and unprofitable as the belief held back in 2008 that economies around the world would remain untouched by the U.S. housing meltdown.
The markets also seemed to shrug off last week’s disappointing jobs report as an anomaly. Perhaps a colder-than-normal August is a good scapegoat. But this week, Janet Yellen gave us an interesting glimpse into the Fed’s view of the jobs picture with her “Labor Market Dash Board”. It showed that only three out of nine metrics regarding the labor market are better than they were prior to the start of the Great Recession. Investors should think again if they believe the Yellen Fed will be aggressively raising rates and boosting the value of the dollar given the labor market’s already-fragile condition.
Most importantly, the tide of shrinking budget deficits is about to turn. For instance, since 2011, we have seen a significant reduction in defense spending (down 5.5% during 2014 alone), due to the drawdown of troops in Iraq and Afghanistan. And although we have yet to learn the full costs associated with Obama’s plan to destroy ISIS--we can safely assume it will be very expensive.
Adding to this, is the drastically underestimated cost of Obamacare. Insurance risk pools failed to get the proper demographic mix, and the Cadillac tax--delayed until 2018--has companies scheming to redesign existing plans in order to avoid these taxes. Add to this the unexpected costs of illegals flooding the border, demographics moving far out of favor, and an increase in interest rates that will drive up debt service costs, and you can see why deficits will rise. But nothing adds to the deficit like a recession. Our asset-bubble addicted economy faces another reduction in GDP growth very shortly. This factor alone will send deficits north of $1 trillion in short order.
Faced with a worldwide economic slump, central banks remain the only game in town. And today’s central banks, determined to smooth out every hiccup in the economy, only have one answer--print money. When all you have is a printing press, every problem looks like a monetary crisis.
The Fed will not be raising rates anytime soon. To the contrary, Ms. Yellen will soon be forced back into the money printing business in an attempt to; force higher money supply growth, push real interest rates further into negative territory, keep the dollar from rising, and to make sure debt service payments remain under control.
Therefore, very soon we will once again have a perfect storm in which gold will rise. The next phase in the gold bull market will include all four conditions that existed in the massive bull run that started in 2009; negative real interest rates, rapid money supply growth, a falling dollar and skyrocketing deficits. Investors that have the foresight to realize this opportunity today stand to benefit greatly in the near future.
The deafening cacophony on Wall Street for the past six years has been since interest rates are at zero percent that there is no place else to put your money except stocks. For most, it just doesn’t matter that the ratio of Total Market Cap to GDP is 125 percent, which is 15 percent points higher than in 2007 and the highest at any time outside of the tech bubble at the turn of the century. Sovereign bond yields are at record lows across the globe and the strategy for most investors is to ignore anemic economic growth rates and just continue to plow more money into the market simply because, “there’s no place else to put your money.”
But the epicenter for this market’s upcoming earthquake will be in the FX market. The US dollar has soared since May due to the overwhelming consensus that while the Fed will be out of the QE business in October and raising rates in 2015, Japan and the Eurozone are headed in the exact opposite direction. The BOJ is already going full throttle with QE and the ECB announced last week that its own asset back security purchase program would begin in October. The Greenback is already up over 5 percent on the DXY in the past four months and a continued increase in the dollar’s values will start to significantly impair the reported earnings on US based multinational corporations. This deflationary force is one reason why stock prices could correct very soon.
But what is even more likely to occur is a sharp and massive reversal of the dollar’s fortunes. As stated before, nearly everyone on Wall Street is convinced the Fed will be hiking rates next year. And now that the BOJ and ECB have committed to go all-in on QE, how much more can they really do to cause their currencies to depreciate further? With the Ten-year notes in Germany and Japan yielding just .93 and .50 percent respectively, can these central banks really make the case that borrowing costs are still too high to support GDP growth?
If robust U.S. GDP growth does not materialize this year as anticipated, just as it has failed to do each year since the Great Recession ended, the dollar will come under pressure. In fact, real GDP growth has not grown north of 2.5% since 2006. With the Fed ending its massive bond purchases and the rest of the developed world flirting with recession, it’s hard to make a case why this year’s growth rate would be the exception—U.S. GDP growth for the first six months of this year is running at just 1 percent.
If the market perceives that Fed won’t be able to hike rates next year and may be forced back into the QE business due to a stalling U.S. economy, a reversal in the yen carry trade will occur. Financial institutions have been borrowing yen at near zero percent and investing into our bond and stock markets. Since yields are higher in the U.S. and the direction of the yen was virtually guaranteed to be headed lower due to the continued intervention from the BOJ, the trade has been a double-win. However, if the dollar reverses course it will cause a stampede of dollar sellers out through a small and narrowing door to sell overvalued stocks and bonds in order to purchase back a rising yen.
Massive currency volatility is just one of the incredibly-destructive effects resulting from this unprecedented manipulation of interest rates on the part of global central bankers. The unwinding of the yen carry trade is one factor that could bury the notion that stock prices can’t fall while the Fed is at the zero bound range.
Of course, the selloff in stocks would merely be a tremor that forebodes a much greater earthquake—one that would be devastating for both stocks and bonds. The real quake I’m speaking of is the inevitable synchronized collapse of global sovereign debt prices.
This is because the free market works a lot like plate tectonics. Continental drift causes friction in the earth's lithosphere. The slippage of these plates causes the earth to quake and is really nature’s way of relieving pent-up pressures. Smaller earthquakes tend to preclude larger ones from occurring by gradually relieving that stress. Likewise, recessions and depressions relieve the imbalances of debt and asset bubbles that build up in the economy. Trying to prevent minor earthquakes and recessions from occurring can only lead to a complete catastrophe.
Central banks tried to avert a healing recession in 2008 by completely commandeering the global sovereign debt market. And now, yields in Europe, Japan, and the United States have never been lower in history. Record-low sovereign bond yields should be the result of plummeting debt to GDP ratios and central bank balance sheets that have shrunk down significantly to ensure inflation will be quiescent.
However, the exact opposite is the case. For example, U.S. National debt has increased by $8.6 trillion since 2008 and the debt to GDP ratio has increased from 64 percent, to 105 percent during that same time frame. In addition, the Fed’s balance sheet has jumped from $800 billion to $4.4 trillion in those same years. Therefore, the credit quality has vastly decreased while the danger of inflation has dramatically increased due to the growth in the monetary base. Unless the economy is flirting with a deflationary depression, interest rates would be much higher than they are today.
Central bankers should eventually achieve success in creating inflation above the 2 percent target. But these money printers can’t pick an arbitrary inflation goal and stick the landing perfectly. It is likely that inflation will overshoot the stated goals. The difficult choice would then be to either allow inflation to run out of control or force bond sales. This means central banks would swing from being a huge buyer of sovereign debt, to selling massive quantities of bonds. In this scenario interest rates would not only mean revert very quickly but most likely eclipse that level by a large degree.
In the case of Japan, the 10-year note averaged 3 percent from 1984 until 2014. A spike in yields from .50 percent to over, 3.0 percent would cause interest expenses on sovereign debt to explode to the point where the economy would be devastated. Much the same scenario holds true for the Eurozone and the United States.
In contrast, if these central banks are unsuccessful in creating growth and inflation, then the resulting economic malaise will cause bond investors to lose faith in the government’s ability to ensure debt service payments don’t outstrip the tax bases of these countries. This is exactly what occurred in Europe during the recent debt crisis of 2010-2012. Once a market becomes convinced that a nation can’t pay back its debt in real terms the value of that debt plummets.
Ultimately, this is the real crisis that awaits us on the other side of this massive and unprecedented distortion in global bond yields. And is why this equity market rally will end sadly in a massive quake that will make 2008 seem like a mild tremor.
Unless you have been living under a rock for the past month, you have more than likely heard of the ALS Ice bucket challenge. But, just in case you have been living under that rock--the challenge dares nominated participants to be filmed having a bucket of ice water poured on their heads and challenging others to do the same. The stipulation is that the nominated people have 24 hours to comply, or forfeit by way of a charitable donation to ALS. It is an ingenious marketing campaign that has thankfully raised awareness and millions of dollars for ALS.
However, we all know that while many made a monetary contribution, others just dumped a bucket of water on their head under the guise of helping the cause, simply because everyone else was doing it. In social media circles, this is known a slactivism. A pejorative term that describes "feel-good" measures, in support of an issue or social cause, that have little or no practical effect other than to make the person doing it take satisfaction from the feeling they have made things better.
And in a similar, but far more dangerous fashion, the Fed is engaging in its own form of "slactonomics". It forces new dollars into the economy in order to stoke inflation, with the hope that rising asset prices will give the illusion of a booming economy. Therefore, the Fed's specific Ice bucket challenge is: Put your cash in stocks, bonds and real estate assets; or watch your money earn no interest while it loses its purchasing power against those same assets. And, just like the herd mentality of humans causes us to dump ice water on our heads, the lemmings in the market are loading up on stocks despite the fact that equity valuations have become far removed from the underlying anemic fundamentals of the economy.
But here is the catch--the Fed thinks it can escape its huge marketing campaign that involved years of market manipulation with impunity. But, it has made an egregious miscalculation.
Wall Street has completely bought into the fantasy that the Fed can end its $3.5 trillion dollar QE programs and also normalize interest rates after having them near zero percent for over six years without hurting GDP growth or having a negative effect on equity market prices.
However, one of the unintended consequences from normalizing interest rates is the effect on the U.S. dollar. The dollar is already rapidly rising as the Fed winds down QE3; just imagine how high it would rise if interest rates were to rise here in America.
Beginning in early 2009, asset prices in the U.S. increased in tandem with that of the developed world, as most global central banks depreciated the intrinsic value of their currencies in concert. However, we now see the dollar rise and asset prices in the U.S. begin to fall (S&P Case-Shiller Home Price Index now down two months in a row) as the Fed winds down its latest $1.7 trillion dollar QE program and sets the table for a lift off from a zero percent Fed Funds rate in the first half of 2015. In fact, the dollar index has already increased from 79 in May, to over 82.6, which is a 52 week high.
The real estate market is starting to factor in the end of QE and the rise of the dollar, but equity prices seem to be still in a state of denial. The Fed's Ice bucket challenge seems to have frozen investors' brains into believing the exit from QE will be a smooth one for equities and the FX market.
While it is true that a strong and stable currency is the cornerstone of a healthy economy, it is also true that the journey from a massively manipulated currency to one that is subject to free-market forces is never a smooth ride. The Fed cannot tighten monetary policy unilaterally without causing massive disruptions in currency valuations.
The BOJ continues to monetize 7 Trillion yen per month of Japanese assets and the ECB is expected to begin its own substantial QE program very soon. If the U.S. attempts to raise rates while the developed world is printing money to keep rates low, the dollar will skyrocket against our major trading partners.
A surging dollar will crush commodity, real estate and equity prices, as it causes the reporting earnings of U.S. based multi-national corporations to plunge.
This is just one example of the volatile and disruptive ramifications associated with the normalization of interest rates; many of which appear to be out of the Fed's risk calculations. In a very short time from now asset prices should undergo a sharp correction in an amount north of 20 percent because of the end of QE and the tremendous volatility in the U.S. dollar.
But, the Fed's number one fear is deflation. Ms. Yellen and Co. will do everything in their power to make sure inflationary expectations are permanently anchored into the U.S. economy.
Therefore, the Keynesian mind-warped Fed will interpret the surging dollar and plunging stock prices as a catastrophic threat of deflation-even though the rebalancing of capital and asset prices are the only viable solutions to our economy. And is why, in the final analysis, the Fed will not venture very far into its tightening cycle-if it even attempts a serious effort to raise rates at all.
Investors should then use this upcoming correction in asset prices and cyclical period of deflation to position their portfolios in hedged positions that profit from an inexorable increase in the rate of inflation.
Market pundits appear to be mostly dumbfounded as global bond yields continue to set record lows. For some examples; the 10 year German bund fell below 1%., the Italian 10 year note has dropped below 2.60%, Spanish bonds fell to 2.40 % and Japan is offering a shocking one half of one percent to borrow funds for ten years. Even Greece, whose bonds were on ECB life support just two years ago, has a 10 year note yielding below 6%. Worldwide bond yields are at all-time lows, leaving market commentators scrambling to come up with a creative array of explanations for this phenomenon. Tensions in Ukraine and escalating violence in the Middle East are some favorites. But at least in Europe and Japan, most are willing to attribute record-low bond yields to the real cause…that is no growth and deflation.
Curiously, here in the United States--despite bonds yields heading towards 52 weeks lows around 2.31%--those perpetually-bullish market strategists are extremely optimistic about growth in the second half. Just as they have been each year since the Great Recession ended in 2009.
Few commentators in the U.S. are willing to admit the truth that plunging bond yields are signaling the same thing here that they are in the rest of the globe, which is the inability of massive central bank money printing to engender real growth. These pundits have a myriad of other excuses to explain our low borrowing costs. But my favorite red herring is to completely lay the cause for our plunging yields on the low yields that exist in Europe and Japan. They claim it is the yield spread alone that is causing a monetary deluge into U.S. debt.
It is true the benchmark U.S. yield has been running more than 1.30 percentage points above the yield on 10-year German Bunds since the beginning of July. This premium is the biggest since June 1999, which was before the euro was introduced. Leaving many to summarily conclude that our yields must fall commensurately to that of Japan and Europe; despite their contention that the U.S. growth and inflation rates will be drastically different than that of those same countries.
But falling yields in the US are not solely due to an arbitrage between Treasuries and European/Japanese debt. To the contrary, it is because the fundamentals of low growth and cyclical deflation are the same in both countries. If the U.S. had differing fundamentals, like rapidly-rising inflation, then the yield spread would be rising instead of narrowing. That’s because foreign investors would need to be compensated for the increasing differential in real interest rates (much lower in the U.S. than in Europe). Therefore, this condition of falling real rates in the U.S. would cause the Euro to rise vis-à-vis the dollar and erode all incentives to own Treasuries near the same yield as European debt.
The truth is, the investors who make up the bond market are smarter than most who comment on it. They understand, bond prices are a result of Credit, Currency and Inflation risks. Since the credit risks of Europe and the U.S. are fairly commensurate, we have to assume a worldwide decline in yield reflects the market’s perception of inflation risk, or lack thereof. This is because the U.S. is ending its biggest QE program to date ($1.7 trillion worth of Fed asset purchases), which will bring about a short-lived respite from the inflation experienced over the last few years.
In 2011, I said the world was heading into a new paradigm – central banks around the globe were walking their economies on a very thin tight rope between inflation and deflation. Onerous debt levels had reached the point where the central banks would be forced into a difficult decision; either massively monetize the nation’s debt or allow a deflationary depression to wipe out the economy.
In this environment, governments are compelled to seek a condition of perpetual inflation in order to maintain the illusion of prosperity and solvency. However, once the central bank shuts off the money spigot, deflation then returns with a vengeance. As a result of winding down the massive money printing from the Fed, we are now seeing the very early signs of deflation. Yet, the usual talking heads are too busy cheering from the sideline to watch the game. And they see every deflationary signal the market is throwing them as another reason to get their pompoms out.
Falling commodity prices (down 8% on the CRB Index since June) are great for consumers and businesses in the long term. A period of deflation would be greatly welcomed in the long term, inasmuch as it represents a needed healing process from the Fed-induced inflation. However, it is not conducive to rapid growth in the short run because this deflation will be the result of collapsing asset bubbles.
The facts are that Japanese GDP is falling sharply, European growth is nil, and U.S. GDP for the first half of 2014 is under 1%. For those who love to continually applaud every central bank intervention, the failure of our Fed to produce sustainable growth seems not to be an option. So every data point is spun to support the narrative of an economic recovery. Unwilling to admit the Fed’s massive monetary experiment may fail, they sit in perpetual denial about our true economic condition and spin an elaborate web of excuses.
What they fail to realize is that QE never created viable growth, it just inflated asset prices. Likewise, the winding down of QE will not manifest growth, it will just temporarily deflate those bubbles that represent the greatest distortion of asset prices in the history of global economics.
We heard the "surprising" news last week that the Japanese economy shrank at an alarming 6.8 percent annualized rate in the three months through June, its biggest quarterly contraction since the 2011 earth quake and tsunami. Proving Japan’s greatest national disaster, Abenomics, has failed and the Japanese economy has fallen victim to the scam called Keynesian economics. Defined as the belief that a country can tax, spend, devalue and inflate its way to prosperity.
Since the popping of the BOJ- induced bubble in 1989, Japan has been the most faithful adherent of Keynesian principals. At the onset of the crisis they immediately began on their misguided path with large doses of deficit spending. Instead of allowing the economy to rid itself of bad investments and heal, they continued to prop-up failed business models--creating Zombie banks and an equally Zombie-like economy.
As one lost decade turned into two, in the year 2000, they coupled their fruitless spending efforts with massive amounts of money printing. And despite two decades of low growth, the nation stubbornly held on to the popular Keynesian excuse of “if only”…If only our stimulus was larger, if only we weakened our currency more, if only we kept interest rates lower for longer; economic nirvana would be achieved. Keynesians love to use this counterfactual argument because they believe it cannot be proven wrong--that is until now!
In 2012, Prime Minister Shinzo Abe had a master plan to pull the world's third-biggest economy out of its stagnation. His plan was to deploy, in massive and unprecedented fashion, the strategies of central bank credit creation, currency destruction and debt accumulation. The Japanese doubled down on the great Keynesian experiment, as if Paul Krugman himself was running the economy, they placed the economy on Keynesian steroids. Now, we are beginning to see what an economy looks like when the Keynesian playbook is utilized to its fullest extent.
With a first half economic contraction in the books, many economists are now warning that Japan is poised for yet another recession. Back In June, I warned the reported 6.1 percent GDP growth in Q1 will prove to be temporary because businesses frontloaded capital spending in a move to avoid April’s well-anticipated and substantial increase in the consumption tax from 5% to 8%. And because of the asinine belief that growth comes from inflation, Japan’s lethargic economy--whose inactivity had previously been blamed on falling prices--slowed dramatically right after prices went up. Household consumption plummeted at an annualized pace of 19.2 percent from the previous quarter, while private investment sank 9.7 percent. And because of the Japanese battle against deflation, real wages dropped 3.8% year on year in May. Those mismanaging the Japanese economy believe consumption will surge if they can achieve a substantial increase in the CPI. The misguided logic being the Japanese consumer will only spend if they are running in perpetual fear of rising prices.
One of the cornerstones of Abenomics was destroying your currency with the hopes of boosting exports. Ironically, last week the central bank warned over a worsening export and factory output picture. In fact, June showed the worst trade deficit ever in Japan, and a 57 percent rise in the trade deficit for the first half of the year.
And today with a near 250% debt to GDP ratio, it’s difficult to argue Japan didn’t engage in enough deficit spending. Over the past three years, interest rates on the JGB 10-year note went from 1.5% to .52%. Under its own brand of quantitative easing policy put in place last April, the BOJ now buys 70 percent of all new government bonds issued in markets, as well as other more risky assets. With the JGB market on virtual life support courtesy of the BOJ, it is impossible to argue rates aren’t low enough or that the BOJ hasn’t monetized enough. They spent, they printed, they taxed; but the Japanese economy is out of gas, and the Keynesians who own this plan are now out of excuses.
The truth is Japan is a perfect example to the counterfactual argument that anemic U.S. growth is the result of a Keynesian plan that was launched half-heartedly.
The United States should heed Japan’s economic woes as a warning sign, and a reason to change course while we still have a chance. With U.S. debt to GDP at 105 percent and household debt at over 80 percent, the aggregate amount of our nation’s debt is at an all-time high. But unlike Japan we have the overwhelming privilege and responsibility of holding the world’s reserve currency.
Obliging other nations to trade and hold U.S. dollars is not written anywhere in the bible. These nations have, for the time being, decided to maintain a holding that is equal to 50 percent of our publicly traded Treasury debt. Losing their confidence in our credit and currency would be devastating to our economy. Japan has no such worries about keeping foreign investors happy because they finance 90 percent of their debt internally.
We have become a country that habitually over-consumes and under-produces. Debt levels have skyrocketed while our demographic and labor force participation conditions are quickly approaching critical mass.
We have to abandon these failed Keynesian policies while there is still time. We must boost our employment to population ratio, deregulate the economy, simplify the tax code, balance the budget, cut expenditures, end the Fed’s runaway printing press and allow the free market to set interest rates and asset prices. Only by doing this do we stand a chance of not falling further into Japan’s stagflationary nightmare. But if we persist in following the Keynesian counterfactual, our fate will be worse than that of Japan, as the deluge of debt being dumped by our foreign creditors causes the dollar to be dethroned, interest rates to soar and inflation to skyrocket.
In the middle of July the stock market finally awoke from its QE-induced coma and realized the Federal Reserve's tapering, which has been going on for the last six months, was for real. Like a child, who becomes accustomed to a parent that threatens punishment but never follows through, the market had been in denial to the Feds withdrawal of monetary stimulus. But now, thankfully, the ending of Fed asset purchases will be the pin that pops this QE-inflated market and economy. But please do not confuse the end of QE with the Fed actually fighting inflation and selling trillions of dollars' worth in Treasuries and mortgage backed securities (MBS)…because that will never happen.
The Fed has increased its balance sheet by an unprecedented $3.5t since 2008. They accomplished this by purchasing Treasuries and MBS from banks in exchange for Fed credit. A credit from the Federal Reserve is a nuanced way of saying "new money". This new money is transferred as a credit to the banks with the idea that the Fed can and will reverse this transaction at its discretion. Like an army releases reserves, the Fed (with the help of private banks) has marched many of these new dollars into the economy to "save us" from deflation. Once the job is done, the Fed intends to call these dollars back and shrink its balance sheet back to pre-crisis levels. This all sounds great in theory, but as we will soon see, the practical applications of shrinking the Fed's massive Balance Sheet has become impossible without creating a monetary depression.
For the past few years, the central bank's credit and inflation has been predominantly deployed in bonds, real estate and equity assets. However, recently this new money has leaked into the government's manipulated CPI calculation. Therefore, our government can no longer promulgate the lie that inflation is some elusive goal that it cannot achieve. And, the argument that stronger economic growth is around the corner in a context of low inflation has been fully debunked. That is why the market sold off last week. In a word, it is inflation. The Employment Cost Index (ECI) component in the GDP data put the Keynesians on "high wage inflation alert".
But, most will be blindsided by the temporary period of deflation that will result from the end of the Fed's massive asset purchases, as the monetary spigot for the primary beneficiary of the Fed's credit--namely stocks and bonds-gets turned off.
Similar to the housing market in the mid-2000's, we are about to relearn the lesson that many equity investors (especially those on margin) can only afford to hold on to an asset when prices are rising.
However, on the other end of this cyclical period of deflation, lies a period of inflation that will make the '70s seem like an era of hard money. The reason for this is in order to fight inflation the Fed will have to bring home trillions of those "money troops" it sent into the economy. Calling the money back is going to be far more difficult than it was deploying it.
When the Fed buys Treasury debt, most of the interest payments made go back into the government's coffers. In fact, by law the Treasury has claim to all income derived from the Federal Reserve; less expenses. So the Treasury pays the Federal Reserve an interest payment and in return receives most of that payment back. This is a pretty good deal for the Treasury, considering the Fed's profit is in the neighborhood of $91 billion a year. This means the Treasury not only didn't have to find a real buyer for the newly issued debt but it also did not have to worry about paying interest on that debt.
But, it gets even better--as the bonds mature, the Fed has been rolling over the principal. Therefore, it is as if the $2.4 trillion of newly issued Treasury bonds sold to the Fed since 2008 don't even exist. The Treasury gets reimbursed on its interest payments and never even had to worry about what the cost would be for the private market to purchase that debt. To further sweeten the pot, the Fed has pushed rates down to unprecedented lows, leading to relatively-modest debt service payments on all of its record-breaking $17.6 trillion of outstanding debt.
However, if the Fed wants to genuinely fight inflation, it will have to eventually raise interest rates. Ending QE will only provide temporary relief from a weakening currency. To accomplish this in sustainable fashion it will have to shrink its balance sheet back to around the same level it was prior to the Great Recession.
How does the Fed shrink its Balance Sheet? As we discussed, when the Fed purchases a bond from a bank it creates a credit that can be taken back at the Fed's discretion. Taking the credits back on a short-term basis is called a reverse repo-the Fed sells the assets back to the banking system and takes back the cash for a very limited period of time.
But, it just cannot conduct reverse repos to the tune of trillions of dollars without putting extreme pressure on the market for private short-term loans. This means the government is not only going to have to permanently sell the over $2 trillion in bonds into the market, it will have to start paying real interest on that debt as well. And, the private market will also have to finance all the new annual deficits, which will no longer have the luxury of a trillion dollar plus annual QE program from our central bank.
The net effect of all this would be surging interest rates and a complete economic collapse. This is why I do not expect the Fed's balance sheet to significantly contract for many years, if at all. And predict inflation will become a huge and growing problem--especially after the central bank launches another massive QE program in 2015 to re-inflate falling stock prices.
Our government is in a horrific trap because of the record amount of debt it has issued and allowed the central bank to monetize. This is why every time the Fed tries to fight asset bubbles and bring inflation under control it will result in the creation of a monetary depression. And is also why nearly every central bank on the planet has decided the only real long-term objective is to fight against deflation and ensure inflation will always prevail.
The stock market has advanced sharply over the past five years no matter what geopolitical situation has blown up or how tenuous the economic foundation may be. This is because Investors have simply been forced to throw money at the market with a reckless disregard of logic due to the lack of interest provided through the holding of cash.
But if one looks objectively and the true market fundamentals, it is clear to see that the stock market has blown into yet another bubble, except its total magnitude has been masked by the central bank's engineering of corporate earnings growth.
Unfortunately, the sobering truth is stock values are highly extended at this time. And, it is silly to ask the question if these values are justified because of strong earnings growth or because of the Fed's easy money policies--because you can't separate corporate profitability from the record-low interest rate environment provided by the Fed.
The Price to Earnings ratio of the S&P 500 as of this writing is at 19.5. That is about 4 points above historic levels. But, inflated PE's are only part of the story. For most companies in the SP 500, top-line revenue growth has been anemic since the Great Recession ended in 2009. Earnings growth (expected to be 5.4%) is coming primarily from corporate engineering facilitated by the Fed's zero interest rate policy.
There has been so much talk about corporations' pristine balance sheets. But, the truth is non-financial corporate debt is up $3.5 trillion since 2009. Businesses have refinanced much of their $13.8 trillion in outstanding debt at vastly reduced levels, which lowers debt service payments and improves EPS. Nearly 90% of this new debt was used to buy back stock and increase dividends. Less shares outstanding, reduces the denominator of the Earnings per share (EPS) calculation-also boosting EPS and making the PE ratio seem less out of balance.
Likewise, households have also been provided relief on their $13.2 trillion of outstanding debt-boosting their ability to consume more of what businesses sell. And, the Fed's war against savings has been paramount in pulling along this consumption-driven economy, which also has helped artificially inflate corporate earnings.
Most importantly, the zero interest rate monetary policy of the central bank has forced money into stock and real estate assets, which has further supported consumer and business balance sheets. This has greatly abetted our consumption-driven economy and vastly increased corporate profitability.
Therefore, it is absurd to ask the question whether it is earnings growth that has justified the increase in equity prices; or the Federal Reserve. This is because the Fed has been the predominate factor behind earnings growth…you just cannot separate the Fed from equation.
But, just as the Perma-bulls convinced themselves in 2007 that a banking system on the verge of collapse was a great buying opportunity, they are again convinced that the lofty level of equities is justified by a sound business sector today. They ardently refuse to let facts get in the way of their great bull story.
However, the truth is corporate earnings will plummet once the Fed ends QE and/or interest rates rise. And the equity bubble will end badly for the third time in last 14 years. The scariest part is that each equity market crash has been worse than the last. The one right around the corner will be no exception. In fact, if past history is any guide, the mere ending of the Fed's asset purchase program will be enough to send equity prices crashing back to earth. Therefore, gullible investors will very soon realize once again that the latest bull story, which is built upon phony fundamentals, was just that...a load of bull.
Baseball great Yogi Berra had a saying "It's déjà vu all over again", and every year around this time, I am reminded of those words. As we have once again, happened upon that magical time of year I call, recovery summer déjà vu. It's the time of year when Wall Street and Washington apologists trot out their dog and pony narrative, in an attempt to spin the actual data, proving we have finally embarked on the summer that will launch sustainable economic growth.
And this year is no exception, as those same people appear to be downright giddy by the prospect that we finally have something to feel optimistic about. For instance, they are euphoric about the most recent jobs report, some suggesting that there is absolutely nothing to find fault with. Of course, they fail to mention anemic wage growth, the lower quality and part-time jobs created; or the discouraged workers who have left the work force.
Yes, they will admit that they were stunned when GDP contracted in the first quarter, but that was a mere weather-related incident. It was the blizzard of Q1 2014 that left GDP buried under 2.9% inches of negative growth. In truth, a more accurate reason for the economic slump was the move in the 10 year note from 2.48% on October 23rd, to 3.03% on December 31st of 2013. And the move over 3% was the peak of the cyclical advance from the low of 1.63% on May 2nd. The doubling of interest rates, although still to a historically low level, was enough to send this debt-laden asset-bubble driven economy into the freezer. But why allow facts get in the way of a good weather story. So once again we hear cheers for another summer recovery.
The truth is, since 2010 every second half recovery has disappointed and this one will be no exception. The first quarter of 2014 gave us 2.9% negative growth. I am in agreement with most economists that the 2nd quarter will come in somewhere around 3%, resulting in an economic flat line for the first half of 2014. This puts enormous pressure on the second half of year to bring us out of stagnation that has led to the most anemic recovery since WW II. Let's review; after GDP shrank in both 2008 & 2009, growth returned in 2010 by 2.5%, in 2011 it fell back to 1.8%, it then went up slightly in 2012 to 2.8%, but then down again in 2013 to 1.9%. The inability to obtain growth above 3% in each year since the economy collapsed during 2008-2009 underscores this tremendous economic failure to bounce back after the Great Recession.
So why do they think this year will be different? After all, if you subscribe to the Keynesian fairytale of money printing and deficit spending, it was easy to see why they were excited back in the summer of 2010. The economic spigots were over flowing with a treasure trove of demand stimulus and monetary elixirs.
In the summer of 2010 sanguinity was in the air…Time magazine's 2009 man of the year Ben Bernanke was poised to save the day, ready to do whatever it took to get this economy growing again. Today, despite lack luster growth, the Fed is retreating. Essentially conceding-at least for now--printing money didn't solve the problem; QE is set to wind down in just 90 days.
But for a Keynesian it gets worse. Instead of an Obama phone, we have the roll-out of the job-killing Obama-care plan this year and next. In addition, profligate tax-payer subsidized loans that funded the likes of Solyndra, have been supplanted by a capital goods strike. "Shovel ready" has been replaced with anemic real income growth and record debt levels.
Putting the Keynesian fantasy aside, the truth is there isn't much ahead that will stimulate real growth. The middle class, which was already saturated in debt, has not been the beneficiaries of the Federal Reserve's money printing. Instead, those dollars have been funneled into the creation of new asset bubbles and have led to an increase in food and energy prices-like it always has in the past. Stagnant wages are being stretched further to pay for the necessities of living. We still don't have the regulation and tax reform that catapulted the Regan revolution. Companies that have cash flow would rather make stock purchases to increase their Earnings per Share than invest in property, people, plant and equipment. And, unless the economy is headed back into a severe recession, the economic boost from a lower cost of money will be absent.
The truth is there is not much at all on the economic horizon to warrant optimism. Yes, the cheerleaders are hoping if they yell loud enough, a recovery-summer will finally manifest. Unfortunately, until free-market forces are finally allowed to deleverage the system, it will be a disappointing second half recovery--all over again.
According to Pimco’s new Chief Economist, Paul McCulley, the Fed’s war against inflation has been won! But, before we get out our party hats and plan the tickertape parade, we have to ask ourselves – for the past 27 years have we really been at war with inflation? Yes, during the late 1970’s and early 80’s a different Paul (Paul Volcker, Chairman of the Federal Reserve) waged a real battle against inflation. Mr. Volcker painfully took the Fed Funds rate to near 20 percent in June of 1981. The economy suffered a deep recession, it was a treacherous battle plan, but the Fed stayed the course because Volcker was correctly convinced that limiting the growth rate of the money supply was the key to popping asset bubbles, vanquishing inflation and establishing a sound economy.
Fast forward six years, exit Paul Volker, and enter Alan Greenspan. For the back drop, it was the crash of 1987….and after declaring “mission accomplished” on the inflation war, Greenspan sought to fight a new war against falling stock prices. Acting as the veritable Navy Seal of financial market defense, Greenspan valiantly leapt to shield markets from corrections. This “special operation”, was affectionately referred to as the “Greenspan put”. Over the years the “put” has remained, we have merely substituted Greenspan with Bernanke and now Yellen. And so for the past 27 years, the only “war” the Federal Reserve has been waging has been to inflate asset bubbles. These bubbles bring the economy to the brink of financial destruction, leading the central bank to intensify its efforts to fight deflation with each iteration.
McCulley goes on to say "For the last 15 years inflation has been incredibly absent…We've had our cyclical ups and downs but when you look at it on a chart, I think we've achieved the promised land of price stability over many cycles."
I have to assume that McCulley is affectionately gazing at the government-manipulated chart of CPI, where despite all the bureaucratic finessing of these figures, we still can find year over year inflation reaching more than 5 percent during that 15 year period. But a 15 year chart of the NASDAQ and Home Price Indexes tells a more interesting story. Perhaps McCulley dismisses the NASDAQ and Real Estate bubbles under the cover of seemingly innocuous “cyclical ups and downs”; mere speed bumps on the way to the “Promised Land”.
McCulley also states that he and Bill Gross strongly support an increase in the minimum wage, giving celebration I’m sure to all the minimum wage bond traders in New Port Beach, CA. I find it ironic those who espouse the belief that inflation doesn’t exist would argue for increasing the minimum wage. After all, why should incomes have to rise in the face of price stability?
Most importantly, Keynesians, like McCulley and Chairpersons of the Federal Reserve, believe inflation is caused by rising wages. They contend that without rising wages inflation cannot become a problem.
Let me explain something to McCulley and his fellow adherents to this Phillips Curve myth. Inflation is caused by a persistent and pervasive fall in the purchasing power of a currency. The market becomes convinced of substantial currency dilution and the value of paper money falls.
The fact that nearly every other central bank on the planet has followed in the footsteps of our Fed has masked much of the currency destruction against our trading partners. But the value of the dollar has fallen against most assets precisely because of massive money printing and artificially-low interest rates provided by the Fed.
Rapid money supply growth can and often does occur while real wages are falling because commodity and import prices respond first to the drop in the currency’s value, while median nominal wages merely lag in a futile attempt to keep pace with the falling purchasing power of the currency.
History is replete with examples of this fact, and the latest proof that inflation can become a problem without wage growth in the vanguard comes from Japan. The Japanese Yen has lost 30% of its value since 2011 vs. its major trading partners. That’s bad news for an economy that needs to import 80% of its food and energy needs. At the same time, consumer inflation is up 3.7% YOY. In fact, Japan is experiencing the highest inflation rate in 32 years. However, real incomes are down 4.6% YOY and have been falling for 23 months in row. This is just another example of how nominal wages lag inflation when a central bank pursues policies that promote currency destruction.
But the real problem is that these Keynesian misconceptions are not only held by McCulley and, his boss Bill Gross, they are also held by Janet Yellen and her cronies at the Federal Reserve. And by continuing to focus on wage growth instead of the growth rate in the money supply, the Fed has put itself in the position where it will be perpetually behind the inflation curve and delayed in pricking the asset bubbles it is fighting so hard to recreate.
The simple truth is you can’t win a war you don’t fight. How can the Fed have conquered inflation if the only battle it has fought since 1987 is against deflation? Both Volcker and Keynesians cannot be correct. Inflation cannot be defeated by taking interest rates to 20 percent; and also through the process of keeping rates at zero percent for 6 years and counting. Inflation also cannot be declared dead by creating an additional $3.5 trillion of bank credit over the past few years.
Unlike the prosperity induced by Volcker’s deflationary utopia, we now have the dystopia of massive economic imbalances created by central bankers that have completely replaced market forces in the determinations of interest rate and price levels. And it is central bankers’ complete incomprehension regarding the healing forces associated with deflation that will cause the next collapse to be exponentially worse than the financial crisis of 2008. Inflation has not been defeated at all, but rather it is any hope of deflation and economic stability that has been wiped out.
Pimco is putting all their chips on the table, betting that low interest rates, along with lower and more stable global growth, will last for the next 3 to 5 years; an economic condition it is referring to as the “new neutral”.
In fact, the company is so convinced of this “sure thing”, it’s placing a straight bet--selling insurance against price fluctuations on their $230bn flagship bond fund Pimco Total Return. That means it is offering investors price stability in the bond portfolio, in return for a premium.
Instead of just simply investing clients’ money in a normal bond strategy, it is upping the ante by applying a derivatives trading scheme. To this fact, Mr. Gross asserts that Pimco is one of the biggest sellers of insurance against market volatility.
Selling volatility typically involves selling options, which would pay out if a particular market moved by more than a pre-agreed amount. For example, the Volatility index, also known as the VIX, is based on the price of a combination of options on the S&P 500. The more investors are willing to pay to protect themselves, the higher the index goes. The index is said to measure fear in the market place.
Sellers of these types of security derivatives have profited lately from the lack of volatility in the market. This has allowed Pimco to sit back and collect premiums, without having to pay out on market volatility.
Sound familiar? That’s because back in the early 2000’s, insurer AIG placed a similar seemingly riskless bet. They offered banks a way to get around the Basel rules, via insurance contracts, known as credit default swaps. They insured sub-prime securities for a premium. At the time, I’m sure it seemed like easy money--after all, the historical loss rates on American mortgages was close to nothing. They employed extremely bright people who created incredibly sophisticated computer models and assured them that this bet was a sure thing. They wagered big on what appeared to be a lock. And for a period of time, they too sat back and collected premiums without having to pay out.
Needless to say, AIG’s bad bet ended with an enormous bail out from the Federal Reserve.
But, Pimco is wagering on more than lack of market volatility. Doubling down on its new neutral bet, Pimco is borrowing on the short end to invest in longer end bonds. If rates were to take a sudden spike up, it would be paying more on the short end loans than received in interest payments from their bonds--and would be forced to unwind that trade.
And further pressing its bet, making this a potential trifecta of financial disasters, you have to remember that Pimco is a huge player in the bond fund space, with over $1.9 trillion in assets under management. Pimco’s Bill Gross has decided to go large--betting that it will win, place and show. If his horse fails to come in and interest rates go up, the price of Pimco’s bond funds will fall. Investors, who have already been walking away for a consecutive 14 months straight, will then run to the exit doors, forcing Pimco to sell bonds to meet redemptions, driving interest rates up further. This rise in rates will increase volatility, obliging Pimco to pay out on its VOL insurance and place the company under further duress.
This could be a disaster for both Pimco and the financial markets as a whole. And is reminiscent of the Long-Term Capital Management debacle. LTCM used a combination of leverage and complex mathematical models to take advantage of fixed income arbitrage deals. In 1998, when the market was in turmoil, investors panicked and fled the riskier markets for ones with a higher degree of certainty. LTCM, which also bet on the belief that fat tail events were illusory, found that despite their “supposedly” diversified portfolio, they had basically placed the same bet on low volatility. Like AIG, they too required a bail out.
Pimco is pressing its bet on the belief of a new neutral that low interest rates and low volatility will prevail for the next 3-5 years. If correct, the company will produce a modest return for their clients; but if it is wrong and we get a sudden shock in rates, Pimco’s clients will feel compelled to unwind the multi-trillion dollar bond portfolio creating havoc in financial markets, which will put the entire financial system and country in grave danger.
This is just one example of the consequences resulting from addicting the economy to ZIRP for six years. The fact is that a record amount of debt, inflation-driven central bankers and interest rates that have been artificially suppressed at historically-low levels cannot coexist. It is an incendiary cocktail that will soon explode in the faces of our government central planners.
Therefore, we face the daunting collapse of all types of fixed income and high-yielding debt. As a result of this inevitability, the real estate market will tumble as flippers are once again forced to dump their investment properties. The equity bubble will burst when the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer and business loans will come under duress. Banks’ capital will be greatly eroded as their assets go underwater, just as the rates on deposits are increasing. The Fed will become insolvent as its meager capital quickly vanishes. Interest payments on the national debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives—which Pimco now plays a big part in--will go bust.
But you don’t have to get caught on the wrong side of Pimco’s bad bet. A savvy investor can turn this into their market opportunity by betting that Wall Street and Washington’s fantasy of a normal economic recovery is about to collapse into a nightmare.
I've written exhaustively about the real purpose behind the Fed's quantitative easing strategy. So one more time for those who still don't get it; the primary goal of QE is to bolster banks' balance sheets through the process of re-inflating equity and real estate prices. If investors look back at the history of QE they will be able to clearly see what happens when the Fed steps on the monetary gas; and also what occurs once it takes the foot off the pedal.
For example, even though interest rates were already near zero percent, the Fed felt it necessary to begin purchasing massive amounts of bank assets in late 2008 to get the money supply and stock prices moving in the positive direction. The Fed announced a $500 billion Mortgage Backed Security purchase program (QE1) on November 25th 2008. The central bank then followed up on March 18th 2009 with a $300 billion plan to buy long-term Treasury bonds. The total amount of $800 billion in planned QE did exactly what was intended-the U.S. markets, not so coincidentally, ended their massive decline and then started a huge secular advance in March of that same year.
Most investors now agree that massive QE can be extremely positive for asset prices. But most on Wall Street either are not aware, or refuse to acknowledge, what occurs when the central bank stops printing. Therefore, a brief history lesson seems especially prudent at this juncture.
QE1 ended on March 31st 2010. The market soon after headed south, and just over three months later the S&P 500 dropped by 12.6%. The second round of QE ($600 billion) ended on June 30th 2011. This time, stocks began to decline within days after the last bond was purchased, and after three months went by investors experienced a correction of 16.7%. In both instances, a subsequent new round of QE came to the rescue of stock prices, just about when the depth of the correction extended into the double-digit range.
Now that the Fed's QE3 is officially ending, asset prices have lost most of their momentum. The Dow Jones Industrial Average is only up just over 2 percent and most other major averages are either flat to up low single digits so far this year. This is true even though we are over half-way through 2014; and compares to the 30 percent gains experienced last year.
It is important to note that QEs 1 and 2 ended abruptly, whereas QE3 is only being slowly wound down. Therefore, the mere announcement of the Fed's taper back in January of this year did not cause a similar market reaction to that of the other QE terminations. Also, the correction from QE2's end was more profound than that of the first, because equity values become more disconnected from economic fundamentals with each round of intervention.
So investors need to ask why the stock market would be immune from the Fed getting out of the QE business this time around. The truth is that asset bubbles have become more inflated and debt levels have greatly expanded during each iteration of QE. Given this progression, the end of QE3 should bring the major averages down somewhere in the neighborhood of at least 20 percent about three months after QE3 ends in the fall.
However, before the Fed launches yet another QE rescue program like it did after QEs 1&2 failed to generate solid growth, it would have to admit that the previous five years and $3.5 trillion worth of QE have been a complete failure; and that the U.S. economy is addicted to continuous central bank credit expansion. This might not come to fruition as quickly as most on Wall Street now believe it will, and could exacerbate the percentage of the selloff.
Up until now, the perennially-weak economic growth experienced since the Great Recession ended just didn't seem to matter for the stock market. The reason for this was that interest rates were falling from a benign level that already offered little competition for equities. And, the central bank had an overwhelming desire to increase the size of its balance and launch another round of QE at the first sign of falling asset prices.
Contrast that with the situation today. The Fed has become distressed over the amount of bonds it already currently holds and wants completely out of the QE business. In addition, interest rates have ended their decline and must increase along with the rising rate of inflation and the end of Fed bond market manipulation-unless of course rates fail to rise because of a deflationary collapse of the economy.
The overwhelming consensus on Wall Street is that the economy will illustrate vastly improving economic growth during the second half of 2014, in the context of low inflation and quiescent interest rates. And the pervasive belief is also that the end of QE will not have the negative effect on stock prices that it did after the last two rounds ended. Given that this scenario is already fully priced into markets, investors would be wise to maintain a very defensive posture during the next few months.
More than twenty years after its infamous real estate and equity bubble burst, Japan has been plagued by economic malaise, an ailment most main stream economists have attributed to something they call a deflationary death spiral. As one lost decade turned into two, and now well into number three, Japan’s Prime Minister Shinzo Abe has vowed to remedy this deflationary flu with an enormous dose of inflation.
In Japan, they affectionately refer to this elixir as Abenomics. In English, this remedy roughly translates to an enormous injection of public spending, more than a spoonful of currency destruction, chased down with a large dose of a consumption tax.
And, if deflation had actually been what had ailed the Japanese economy – it would appear that after more than two decades, they finally found their cure. The price of food is soaring at the fastest pace in 23 years and core consumer prices jumped 3.2 percent YOY in April.
Unfortunately, those Japanese who were only sick of the stagnant economy, are starting to wonder if “Dr. Abe” misdiagnosed the original disease. With an economy in perpetual stagnation, slightly falling to stable prices was the one salve. As anyone who lived through the 1970’s can avow, low growth can’t be assuaged by raising prices. And with wages excluding overtime and bonus payments falling in Japan for a 23rd straight month in April, Japan’s economy is falling victim to a new kind of outbreak--stagflation. Stagflation is an inflationary period accompanied by rising unemployment and lack of economic growth.
In fact, a favorite stagflation diagnostic indicator, termed the misery index, which adds the jobless rate (3.6 percent) to overall inflation (3.4 percent), climbed in April to 7--a 33-year high. Rising prices helped push Japan’s misery index to the highest level in decades, while wages adjusted for inflation fell the most in more than four years. If inflation continues at this clip, it won’t be long before Abe is forced to forego his Abenomic tonic in favor of a bottle of a Japanese version of WIN (Whip Inflation Now) buttons.
The economy is seen contracting an annualized 4.3 percent in the three months through June, following 6.7 percent growth in the first quarter—the surge in Q1 will prove to be temporary because businesses frontloaded capital spending in a move to avoid April’s well-anticipated and substantial increase in the consumption tax.
And, as Japan falls sick with the stagflation flu, it’s only a matter of time before we see this pandemic spread to Europe, just as it has already infected America. The Japanese prescription for deflation contains the same active ingredients of tax hikes, government spending and money printing that has caused the U.S. economy to begin to resemble that of the 1970’s. Indeed, consumer prices across the developed world have already stopped the healthy decline experienced after the real estate bubble burst in 2007, and since have broadly headed higher.
U.S. consumer price inflation is exceeding the 2 percent Fed target as of May; after falling throughout most of 2009. That should have been enough for Ms. Yellen and co. to abruptly end QE and begin to normalize interest rates. However, since growth targets have remained elusive—and will continue to disappoint until central banks stop looking to boost GDP through money printing—the Fed stubbornly clings to its easy monetary policies.
It seems that no matter how overwhelming the evidence is to the contrary, governments cling to the belief that growth comes from inflation. Perhaps the truth is that governments’ primary agenda is not to produce growth, but rather to find any excuse to create the massive amount of inflation needed to bail out the insolvent condition of their nations by reducing the value of that debt. Therefore, it is sad to say it’s time for Japan, along with Europe and the U.S., to say sayonara to the mollifying condition of deflation and konnichiwa to the dreaded situation of stagflation.
The size of central banks’ balance sheets around the globe have massively expanded into record territory in recent years. This should have caused a commensurate increase in the gold price across multiple currencies. Adding to the upward pressure on the yellow metal is the estimate from China’s chief auditor that the nation used $15.2 billion worth of phony gold ownership to vastly increase access to credit. Chinese security authorities are also probing alleged fraud involving other metals such as copper and aluminum stockpiles, which have been pledged multiple times in order to expand collateral for loans. This factor has aided the Chinese economy to increase debt 25 fold since the year 2000.
Debt levels have exploded across the world alongside the proclivity of central banks to create record amounts of credit. In addition, real interest rates are profoundly negative and persistent inflation has now become the stated goal from most governments. Most importantly, recently-achieved inflation targets set by the Fed are being completely ignored by Janet Yellen. And finally, the manipulation of prices and fraudulent use of supplies have created a tremendous tailwind for gold values. For these reasons, PPS has recently increased its allocation to gold mining shares in its Inflation/Deflation Dynamic Portfolio.
The Fed wants investors to be as unconcerned as the central bank is about inflation. Even though year over year consumer price inflation is above its target, the Fed chose in its latest press conference to claim the 2.1 percent YOY increase in prices paid merely represented “noisy” readings in the inflation gauge. However, the truth is that rising prices are a direct result of years’ worth of zero percent interest rates and $3.5 trillion in money printing provided courtesy of both Banana Ben Bernanke and the Counterfeiting Queen, Janet Yellen.
It makes no difference to Ms. Yellen that price increases in the major inflation categories are rising above the Fed’s target. For example: Food at Home is up 2.5 percent; Energy went up 3.3 percent; Shelter rising at 2.9 percent; Medical Care Services up 3.0 percent and Transportation Services climbing 3.1 percent. But somehow the widely dispersed increases in year over year inflation, which are already far above the Fed’s target, are being summarily dismissed as “noise” by our central bank. In the spirit of today’s central bankers, inflation is seen not only as a dear friend; but one that they never seem able to recognize face to face.
The Queen Counterfeiter also stated in her press conference that equity prices seem to fairly valued from the Fed’s viewpoint. Perhaps she is also unaware that the ratio of total market capitalization to GDP is currently 122 percent. That figure is the second highest in recorded history—1999 being the only exception—and is 70 percentage points higher than the average from the time Nixon broke the gold window in 1971, all the way through 1990! In fact, this key ratio is a full 10 percentage points higher than it was at the previous peak before the start of the Great Recession in 2007. As a reminder; stock prices proceeded to lose more than half their value from the summer of 2007 thru March of 2009.
The bottom line here is that central banks around the world have fallen into a passionate love affair with inflation and asset bubbles. That is because these fiat-currency apologist believe inflation is commensurate with economic growth; and that the solvency of sovereign debt can only be achieved through massive money printing and negative real interest rates from here to eternity.
But the joke will be on these market manipulators and legalized counterfeiters in just a very short amount of time. Doubling down on the failed strategies of debt, inflation, currency destruction, regulations, taxes and artificially-low interest rates will soon explode in their faces once again—but only to a much great extent this time around.
The most humorous part of all this is Wall St. and Washington have duped most investors into believing the fairy tale that our central bank can end a multi-trillion dollar bond buying program and six years of ZIRP without experiencing any ill effects. And, at the same time they are telling us that economic growth will be accelerating, while the cost of money and the rate of inflation do not increase. I can assure you that there is virtually a zero percent chance of that happening. Therefore, I'm unfortunately completely convinced our government's fantasy will end in a catastrophe for markets and the economy.
Governments are not engaged in a systemic conspiracy to alter economic data after it has been collected. To get a multitude of individuals agreeing on how to fudge information would be far too difficult to control. Instead, it is much easier for a small group of government officials to simply change the formula for calculating the data points that they desire to manipulate to make the information seem more palatable.
For example, since the world completely abandoned the gold standard back in 1971, governments have repeatedly tinkered with the CPI formula in order to convince the public that prices are vastly more stable than they are in reality. And now, since the developed world is suffering from anemic growth rates due to a massive debt overhang, governments have turned their attention to changing the way GDP is calculated.
Starting this year, the government of Italy will add the mafia's "contribution" of goods and services to its GDP. In fact, illicit activities like smuggling, prostitution and narcotics will now factor into the growth calculations of the U.K. as well. Analysts expect this accounting change to boost Italy's GDP a couple of percentage points each year. And another study found that America's underground economy was worth about $2 trillion annually. That's more than 10 percent of our legitimate GDP. Therefore, you can bet that the U.S. isn't far behind in adopting Europe's new GDP formula.
The U.S. already performed a little hocus pocus on the GDP numbers back in July of last year. The government made a significant change to the gross investment number, which now includes; research and development spending, art, music, film and book royalties and other forms of entertainment as the equivalent of tangible goods production.
GDP numbers have been chronically subpar in the U.S. since the Great Recession supposedly ended. Growth increased just 1.9% for all of 2013 and posted a negative 1% during Q1 of this year. And much the same can be said to describe the GDP data over in Europe as well, as they also have endured subpar and/or negative growth. As further evidence of the deteriorating growth condition, on June 10th the World Bank lowered its global growth forecast and cut U.S. growth to just 2.1% for 2014, from the previous estimate of 2.8%.
Therefore, our government leaders have sought to tinker with the formula more and more until they can produce the desired result they want to portray. Look for official government data on both a nominal and real GDP basis to become even more overstated in the future. Logically speaking, investors can also count on metrics such as debt and deficits as a percentage of the economy to appear much more benign than reality would otherwise present.
However, governments cannot so easily alter the most important metric in relation to the health of a sovereign nation. While it is easy for politicians to embellish the stated level of economic activity and growth, they are unable to increase the revenue to the government without actually extracting and redistributing private wealth through taxation. This means that the revenue available to service national debt will remain unaffected, no matter what formula the government comes up with to calculate GDP. The consequences of this will be devastating as an unprepared public is lulled to sleep with rosy debt metrics; but gets crushed when the bond bubble bursts due to insufficient revenue that is falling sharply in relation to interest payments on government debt.
Officials can triple count illegal activity if they so desire. But since it is illegal, by definition no additional revenue can be directly derived from it-especially from an arbitrary level of illicit activity made up by the government.
The sad truth is that economic growth will continue to disappoint and should worsen throughout the year, after perhaps a marginal bounce in Q2. One of the main reasons why there will be no sustained economic recovery is because the stimulus derived from the massive decline of interest rates has already accrued to the economy.
For example, corporations have been able to generate increasing profits, and individuals were able to reduce debt service expenses through the continuous refinancing of debt. To further illustrate this point, mortgage application are down 17% year over year. This is because the pipeline of people who have the ability to refinance their mortgage or that can qualify to purchase a home has already been vastly drawn down. With the refinancing and first-time buyers' market pipeline mainly exhausted, the housing market's support to the economy is fading. Now that interest rates have leveled off at rock bottom, after falling sharply for over 30 years, the tremendous tailwinds of ever-reducing borrowing costs have abated.
As the economic fundamentals continue to deteriorate, look for official government data reports on inflation and growth to become more imaginative and creative. But here's a brief reality check for investors:
Another sad reality is that we used to live in a world in where asset prices were determined by the unfettered competition of markets. Today, markets have been obliterated by a handful of central bankers competing to provide the lowest interest rate and the greatest amount of monetary manipulation.
But in the end free markets always prevail and the eventual adjustment from the current fantasy world created by central banks and governments will be extremely violent and destructive. The chances are high that the adjustment will begin within the next two months, as the Fed's asset purchases will be nearly halved by the end of July QE. And will end completely a few months after. It is during that timeframe that I believe the gravitational forces associated with the free market reconciliation of asset bubbles begins to take effect.
It seems that nearly everyone is confounded by the record low bond yields that are prevalent across the globe today. If investors can correctly pinpoint the real reason behind these low sovereign debt yields, they will also be able to find a great parking place for their investment capital to weather the upcoming storm.
Wall Street cheerleaders are explaining that yields in the world's largest economy are falling for strictly "technical reasons." Specifically, they claim that there is a lack of supply of U.S. debt to purchase because deficits have come down so dramatically in past few years. But when you look at the data, you'll find this cannot be correct.
As a point of reference, the 10-Year Note in the United States is now at 2.5 percent, and yields on sovereign debt across the entire globe are likewise at, or very near, all-time record lows. This is true even if when looking back centuries.
In order to destroy the misinformation that there is a lack of supply of Treasuries, I gathered data during the four years when the U.S. actually had an annual budget surplus. The years were 1998 - 2001; and here are the deficit numbers as a percentage of GDP: 1998, positive 0.7 percent; 1999, positive 1.2 percent; 2000, positive 2.2 percent; 2001, positive 1.2 percent.
Those were the surpluses as a share of the economy during the late 1990s and early 2000s. In addition, the national debt back then ranged between $5.4 trillion in 1998, and increased to $5.9 trillion by 2001. And yet, given that we actually had budget surpluses and much lower levels of nominal debt and debt as a percentage of the economy, the U.S. 10-Year was trading from a range of 5.51 percent in 1998, to 5.03 percent by the end of 2001.
U.S. Note yields during the surplus years were more than twice as high as the yields seen today. Therefore, the misinformation being told to the American public that yields are at record lows due to a lack of supply issuance is preposterous. Indeed, sovereign debt levels amongst the developed worlds are at record levels; and yet, bond prices keep rising.
Today we have $17.5 trillion in debt, and the fiscal 2014 deficit is projected to be a negative 3 percent of GDP. And that nominal deficit number is estimated to be $500 billion. The 2014 deficit is being touted as an example of sound fiscal policy; but it should also be noted that the half-trillion deficit for this fiscal year is higher than any other budget deficit in American history outside of the Great Recession era-even when adjusted for inflation.
When people in the financial media try to tell the investment public that yields are down because there is no supply of debt, they should understand that the exact opposite is true. We have a $17.5 trillion national debt-a 250% increase in just over a decade--and a significant portion of that is short-term debt, which has to be rolled over every few weeks. The deficit is extremely large in nominal terms and double the level it was before the economy collapsed in 2008. Also, the amount of Treasury issuance is far greater today than it was 15 years ago.
We currently have falling growth rates in Japan, Europe, China, and posted a minus 1 percent annualized GDP print for Q1 here in the United States. These low yields are predicting that even beyond the slow growth that is evident right now, the risks are extremely high that the global economy will undergo a meltdown similar to what was experienced six years ago. The skyrocketing late payments on Chinese bank loans could be the catalyst that sets this chain reaction into motion.
The only legitimate reason why bond U.S. bond yields would be falling even as the Fed is getting out of the bond-buying business is that we are facing a contraction in global growth. It is not because of "technical reasons", "geopolitical concerns" or, especially not because "there are no bonds to buy."
And you can also throw away the argument that European bond yields are currently at or below those in the U.S.; therefore, global investors are simply doing a yield arbitrage. This reasoning really only serves to underscore the reality of declining economic growth throughout the developed world; and fails to explain how the U.S. economy can function with impunity from a globalized funk.
Unless Mario Draghi is about to make the ECB launch a QE program that would make the Fed blush, there is only one reason why the bond bubble has gone into hyper drive.
The truth is that the world is awash in sovereign debt. And the credit, currency and inflation risks associated with owning that debt has never be more elevated. Therefore, the only reason why yields are at historic lows is because they are predicting the chances of a meltdown in the global economy is extremely elevated at this time.
The Bureau of Economic Analysis (BEA) recently reported that Q1 GDP was only 0.1% in the United States. Most of that anemic number was blamed on worse-than-usual weather. But it should be noted that if our government accurately accounted for inflation, it would be clear to all that economic growth didn't just stall at the start of 2014; but rather it contracted sharply. And if our economy can be thrown into a tailspin by a few snow storms, it is an economy that simply has not recovered from the Great Recession--which supposedly ended five years ago.
Nominal GDP (Real GDP plus inflation) was reported by the government as 1.4% last quarter. This means that inflation in Q1 was estimated by the BEA to be running at a 1.3% annualized rate. However, according the Bureau of Labor Statistics, energy prices were up 3.3% year-over-year. Food prices as measured by the protein category (meat, poultry, fish, and eggs) were up 6.4% year-over-year. And Health care costs were up 9.9% in the past year--that's the largest increase in health care expenditures in 30 years. Home prices were also up 13% in the past year.
The plain truth is that the cost of living has risen significantly in the past year for anyone accustomed to eating proteins, or anyone seeking to be healthy, or people that use energy, and/or those individuals needing to provide shelter. If those components were correctly weighted in the BEA's inflation index, Q1 real GDP would have been negative. Therefore, taking a more realistic inflation measure off the Nominal GDP print, you can clearly see that the U.S. economy isn't just stuck in neutral, but is shrinking significantly right now. The real figure would most likely close to the minus 2.7% annualized rate it contracted at the start of the Credit Crisis in December of 2007.
The reason why we are in a further period of contraction is that the government never allowed the economy to heal. A period of asset price, money supply and debt deflation is needed to rebalance the economy from the excesses experienced during the last two decades. Instead, the Fed chose to use quantitative easing to re-inflate real estate and stock prices, which also encouraged the public and private sectors to take on debt to a greater extent. This has served to further weaken the American middle class; just as it also increased our wealth gap.
The tapering by the Fed is now halfway done. So we are going to start a new paradigm, which is really a resumption of the old paradigm. Namely, the healing process that began in 2007--the contraction of money supply growth, restructuring of debt and a collapse of asset bubbles.
The Fed will be effectively done with its tapering in the fall. This will once again lead to a healthy period of deflation and recession. Nevertheless, after it dawns of Ms. Yellen that the economy is addicted to QE, she will reverse course and launch another quantitative easing program.
This is because the shocking aspect of the Fed's strategy is that it doesn't grasp how ineffective the QE program is in providing viable and sustainable growth. Yes, massive money printing can send erstwhile falling asset prices higher and also boost the net worth of the wealthy. But it also destroys the purchasing power of the middle and lower classes. And an economy cannot function properly when wealth is unbalanced and concentrated at the very top. QE also prevents the economy from deleveraging, which is a necessary step to promote viable savings and investment. And by not allowing asset prices to fall to a level that can be supported by the free market, more capital is funneled toward the building and servicing of asset bubble, instead of increasing productivity.
As proof of how badly the economy in the United States is struggling, look at the retail sales numbers that were recently released. The following companies that cater to the middle class reported vastly disappointing revenue and earnings: Target, Home Depot, Walmart, Lowe's, Dick's Sporting Goods, PetSmart, Urban Outfitters, Staples, and Sears. And that's just a partial list. This weakness has continued into May, so it has little to do with the weather.
One of the few retailers that beat expectations was Tiffany's. They actually raised their profit forecast on stronger than expected earnings. This best exemplifies how and why the middle class is being destroyed and why this economy cannot grow. You cannot grow an economy in aggregate if you do not have a healthy middle class.
The U.S. economy will never get healthy until we actually address the imbalances that afflict the middle class. This also means the Fed would have to embrace deflation-at least for a little while. But I have sincere doubts about whether the Fed, or any other developed world central bank, will ever allow that to happen.
Each year since the recession officially ended in the summer of 2009, Wall Street and Washington have tried to dupe investors into believing a second half recovery was in store for the stock market and economy. However, this promise has failed to come into fruition each year, as annual GDP growth has not reached north of trend growth (3%) since 2005. But, with the hope that investors have a perennial case of amnesia, these cheerleaders are yet again trumpeting the illusion that economic growth is about to surge.
The year 2014 didn't start off so good for those who desperately want investors to be convinced the economy has healed from the Great Recession. After posting annual GDP growth of just 1.9% for all of 2013, which was much lower than the 2.8% growth experienced during 2012, this year started off with annualized GDP growth of only 0.1% for Q1. This means GDP growth for Q2 has to be near 5% just to produce the same 2.5% growth pace experienced back in 2010.
But the recent Retail Sales report for April showed an increase of just 0.1% from the prior month--so much for a strong rebound from the winter's weather--and not good news for those that need investors to believe in the fantasy of robust growth in order to keep them supporting stock prices at these levels.
The sad truth is that this year's GDP growth won't produce results any better than those years following the credit crisis. The reason being, our leaders don't understand where growth comes from and/or are unwilling to take the painful steps necessary to achieve it.
Unfortunately, most of those that inhabit D.C. are economic illiterates; and Wall Street enables Washington with alacrity in order to keep the party going. They fail to realize that U.S. GDP growth is stuck in neutral because an economy needs low and stable tax and interest rates; and benign inflation to generate productivity and strong growth. This is the only foundation from which sustainable and healthy growth can be built. And those conditions are virtually impossible to maintain when the U.S. economy is currently carrying a debt level equal to 330% of GDP-the exact level it was at the precipice of the Great Recession.
In order for an economy to grow it needs savings and investment to enhance productivity. The savings rate in the U.S. was well into the double digits before the abolition of the gold standard in 1971. It has now cratered down to 3.8%, which is 1.3 percentage points away from an all-time low and very close to the same level it was leading up to the credit crisis.
Indeed, many conditions are eerily reminiscent to those that led up to the collapse of the economy in 2008. Spreads between corporate bonds and Treasuries are razor thin once again and yield starved investors, backed by a Put from global central banks, are even willing to own a 10-year Greek bond that now yields just 6%. This is despite the fact that the Greek 10-year yielded near 40% just two years ago; and after the nation subjected owners of these bonds to over a 50% reduction in the principal. But history and fundamentals don't matter when investors are convinced, now more than ever, that money printers around the world stand ready to guarantee that asset prices won't be allowed to fall-at least not very far.
Of course, one thing-the really important thing-is much worse now than it was at the start of the Great Recession. Debt levels have exploded across the globe. For examples; Chinese government, corporate and household debt is now about 250% of GDP, up from around 145% in 2008; and U.S. debt has soared by $7 trillion since the Great Recession began. But what else would you expect to occur when governments have the hubris to believe they can repeal recessions by endlessly borrowing massive amounts of money from their central banks.
An economy just can't become more productive when the savings and investment dynamic is broken. And the way it breaks is when investors become aware that; tax levels must significantly increase to help service debt, interest rates face extreme upward pressure because inflation risks have soared, and when investors also understand that the currency's purchasing power will destroyed in an attempt to lower the value of the nation's debt. Under this unfriendly economic environment, investment in capital goods dries up and productivity rates fall. This is why productivity during Q1 of this year fell at a 1.7% annual rate.
Those are the genuine reasons why robust growth has been a phantom for the last six years. And the economy will continue to disappoint until governments allow a healthy deleveraging to take place in both the public and private sectors. Asset prices need to fall, bad debts need to be restructured, and central banks need to allow the market to set interest rates.
Until then, we will struggle with huge volatility in tax and regulatory policies, interest rate levels and currency valuations. This is also the main reason why April's labor force participation rate for Americans between the ages 25 to 29 hit the lowest level since 1982, when the Bureau of Labor Statistics started tracking such data. Old people can't afford to retire and young people are dropping out of productive society-that's the sorry truth behind the decline in the labor force.
However, another phantom recovery this year will be especially troubling for U.S. equities. Stock prices didn't care so much that GDP was anemic when the Fed was expanding credit at a trillion dollar annual pace. But, in just a few months the Fed's QE program will hopefully be finished. And asset prices may finally start to undergo a painfully-necessary correction.
For instance, perhaps by allowing free markets forces to work, first-time home buyers may once again be able to afford a new house, rather than being constantly outbid by hedge funds. Case in point, a study was recently done by real estate researcher Trulia that showed only 25% of homes for sale in the New York area are affordable to middle class buyers. Shockingly enough, the recent response from government to this second bubble in real estate in the last six years is to force Fannie Mae and Freddie Mac to further expand the amount of lending in the housing market! It seems all we have learned since the 2008 economic crisis is how to make the same mistakes as before, but to a much greater extent.
Nevertheless, investors need to take advantage of this brief moment of sanity from the Fed, because it should not last very long. The Fed's tapering of bond purchases should provide an excellent opportunity to acquire assets at a significant discount to the bubble-like valuations seen today. Unfortunately, the economy is now completely addicted to zero percent interest rates and the endless expansion of Fed credit. Once Ms. Yellen realizes the Fed's number one enemy (deflation) will be the result of ending QE, get ready for an inflation quest the likes of which America has never endured before.
It is imperative to understand the dynamics between the U.S. dollar and the Japanese Yen in order to grasp what is occurring across international markets. Investors have been borrowing Yen at nearly zero percent interest rates and buying higher-yielding assets located worldwide. These market savvy institutions and individuals realize that buying income producing assets, which are backed by a currency that is gaining value against the Yen, is a win-win trade.
Because of the policies embraced under the regime of Japanese Prime Minister Shinzo Abe, the Japanese economy was subjected to significant currency depreciation, government deficit spending and stagflation. When global investors unanimously become assured that the economic "recovery plan" of Japan would be based on massive debt accumulation and money printing, the yen received a death sentence.
It was on this basis that the Yen suffered a decline of 25% against the dollar, since Abenomics went into effect late last year. The most interesting part of this failing economic plan of the Prime Minister, is the relationship between the Dollar/Yen and the performance of the S&P 500. The U.S. dollar appreciated 30% against the Japanese Yen since the assumption to office for Shinzo Abe (in December of 2013), through the commencement of the Fed's tapering of asset purchases, in January of 2014. It is no coincidence that the S&P 500 also appreciated 30% during that exact same timeframe. You can see the high correlation between the Dollar/Yen and the S&P in the two-year chart shown below.
The relationship between the dollar/yen and the U.S. market is undeniably clear. But it is also important to point out the divergence that has taken place since the start of this year. The dollar is beginning to lose strength against the yen; and yet the S&P 500 has managed to post a very small gain. It is prudent to conclude, given the dynamics of the dollar/yen relationship, that the U.S. stock market is about suffer a correction. This is especially true given the likelihood of further yen strengthening in the short term.
There exists two powerful reasons why the yen should rise against the dollar in the short term.
Reuters reported last month that for the first time in 13 years there was absolutely no trading in Japanese Government Bonds (JGBs) for more than one day. The fact is that no JGBs traded for 36 hours and the volume in Japanese debt is down 70% YOY. The Bank of Japan, in cooperation with the Abe government, has so perverted the bond market that private interest to buy JGBs has fallen to practically zilch.
With virtually no private market for Japanese debt and inflation soaring to over a five-year high, the BOJ may not be incentivized to further depreciate its currency and push JGB yields even lower by increasing its 70 trillion yen per annum stimulus plan at this juncture. In a rare and brief moment of sanity, the government of Japan could try to restore some liquidity in its bond market by allowing yields to incrementally rise from the current 0.6% on the Ten-Year Note. After all, yields must rise to a level that begins to reflect the realities of a bankrupt nation with rising inflation, in order to attract some interest from an entity other than the BOJ.However, it is also true that the BOJ will eventually have to intervene in the JGB market to an even greater extent in order to keep debt service payments from spiraling out of control. But, in the short term, it is also likely that the Japanese government will not imminently expand its QE program, despite what all carry-trade investors are betting on. This is primarily because the central bank is reluctant to increase the pace of JGB ownership at this time.
The second reason why the dollar should lose ground against the yen in the short run is because the Fed may soon confound all carry-trade investors by getting back in the QE business.
The flat Q1 GDP print for the U.S. was summarily dismissed as a weather phenomenon. Nevertheless, when a "second-half recovery" once again fails for the 6th year in a row, stock market cheerleaders will have to find a different excuse for the perennially-weak economy. But the Fed may stop its tapering just around the time it gets down to near zero on new asset purchases-sometime before the end of this year. It then should actually increase its monthly allotment of QE shortly thereafter. If the Fed gets back in the money printing business it will shock investors-especially those who are trafficking in the yen carry trade.
As the yen carry trade begins to unravel, stock prices will fall across the globe. This will feed on itself, as investors are forced to buy back yen at increasingly unfavorable exchange rates.
The bottom line is that there should be a temporary reversal in the yen carry trade in the very near future. Once the myth of an economic recovery in the U.S. is rejected by most investors, the Fed will be unable to raise interest rates and will be pressured to get back into the QE business In addition, the BOJ will feel compelled to stem the pace of the drop in the yen, especially because its 2% inflation goal now appears to be in sight.
A respite from the yen carry trade will cause a global stock market meltdown in the short term and a sharp drop in the value of the dollar. It will also be the start the next major leg upwards in the secular bull market for precious metals.
David Tepper is the founder and manager of the multibillion dollar hedge fund Appaloosa Management. He is also well known for an appearance made in the financial media back in September of 2010. In that segment Tepper made the case to investors that stocks would go higher regardless of whether or not the then nascent economic recovery was for real.
During that TV segment, he outlined what would be called the Tepper Argument: the premise that the economy would recover, causing stock values to rise; or that the economic recovery would fail, causing the Fed to massively pump up stock prices by expanding its QE program. To learn how the Fed uses QE to boost the market read last week’s commentary.
Mr. Tepper deserves credit for recognizing, in the wake of the financial crises, that stock prices would go up no matter what economic condition prevailed--I also advised investors to go long equities in early 2009, after advising them to head into cash during the summer of 2008.
However, it is imperative for investors to realize that the exact reverse of the Tepper Argument is now in play when analyzing the market today.
The Tepper argument made a great deal of sense in the fall of 2010 for several reasons. First off, the Fed was an avowed money printer and openly proclaimed its ready and willingness to aggressively expand its balance sheet to combat deflation. At that time, the Fed held “only” $2.3 trillion worth of assets. But today, the Fed’s balance sheet has swelled to $4.3 trillion. The central bank has now become fearful about the amount, duration and quality of the assets it holds and superfluity of Fed credit held by financial institutions.
Secondly, the S&P 500 was trading at 1,109 when the Tepper argument was first made. Today, the benchmark index is at 1,878—a 70% increase! In fact, the S&P is up 180% since the March 2009 low. The market has gone from undervalued, to bubble territory in just a few years. For example, the Russell 2000 had a PE ratio of 34 last April. Today, the PE ratio has soared to over 100.
Most importantly, and in sharp contrast to several years past, the Fed is now committed to ending QE and the cessation of its balance sheet expansion. Whereas in 2010, Mr. Bernanke was committed to exorbitant money printing to obtain his inflation quest, the Yellen Fed has made it clear that it will primarily utilize Fed Funds rate targeting to meet GDP and inflation goals, instead of purchasing long-term Treasuries.
Therefore, investors now face an entirely new paradigm that is diametrically opposed to the original Tepper argument.
Scenario number one: Economic growth and inflation reach the Fed’s target levels and interest rates rise sharply on the long end of the yield curve to reflect the increase in nominal GDP. This will cause a selloff in the major averages, as the 10-Year Note jumps to 5% from its current level of 2.70%. Surging interest rates—the result of inflation and the end of QE rate suppression—will provide competition for stocks for the first time in seven years and a correction of around 10-20% occurs.
Scenario number two: The economy once again fails to make a meaningful recovery, and the overvalued market crumbles under the weight of anemic revenue and earnings growth that is woefully insufficient to support the current lofty PE ratios. Without the aid of massive money printing from the Fed, or a surge in GDP growth, a significant correction north of 20% is highly probably. Keep in mind revenue and earnings growth are less than half the historical average, and need to rapidly accelerate in order to justify the current level of the market.
For stocks prices to rise from this point, the economy must grow rapidly without causing interest rates to rise. This is a virtually impossible scenario, especially since the Fed is removing its bid for Treasuries. So, it’s either the economy doesn’t improve and stocks fall—because the Fed won’t reverse course and increase QE on a dime; or the economy improves and the interest rates spike spooks the market. Either way, the market goes down in the short term.
I believe a bear market will ensue from weakening economic growth combined with the attenuation of Fed asset purchases. Further proof of our structurally-anemic economy, came when the BEA released data on April 30th that showed the economy grew at an annual growth rate of just 0.1 percent during Q1.
Our central bank is now buying $45 billion per month of MBS and Treasuries. Down from $85 billion at the start of this year. That number will be near zero in just a few months. Real estate and stock prices have already stopped rising and economic growth has almost completely stalled since the start of 2014. The bear market in equities and stubbornly-high unemployment rates should bring the Fed back into the debt monetization business shortly after the market crashes. This significant selloff should prove to be a crucial buying opportunity in which investors need to be preparing now to take full advantage of.
So where does this leave investors? Here’s a brief synopsis.
If this is an environment in which investors want to jump into stocks, they can do so without me. Just as was the case in 2008, a little bit of patience should prove to be an incredibly smart decision, and it should also save investors from a lot of pain.
The government's "ingenious" solution to end the Great Recession was to recreate the same wealth effect that engendered the credit crisis to begin with: The definition of the wealth effect is an increase in spending that comes from an increase in the perception of wealth generated from equities and real estate.
Our Treasury and Federal Reserve figured the best way to accomplish this was to rescue the banking system by; taking interest rates to zero percent, buying banks' troubled assets, and recapitalizing the financial system. Most importantly, our government loaded banks with excess reserves. This process, known as quantitative easing (QE), pushed lower long-term interest rates through the buying of Treasury Notes, Bonds and Agency MBS.
It is imperative to understand the QE process in order to fully understand why the tapering of asset purchases will lead to a collapse in asset prices and a severe recession.
The QE scheme forces banks to sell much higher-yielding assets (Treasuries and MBS) to the Fed, and in return the banks receive something know as Fed Credit, which pays just one quarter of one percent. For example, the Five-year Note currently yields 1.75 percent and the Seven-year Note offers a yield of 2.30 percent. The Fed is currently buying $30 billion worth of such Treasuries per month and $25 billion of higher-yielding MBS.
In fact, the Fed has purchased a total of $3.5 trillion worth of MBS and Treasuries since 2009 in a direct attempt to boost equity and real estate prices. QE escalated in intensity as the years progressed. The year 2013 began with the Fed promising to purchase over a trillion dollars' worth of bank debt--without any indication of when the QE scheme would end…if ever.
Therefore, financial institutions did exactly what rational would dictate. These banks bought bonds, stocks and real estate assets with the Fed's credit because not only were the yields higher, but they also understood there would be a huge buyer behind them-one that was indifferent to price and had an unlimited balance sheet. Since these assets offered a yield that was much greater than the 25 basis points provided by the Fed and were nearly guaranteed to increase in price, it was nearly a riskless transaction for banks to make. This QE process also sent money supply growth rates back up towards 10% per annum, as opposed to the contractionary rates experienced in 2009 and 2010.
Of course, most on Wall Street fail to understand or refuse to acknowledge that ending QE will cause asset prices to undergo a necessary, but nevertheless healthy correction. However, looking at the evidence since the tapering of asset purchases began, it is clear that the Fed's wealth effect has ended.
The Fed announced in December of last year its plan to reduce asset purchases beginning in January of this year. Its base-case scenario would be to reduce QE by $10 billion per each Fed meeting. Since the start of this year, asset prices have stopped rising. According to the Case-Shiller National Home Price Index, home values have actually dropped 0.33% during the last 3 months of the survey. In addition, the Dow Jones Industrial Average and the NASDAQ have both dropped in price over the past four months. Only the S&P 500 has managed to eke out a very small gain so far this year-and one third of the year is over.
Real estate and equity values have already lost their momentum, as the Fed is removing its massive support for these assets. In a further sign of real estate weakness, the Commerce Department recently announced that New Home Sales fell three months in a row and plummeted 14.5 percent in March from the prior month's pace. But Wall Street will try to convince investors that the spring allergy season-also known as the pollen vortex--is unusually bad this year. Therefore, nobody wanted to go outside and purchase a new home, even after all the snow melted.
The bottom line is as the central bank stops buying assets from private banks, these institutions won't have the need or the incentive to replace them, and the direct result will be a contraction in the money supply.
But nearly every market strategist believes the Fed's taper will have an innocuous effect on markets. They believe this because of their conviction that new bank lending will supplant the money creation currently being done for the purpose of buying new assets. But what would cause banks to suddenly start lending to the public?
The government has overwhelmed banks with new regulations and announced on April 8th that it will force banks to add $68 billion to their capital, which will negatively affecting balance sheet growth. The public sector is still greatly in need of deleveraging because Household Debt to GDP ratio is still over 80%, opposed to the 40% it was in 1971. Real disposable income is not increasing, which has left the consumer with little ability to take on more debt. There just isn't any reason to believe that consumers will suddenly ramp-up their borrowing.
It wasn't any coincidence that the size of the Fed's balance sheet and the S&P 500 were both up 30% last year. But very soon the amount of QE will be close to, if not exactly at zero. And without banks supporting asset prices by consistently creating new money at the behest of the Fed, stocks and home prices have nowhere to go but down.
I anticipate the reduction of the wealth effect to intensify as the taper progresses. Since the economic "recovery" was predicated on the rebuilding of asset bubbles, a long delayed and brutal recession will start to unfold later this year.
The real question investors need to answer is to determine how long Janet Yellen will wait before admitting the economy is completely addicted to QE, and that there is no escape from the Fed's constant manipulation of money supply growth and asset prices.
Having raised significant funds ahead of this huge selloff in order to profit from the launch of the Fed's next massive round of debt monetization should prove to be one of the most important investment strategies of a lifetime. This is exactly the reason why Pento Portfolio Strategies has been in 75% cash since January.
There’s been a lot of attention being paid to high frequency trading (HFT) as of late. The question has been raised as to whether or not HFT rigs markets. It is true that HFT adds nothing to GDP and is simply a legalized form of high-tech front running. However, the real problem with the stock market—and the economy as a whole—isn’t the fact that HFT skims pennies off transactions from institutional traders; but rather that the Fed has rigged interest rates and asset prices to the extent that investors can no longer distinguish reality from fiction.
It is well known that the Fed has already purchased trillions of dollars’ worth of MBS and Treasuries since the start of the Great Recession. It also is no secret that the Fed Funds Rate has been pegged at zero percent since the end of 2008. Yet, somehow, this is not considered rigging the market. Nor do these conditions elicit the proper scrutiny of most investors. But instead, are nearly universally embraced as the perfunctory and necessary undertakings by a prudent central bank.
Market participants are ignoring the fact that the cost of money and the supply of credit and savings--the most important signals in an economy—should be set by the free market and not manipulated by the Fed. But investors are now taking their ignorance a step further. Since investors refuse to acknowledge the central bank’s unprecedented influence in monetary affairs, it then follows that they have also deluded themselves into believing the Fed has not been the primary driver behind stock market gains.
Wall Street is fond of claiming that earnings growth has been relatively healthy throughout this “recovery” from the Great Recession and that earnings are the “mother’s milk of stocks.” Earnings growth comes from consumer spending because consumption drives the U.S. economy. In fact, seventy percent of U.S. GDP is derived from consumption. Therefore, it is logical to conclude that this was the reason behind our government and central bank’s efforts to boost consumption following the credit crisis.
Forty nine percent of Americans receive transfer payments and yet only 47% of U.S. citizens pay Federal income taxes. The Fed has monetized $3.5 trillion worth of government obligations since 2008. It did this in order to allow the Federal government to run trillion dollar deficits for years on end without debt service payments spiraling out of control.
It is abundantly clear that the Fed rigged lower debt service costs for both consumers and the government in order to artificially boost consumption. In addition, keeping interest rates at record low levels directly re-inflated bond, real estate and equity market bubbles. This further boosted money supply growth and fueled greater consumption.
Since real wages have been falling, our government has sought to boost consumer spending by propping up asset prices and lowering interest expenses, rather than seeking a viable market-based economy.
Therefore, it is completely silly to believe our stock market is not rigged. It is. But much more so by the government than it is by the “Flash Boys”. The markets, and the economy as a whole, are rigged in favor of the wealthy and those involved with financial services, but against the middle class and those that embrace free markets.
To believe otherwise is to claim that interest rate levels have no relationship to; debt levels, money supply growth, asset prices, equity market values or economic activity. Only a fool would then maintain that the Fed has not rigged markets. And it has done so for the direct purpose of artificially boosting consumption, which has led to an increase in GDP and earnings growth. This has in turn created a synergistic effect and spurred stock prices to an even more unsustainable level following the initial boost received from the Federal Reserve.
Once the Fed stops buying banks’ assets (the very essence of QE) these institutions will have no need to replace them. Therefore, the money supply will shrink as asset prices tumble. It is then logical to conclude that the end of the Fed’s manipulation of interest rates and money supply will lead to a collapse of this phony consumption-driven economy, as it also takes the stock market along for the ride down.
The entire global economy now clings precariously to one crucial phenomenon. That is, how much longer can the central banks of the developed world artificially suppress interest rates at near zero percent?
The violently-negative market reaction to Janet Yellen's comments during her first press conference was a clear indication of how vulnerable the stock market is to the eventual reality of rising interest rates. All Ms. Yellen did was remind investors that the Fed Funds Rate would have to be moved up from zero percent—probably beginning in the middle of next year. That was enough to send the major averages cascading downward faster than you could say the words “flash trading.”
In typical fashion, a cacophony of Wall Street Cheerleaders were quick to dismiss the negative market reaction by claiming investors misunderstood what the new Chairperson meant to say; or that the rookie Fed Head simply misspoke. And, more importantly, these bubble-apologists also were quick to make the case that even once the Fed eventually gets around to raising interest rates, it will merely be a sign of economic health--a move that the equity market should fully embrace.
The reality is that rising interest rates will soon arrive, either courtesy of the Fed or through free market forces. And a rising cost of money never bodes well for the stock market or the economy. This fact will be especially true this time around because growth—or the lack thereof--won’t be the salient issue; but rather it will be the attempt to end the Fed’s massive manipulation of rates. The removal of the Fed’s all-encompassing and price-indifferent bid for Treasury debt will place tremendous upside pressure on rates. And even if interest rates do not increase, the outcome for investors will be equally devastating—I’ll explain the simple reason behind that in a minute.
But first let’s see if rising interest rates are really all that good for equities, as Wall Street so desperately wants investors to think.
The 10 Year Note is Spain was trading at the 4% level during October of 2010, while the benchmark IBEX 35 was trading at 10,900. Yields then surged to 7.7% by August of 2012. Not because the ECB raised interest rates, but because the free market deemed its sovereign debt to have come under significant duress. The IBEX tumbled 35% to 7,040 in less than two years.
It was much the same story In the United States. Interest rates went through a secular uptrend throughout the 70’s and into the early 80’s. This time it was an outbreak of inflation that caused yields to rise. In March of 1971 the Ten Year Treasury had a yield of 5.5%, while the S&P 500’s value was 100. By January 1982 the benchmark yield soared to 14.8% and the S&P 500 traded at just 115. During those 11 years the market increased by a total of only 15%, even though consumer price inflation skyrocketed 135%! This means in real terms investors in U.S. stocks lost over 50% of their purchasing power.
Staying in the U.S., rising rates in 1987 didn’t bode well for the market either. The Ten-Year Note started off in January at 7.01%, and jumped to 10.23% the month before the Dow crashed 22.6% on October 19th 1987.
It is true that there are brief periods when stocks rise at the onset of rising rates. However, the reasons why interest rates increase in a significant and protracted manner are because of rising inflation and/or burgeoning debt levels--and that is never healthy for equity values or economic growth.
What will happen to our debt-laden economy once interest rates normalize? Municipalities will come under great stress, as they try to manage soaring debt service payments from a tax base that is quickly eroding. Real estate flippers will be dumping their investment properties, as home prices begin to tumble once again. Equity market investors will sell shares, as the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer debt will come under duress, severely hampering discretionary consumption. Banks’ capital will be greatly eroded as their loans, MBS and Treasury holdings go underwater—vastly curtailing the amount of new credit available to the economy. The Fed will be deemed insolvent as its meager capital quickly vanishes. Interest payments on Federal debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives will go bust. This will be the result of creating an economy that is completely addicted to debt, asset bubbles, ZIRP and QE for 7 years.
In essence, the entire economy will collapse…perhaps this is the real reason why the Fed found it expedient to completely remove the numerical unemployment rate target for when it would begin rising rates. Let’s be clear; the Fed is ending QE not because the economy has reached the inflation and unemployment goals it set out to achieve, but rather from fear of the monstrous size of the balance it has created.
But what if interest rates don’t rise as a result of the Fed’s exit from QE? If interest rates stay at these record-low levels it will be because the private market supplanted all of the Fed’s purchases at these ridiculously-low yields. The only reason why that would occur is if the tremendous deflationary forces unleashed in the wake of the Fed’s absence from its support of money supply growth causes equity and real estate prices to tumble, bringing the economy along for the ride.In either case the outcome for investors will be shocking. Market participants should prepare now for the failed exit of QE. On the other side of this imminent revelation will be unsurpassed volatility between inflationary and deflationary forces, which will dwarf those experienced during the credit crisis. Because of the unprecedented and unsustainable amount of debt outstanding, central banks now face only two choices: stop printing money and allow a devastating deflationary cycle to pop the asset bubbles that exist in equities and real estate; or continue expanding the money supply until hyperinflation eradicates the middle class and the economy.
Therefore, our Investment outlook remains very cautious. It should be noted that the S&P 500 is up just 2%, and we are in April. That paltry return is not worth the risk of being anywhere close to fully invested. In fact, I believe a trap lies in waiting for long-only investors. An anemic global economy, a record amount of margin debt and the Fed’s tapering of asset purchases will cause a sharp selloff very soon. To be specific sometime between now and before summer gets going. We will use that opportunity to get back into the market at much lower prices.
I first warned about the impending bust of Japanese Government Bonds (JGBs) when I wrote "Abe Pulls Pin on JGBs" back in January of 2013. In that commentary I laid out the math behind a collapse of the Japanese bond market and economy stemming from the nation's massive amount of government debt, combined with the Bank of Japan's (BOJ's) folly of pursuing an inflation target.
It was my prediction back then that a spike in interest rates was virtually guaranteed in the not-too-distant future. I also predicted that debt service payments would soon reach 50% of all government revenue, which would be the catalyst behind the rejection of JGB's on the part of the entire global investment community. Sadly, that prediction should come into fruition during the next few months.
The Japanese Finance Ministry recently predicted that debt service payments would reach $257 billion (25.3 trillion Yen) during this fiscal year; up 13.7% from fiscal 2013. Also, revenue for this year is projected to be 45.4 trillion Yen. This means interest expenses as a percentage of total government revenue will reach 56%. Therefore, it should now be abundantly clear to all holders of JGBs that since over half of all national income must soon go to pay interest on the debt, the chances of the principal being repaid in anything close to real terms is zero. A massive default in explicit or implicit terms on the quadrillion yen ($10 trillion), which amounts to 242% of GDP, is now assured to happen shortly.
Exacerbating the default condition of Japan's debt is the BOJ's increasing obsession with creating more inflation. Central Bank Governor Kuroda said recently that the inflation goal of 2% is well on track to be realized. Core inflation is already up 1.3%, and overall prices have climbed 1.6%, while fresh food prices have surged 13.6% from the year ago period. In fact, Japanese inflation is now at a five-year high.
Surging debt levels and rising prices belie the quiescence of the Japanese bond market. For example, the 10-Year Note offers a miniscule yield of just 0.62% as of this writing. That yield seems especially silly when viewed in historical context. The average yield on the 10 year Note is 3.04%, going back to 1984. And you only have to go back 6 years to find a 2% yield on that benchmark rate. Of course, those much-higher yields occurred in the context of significantly less debt and inflation than we see today.
The facts are that Japan has a record amount of nominal debt and also a record amount of debt as a percent of the economy. Deflation has ended, thanks to hundreds of trillions worth of Yen printing by the BOJ, and the central bank's increasing success at creating inflation will lead to insolvency for the nation's sovereign debt.
How can it be possible for interest rates to be at record lows if the nation is insolvent and inflation is rising? The answer is of course that the central bank is the only buyer left. For now, the ridiculous pace of 70 trillion Yen per annum worth of BOJ money printing seems to be enough to prevent rates from spiking. But as inflation waxes closer to the central bank's target, interest rates must rise. The BOJ will soon have to stand up against the entire free market of investors who will be betting more and more with their feet that JGBs will default.
The bottom line is the BOJ will have to dramatically step up its pace of bond buying, as interest rates rise and bets against JGBs intensify.
Unfortunately, Japan isn't alone in the insolvency camp. The U.S. and parts of Europe face the same fate. There will soon be an epic battle taking place between the developed world's central banks and the free market. The sad truth is there isn't any easy escape from the manipulation of sovereign debt on the part of the ECB, BOJ and Fed. The exit of government bond buying from these central banks will lead to a massive interest rate shock and a deflationary depression. On the other hand, if these central banks continue printing endlessly it will lead to hyperinflation and total economic chaos.
The New Chairperson of the Federal Reserve showed off her dovish feathers after the latest meeting of the FOMC. Ms. Yellen abrogated the threshold of 6.5% on the unemployment rate as the starting point for short term rate hikes and replaced it with amorphous and ambiguous language that allows plenty of wiggle room with rates.
Just like a child sometimes changes the rules of a game in mid-stream in order to guarantee a favorable outcome, the Fed has ripped up the rulebook to suit its own needs.
The Fed was fully aware when it first stipulated its guidelines for starting rate hikes, that a 6.5% unemployment rate threshold could be breached with the help of a contraction in the labor force participation rate and not fully through increased hiring. However, it still drew a line in the sand in which investors were forced to determine when the cost of borrowing money would begin to be increased directly by the central bank.
To the central bank's credit it did follow through on the promised continued reduction of asset purchases by $10 billion per month. The Fed is now purchasing $30 billion in Treasuries and $25 billion worth of MBS. This reduction was already in the cards and didn't surprise anyone. Nevertheless, the Fed completely abolished a numerical threshold for the unemployment rate to fall below before it begins to raise the Fed Funds Rate. The reason for this is clear; the Fed realizes it cannot raise short-term rates without pricking the asset bubbles it has worked so hard at creating and sending the economy into a deflationary tailspin.
The condition of the U.S. economy (and indeed global GDP as a whole) is so anemic that even after 5+ years of massive Federal Reserve market manipulations, the Fed cannot raise short-term interest rates. In other words, they will keep making excuses as to why they can't raise interest rates and continue to move the goal posts for their convenience.
The Fed is in the process of trying to end QE, but the stock market and Fed don't yet realize that the tapering of asset purchases is tightening monetary policy. This will cause long-term interest rates to rise-and the worst is still to come. For instance, the 10-Year jumped to 2.77%, from 2.68% on the same day of FOMC's decision to reduce asset purchases by another $10 billion. And short-term rates are rising to an even greater extent, despite the fact that the Fed is still posting a bid of $55 billion each month for these debt instruments.
The Federal Reserve's quantitative easing program was the only reason why the 10-Year Note, and longer-term interest rates in general, are as low as they are today. Ending QE will cause a huge spike at the long-end of the yield curve unless the economy is sharply contracting. Whether or not the Fed admits this is irrelevant.
The fact is the Fed is going from buying all of the newly issued Treasury debt, to zero of the newly issued debt market. And there isn't any entity that I am aware of in the entire world that will supplant the Fed's purchases at anywhere near today's rates. So interest rates are going to rise, and that is deflationary and also bullish for the U.S. dollar in the short-term.
But the anemic economic data should continue to worsen as interest rates rise. This means that the Fed will stop tapering sometime in the very near future -- probably in the summer or early fall -- and then they will feel compelled to launch QE V. When this shift in policy takes place it will be incredibly significant for world markets--beyond anything we have seen before.
In the interim, investors that have bet on an easy escape from QE will find out how wrong they have been. The equity market should undergo a severe correction once it becomes clear that asset prices and the economy have been highly reliant on debt monetization from the Fed.
The gold market has priced in a worst case scenario for the yellow metal--a balanced budget and no growth in the money supply. That's clearly not going to happen. In fact, the opposite is much more likely to occur. However, as I've stated many times before, the major move higher in precious metals won't occur until the overwhelmingly-accepted notion regarding the Fed's ability to end QE and raise interest rates with full impunity is proven to be fantasy.
Therefore, a significant spike in hard asset values will occur when the Fed acknowledges the fact that there is no easy escape from QE and the economy is destined to head into a deflationary collapse without the Fed's continuous support of bond prices. Although that would be healthy for the economy in the long term, it isn't going to happen voluntarily because of the hubris of politicians and their constituents. The Fed will stop tapering and undergo a massive and extended QE program in the latter part of 2014. That is when investors need to go all-in on inflation hedged securities. Until then, it is prudent to hold an abnormally high level of cash in your portfolio to be able to take advantage of the coming selloff.
I sometimes feel that the economy is living out the Hans Christian Andersen's fable called "The Emperor's New Clothes". He wrote the story back in 1837 about a vain emperor who hired a couple of charlatans that promise to make him the finest robes out of invisible thread. They convinced the Emperor that anyone not appreciating the sartorial splendor of the two swindlers should be deemed hopelessly stupid and unfit for their positions.
The current economic "recovery" and stock market rally have many similarities to Mr. Anderson's work. The underlying fundamentals behind the S&P 500's 180% advance since March of 2009 should be blatantly recognized as phony, even to a child. Yet traders and economists appear to willingly overlook the nakedness of it all.
There has been a subpar increase in personal income, employment, corporate revenue and GDP since the supposed end of the Great Recession back in the summer of 2009. But the key point to understand is, whatever phony growth that has been achieved came from governments' ability to borrow and print enough money to keep asset prices from plummeting. One can't say that equity and real estate values are soaring once again because the economy has healed, and therefore, it's has nothing to do with the Fed. Without the support of protracted and humongous monetary welfare, gratis of the central bank, debt levels, money supply and asset prices would need to contract to a level that can be supported by markets-rather than by government decree.
For example, the U.S. has incurred an additional $6 Trillion more in total debt than it had at the end of 2007. What our government and central bank have been able to achieve is set in stone our economy's addictions to debt, low interest rates and money printing by taking all of those conditions into incredible extremes. The Fed has kept the short end of the yield curve at zero percent for over five years and promises to keep interest rates there for as far as its eyes can see. Our central bank has also increased the amount of high-powered money from $800 billion to $4.2 trillion-and that number is still growing.
The economy and markets are much further away from removing the hand of government manipulations than at any other time in our nation's history. There has been no structural or entitlement reforms done at all. In contrast, Washington has succeeded in piling on an additional entitlement program (The Affordable Care Act), which the nation has no capability of paying for, adding to the myriad of entitlement programs that are already insolvent. Nothing of substance has changed for the good, only the government's ability to massively increase the amount of aggregate debt outstanding and appear to remain solvent by temporarily servicing that debt at an artificially-low rate.
Economically sensitive markets are clearly exclaiming that this recovery is naked. Industrial metals like copper have fallen 17%, while aluminum is down 10% YOY. Also, emerging market currencies and equity markets are reeling from the end of the dollar carry trade. However, faltering economic data in the U.S. has been conveniently and summarily dismissed due to winter's snow. But unless we are headed into another ice age, the excuse of cold weather will soon be undressed with the spring thaw.
The hole in the weather excuse is that the entire globe is showing signs of weakness. Chinese exports tumbled 18.1% from the year ago period, while the Shanghai stock market was down 12.5% during the same time frame.
The obscene amount of money printing by the Bank of Japan has caused the current account deficit to hit yet another all-time record high. The deficit for January was 1.59 trillion Yen ($15.4 billion) and the overall economy grew just 0.7% on an annualized basis in the final three months of 2013. This was a downward revision from the initially projected 1% growth rate.
The government of Japan is a paragon of the Keynesian experiment to avoid a cathartic recession by forcing higher the rate of money supply growth, depreciating the currency, levying new taxes, creating more inflation and drastically increasing the amount of aggregate debt outstanding. It has been well over a year since Abenomics took over in Japan and its failure should be nakedly obvious. Soaring debt levels, huge trade imbalances, a plummeting currency, a sputtering economy and insolvency are the tradeoffs for a stock market that is rising in nominal terms, and not yet back to the where it was before the Great Recession began over five years ago.
Given the above facts, it seems silly to buy into the belief that the global economy is on a sustainable growth pattern. Yet, the overwhelming majority of market pundits purport that fable to true. Perhaps, it is just more expedient and profitable to agree with what our leaders tells us is the truth, rather than to trust what our own eyes see and conscience dictates.
The sad truth is that global governments, in cooperation with their central banks, have now rendered much of the developed world insolvent. And that condition will be made evident to all once interest rates rise and the artificial support of bonds, stocks and real estate is finally, either voluntarily or involuntarily, removed.
For now, investors have decided to ignore the obvious and pretend that the economy-much like the townsfolk in Anderson's story--is in "excellent and magnificent" condition. But, once the economy crashes yet again, we will understand with the clarity of hindsight that the recovery was completely bare.
Investors are currently receiving mixed messages regarding the ramifications resulting from the Fed’s exit of debt monetization. Officials from the Federal Reserve are assuring market participants that there will be a smooth transition from the central bank’s manipulation of long-term interest rates. But markets are reaching a completely different conclusion.
The major averages in the U.S. are unchanged so far this year and are not giving a clear signal as to the future condition of the economy. However, many other markets around the world are giving investors a clearer indication regarding the negative fallout from the ending of QE.
For example, if the rate of economic growth was indeed improving, as most pundits would have you believe, then why are stock markets in the former engines of global growth, like Brazil and China, faltering? The Brazil and Shanghai stock markets are both down 12% since May 22nd of 2013—the date former Fed Chairman Ben Bernanke first mentioned the tapering asset purchases. Emerging markets like Turkey have plummeted 34%, while the Lira is down 20%, since Bernanke first indicated the ending of QE was imminent. In addition, why has copper, one of the most important industrial commodities, dropped by 11 % in the last year if economic activity is about to enter into a protracted expansionary phase?
Most importantly, sovereign bond yields are falling across the globe at the same time credit spreads are rising. This is completely counterintuitive to the consensus that global growth is accelerating.
In the U.S., nominal debt levels are increasing substantially. Meanwhile, the Fed’s purchases of Treasuries is headed towards 0%, from nearly 100% of all new debt issuance. In addition, the Fed is assuring markets that an inflation target of 2% and a real GDP growth level of 3% is going to be achieved in the near future. But the Ten-Year Note is currently yielding just 2.6%, and that yield is also falling. It is inconceivable to believe nominal GDP is going to be near 5%, while the Ten-Year Note is just half that level. This is even more incredulous given the historically-high deficits, which the Fed is supposedly ceasing to monetize.
The simple truth is the Fed’s taper of asset purchases is going to lead to a collapse of stock and real estate values in the United States. And this will cause major turmoil in currencies, equities and interest rates across the globe.
International equity markets, commodity prices, credit spreads and bond yields are all clearly telling investors that global economic growth is anemic and contracting. Therefore, investors need to decide who they want to put their faith in; the promises from governments that have massively manipulated economies worldwide, or whatever is still left of the free-market.
Putting new money to work into stocks when the S&P 500 is near a record high (predominately through the use of a record amount of margin debt) is a dangerous game. This is especially true in light of the fact that earnings growth is built upon near-zero revenue growth and market cap growth is woefully unsupported by GDP growth.
The only viable conclusion to reach at this juncture is that the real money to be made in 2014 will be to position your investments to profit against a failed exit of QE by the Federal Reserve.
Wall Street and Washington have summarily dismissed the recent spate of disappointing economic data by claiming it is solely based upon the weather. The equity market is 100% convinced that winter is to blame for the faltering economy; and that even if stocks have it all wrong, Ms. Yellen and co. will immediately print enough money to make everything ok.
For example, Industrial Production fell 0.3% and Retail Sales dropped 0.4% in January. Also, the last two Non-Farm Payroll reports came in far below estimates, and there were just 113k net new jobs created last month. Especially interesting in this latest report was that 48k construction jobs were added in January. This is totally contradictory to the claims that the anemic employment growth was caused by bad weather.
In addition, December Durable Goods contracted 4.3%, while the housing market is also showing signs of weakness. The Index of Pending Home Sales dropped 8.7%--to over a two-year low--while Home Builder Sentiment in February posted its largest drop in history. Maybe that explains why Housing Starts fell 16% in January to the lowest level since September, which was also the largest drop since February 2011. Staying on housing, Existing Home sales dropped 5.1% in January, hitting their lowest levels since July 2012. Don’t look for the weather as an explanation here either; sales in the West dropped 7.3% where there wasn’t even a drop of precipitation.
Colder than normal weather may account for some of the decline in U.S. GDP. However, it cannot explain the problems currently being experienced in economies all over the globe.
Japan’s GDP fell to a 1% growth rate in Q4; a far cry from the 3% predicted by most economists. The trade deficit hit a record 11.5 trillion Yen for 2013, nearly twice the level of 2012. This is despite (or perhaps because of) the BOJ printing its currency at a 70 trillion Yen annual pace.
China’s economic data shows that not only has the economy slowed from its prior double-digit pace, but news out from the National Bureau of Statistics showed the official Non-manufacturing Purchasing Managers' Index fell to 53.4 in January, from 54.6 in December. That reading is the lowest since December 2008.
The economy in Turkey is emblematic of the turmoil in emerging markets. A tumbling currency, soaring interest rates and a plunging stock market are sending the country into chaos. The Borsa Istanbul 100 Index is down 30% since its peak on May 22 of 2013. It just so happens that the fist mention of the Fed’s taper of asset purchases also occurred on May 22nd during Mr. Bernanke’s testimony before Congress—far before any snowflakes started to fall.
It may come as a shock to main stream economists that it is cold and snowy in the North-Eastern United States during the December-February time frame. However, worse than expected winter weather in certain parts of the U.S. cannot adequately account for stumbling GDP across the developed world and crumbling securities in emerging markets.
The truth is that global economies are being whipsawed between inflation and deflation, as central banks and governments have created massive debt and asset bubbles. Then, once the stimulus begins to be removed, those bubbles burst. These same governments attempt to re-inflate the same bubbles by monetizing an ever-increasing amount of government debt, causing the asset bubbles to become more pronounced with each cycle.
The resulting instability is causing dizzying swings in most markets and economies. Therefore, it is not the meteorological storm that is to blame for slowing global growth, but rather the destructive forces that result from the clash between the intensifying forces of inflation and deflation. The historic magnitude of these boom and bust cycles are directly caused by the unprecedented manipulation of markets by world governments.
Growth in the U.S. is slowing, along with Asia and Emerging market economies. This is occurring under the context of a continued reduction of Fed asset purchases. Meanwhile, U.S. market strategist are busy looking at the weather charts trying to find excuses. Nevertheless, look for the instability in global currencies, markets, interest rates and economies to worsen as the Fed’s taper progresses.
PPS finds it prudent to stay short the Nikkei Dow and the U.S. Treasury market for now. And to hold gold mining shares and cash as we head further into the teeth of the Fed’s taper.
I first wrote about the "Deleveraging Deception" back in September of 2010. Unfortunately, those that would have you believe the economy has paid down its excessive debt levels are still at work trying to deceive you. But here's the truth.
In order to perpetuate their deception that the economy has deleveraged, many Wall Street pundits often site the statistic that Household Debt Service payments as a percentage of disposable income has fallen to 9.2%, the lowest level since 1980 and down from 13.18% at the peak of the Great Recession.
But once again the analysis offered by perma-bulls is marked by sophistry and misinterpretation.
First off, the numerator of the equation has been massively distorted by the lowest consumer borrowing rates in history; provided to us courtesy of the Federal Reserve. In truth, the nominal level of Household debt has only contracted by a meager 6.3% (from $13.96 trillion in early 2008, to $13.08 trillion as of Q3 last year). Therefore, if we strip out the record-low interest paid on debt and just concentrate on Household debt as a percentage of disposable income, the real picture becomes clearer. Household debt as a percentage of disposable income is 103%, as of the latest reading. Taken into perspective, it was 128% at the start of the Great Recession. However, it was just 78% in the year 2000, and just 56% in 1980.
What’s worse, the aggregate level of debt in the economy (taking into consideration all public and private debt outstanding) is 250% of GDP. While that is the same level it was at the start of the Credit Crisis in 2007, it is more than $6 trillion higher in terms of the absolute level.
If we look at some key sectors individually, it is clear to see that the nominal level of debt in the economy has vastly increased during the last 6 years. Since December 2007; business debt is up $2.4 trillion, the Fed’s balance sheet has increased by $3.3 trillion, and the National debt has exploded by $7.2 trillion. Only the banking system has shown significant deleveraging.
It is absolutely crucial to look at nominal debt levels at this time because Household income and GDP have been artificially and temporarily boosted by unsustainably-low interest rates. Rising rates and falling economic growth will put significant pressure on these key debt metrics, as our real addictions to debt become perilously revealed.
A rapidly slowing economy will quickly increase the amount of red ink for the Treasury. In fact, the Treasury Department said just last week that it expects to issue $284 billion in net marketable debt for the January-March period. That is $19 billion more than the department estimated in November of last year. This means the deficit for calendar year Q1 2014 is already $120 billion higher than the deficit for the entire year of 2007 (the year prior to the Great Recession). And, even according to the rosy predictions of the CBO, this year’s deficit will be an incredible $514 billion!
What is especially silly is that adding over a half trillion dollars to the debt in one year is being lauded by Wall Street and the main stream media as a sign of fiscal restraint.
The sad truth is our economy carries more debt today than at any other time in our nation’s history. Taken in aggregate, the nominal level of debt has simply skyrocketed and whatever artificial economic growth the government has been able to manufacture is merely sustaining debt ratios near all-time highs. Therefore, more chaos awaits investors once the Fed either voluntarily or involuntarily loses control over interest rates, causing the denominator of economic growth to fall apart.
Wall Street Cheerleaders like to claim that the tapering of Fed asset purchases is not equivalent to the tightening of monetary policy. But the markets are clearly telling investors something different. Year to date the S&P 500 is down about 4%--not horrific for one month but certainly not following last year’s performance. But the economic data such as; durable goods, initial jobless claims, personal income, and housing sales have all shown a distinctive weakening trend.
The reason why tapering is tightening is because the Fed had been in the habit of taking away $1T worth of higher-yielding bank assets per year and offering them just .25% in return. Banks then needed to purchase a new asset such as; bonds, stocks or by creating a loan, which served to expand the money supply. However, going from $1T worth of asset purchases to $0 of QE, can hardly be offset by the amount of excess reserves held in the banking system. In other words, the banking system isn’t any more compelled to increase its assets and expand the money supply if the Fed’s balance sheet is $5 trillion, rather than when it is $4 trillion. Believing otherwise represents a critical misunderstanding of the QE process and how the level of excess reserves influences the banking sector.
Nevertheless, the Fed continues to promulgate the fallacy that ending QE will not have an adverse effect on asset prices, money supply and the economy. And the majority of the investment public has accepted that nonsense as gospel truth. However, the global turmoil in equities and currency markets are great evidence that the reflation game has changed. Further proof of this is the fact that Treasury yields are falling into the teeth of the Fed’s taper of asset purchases. The only reason this counterintuitive trade would occur is if the market was convinced the overwhelming forces of deflation and recession are going to supersede the falling demand for bonds from the Fed.
The chaos in emerging markets is just one of the destructive ramifications resulting from subjecting the world's reserve currency to 5 years of ZIRP and $3.3 trillion worth of money printing. Because of the Fed's massive manipulation of interest rates and money supply, investors piled into emerging market countries searching for higher-yielding investments denominated in rising currencies. Those foreign central banks had to print local currency to keep it from appreciating too rapidly. That created inflation, which further exacerbated the move higher in asset prices.
Then, at the beginning of this year the Fed started to reduce the monthly amount of QE, forcing investors to panic out of E.M. currencies and equity markets and back into their domestic currencies. The currency market turmoil also forced those E.M. central bankers to raise interest rates to quell inflation and support their currencies.
For example, Turkey hiked its overnight borrowing rate to 8%, from 3.5%. Just imagine what would occur in the U.S. markets and economy if the Fed Funds rate was raised from 0%, to 4.5% in one day!
This is just one example of the unintended consequences resulting from governments’ efforts to bring the global economy out of the Great Recession by massively increasing debt levels and having that debt purchased by central banks.
To be clear, I turned bearish on the markets in 2014, precisely because of the implementation of the deficit-busting Affordable Care Act, soaring interest rates and crumbling currencies in emerging market economies. Also, the Fed’s taper of QE (which will cause asset prices to tumble) and yet another debate and debacle regarding the debt ceiling. Expect global chaos this year to rival that of 2008, at least until the new Fed-head, Janet Yellen, reinstitutes a protracted and substantial QE program.
We are about to witness the sad, but inevitable conclusion, from having a global economic system that is based on fiat currencies. This global experiment in which the quantity of money and credit is left to the discretion of just a few unaccountable individuals is about to come to a disastrous end.
It took a few but decades to reach crescendo, but the end of the Bretton Woods monetary system in 1971 has now led to catastrophic levels of debt and inflation across the developed world. The corrupt business cycle goes like this: Politicians and bankers desire to spend and create more money than what a genuine economy’s savings (through productivity and increased labor force) can generate. Government and private bank interference in the market place continues to grow through the process of increasing the amount of aggregate debt outstanding. When this process goes unchecked for several decades—as is the case in Japan, Europe and the U.S.—debt levels become so onerous that it demands interest rates remain near zero percent in order for the economy to function.
These zombie-like economies cannot grow in a healthy manner because they suffer from: asset bubbles; high inflation; interest rate volatility; currency instability; along with high levels of corruption, regulations and taxation. Therefore, the prescription offered by politicians is more government spending and further central bank intervention in money supply growth and interest rate manipulation.
A great example of the bankrupt economic ideas adopted by these money printers, is the philosophy known as “Beggar Thy Neighbor”; a process in which governments and central bankers try to achieve a competitive trading advantage through the process of destroying the purchasing power of their currencies through inflation. Despite the overwhelming evidence that getting a nation deeply involved into a love affair with inflation does nothing in the way of improving economic growth, it is widely embraced today as a viable method of improving output.
The Plaza Accord of 1985 was an agreement between the U.S. and four of its largest export destinations to dramatically lower the value of the dollar. As a direct result of this agreement, the U.S. dollar lost over 50% of its value against the Yen from 1985 to 1987. Yet, the trade deficit increased from $121.8 billion in ’85, to $151.6 billion a full two years after the devastation to the dollar began. Likewise, there was no improvement in manufacturing as a percentage of the economy either. Manufacturing represented 17.8% of GDP in 1985, and it fell to 17.4% of GDP at the end of 1987.
In another example of the failure of inflation and money printing to fix anything, in 2005 China announced it would increase the value of its currency and abandon its decade-old fixed exchange rate to the U.S. dollar in favor of a link to a basket of world currencies (the U.S. had been pressing for the Chinese to allow a weaker dollar for years and they finally acquiesced). During that time frame, the Yuan rallied from .1208 USD to .1467 USD (a move of over 20%). But the falling dollar had a negligible effect on U.S. exports. For all of 2005 the U.S. deficit with China was $201.5 billion. In 2008, three years into the dollar devaluation and Yuan appreciation, it soared to $266.3 billion (more than a 32% increase). The truth is that inflation and currency destruction makes trade and current account deficits worse not better.
Finally, the new regime of Japan’s Prime Minister Shinzo Abe is also a wonderful example of the doomed policies that promote inflation and currency debauchery. By late 2012, he deployed Abenomics into full effect—the practice of massively increasing; government debt, central bank money printing and currency destruction. The Yen has lost 25% of its value against the dollar so far to date and Abenomics has made the Japanese currency a joke among international traders. Nonetheless, in January of this year their current account deficit soared to an all-time record high 592.8 billion Yen, or $5.7 billion.
So let’s set the record straight. If crumbling a nation’s currency was the pathway to prosperity then all banana republics would soon become manufacturing and economic powerhouses. But that never happens.
Trying to boost manufacturing and GDP growth by lowering the purchasing power of a currency does not “Beggar Thy Neighbor”, but instead bankrupts thyself. It does this by destroying the middle class, discouraging foreign direct investments, disincentives productivity gains and creates damaging imbalances in the economy. These imbalances eventually lead to intractable levels of debt, uncontrollable inflation and unmanageable debt service payments.
The systemic practice of running economies on the spurious belief that inflation and currency devaluation is a necessary pursuit is about to reveal its devastating consequences on a global scale. I expect volatility in global markets similar to what was experienced during 2008 to occur in the middle of this year, as economies experience massive swings between inflation and deflation.
Goldilocks is the term used by Wall Street to describe a nearly perfect environment for stock values to rise. The term is being used again today, just as it was mistakenly uttered in the middle of the housing bubble, to express the belief held by most investors that we have once again reached equity-market nirvana--a point in time where virtually every economic condition is just right.
However, what Wall Street regards as a nearly perfect economic environment is really just another misinterpretation derived from believing money printing, artificial interest rates, debt and asset bubbles can provide sustainable growth.
This same miscalculation occurred when Ben Bernanke first took the helm of the Federal Reserve on February 1st 2006. At that time, former Chairman Alan Greenspan had already slowly and steadily taken the Fed Funds Rate up to 4.5%, from the 1% level back in June of 2003. The newly appointed Bernanke followed Greenspan’s lead and continued to hike the Fed Funds rate three more times in .25% increments. By June of 2006 the Funds Rate was at 5.25% and the Ten-Year Note climbed from 4.5% in February, to 5% by June.
Rising interest rates seemed completely innocuous back then, just as they do today. In fact, the higher borrowing costs were being heralded as a sign that the Fed believed stronger growth was in store; and Wall Street cheered Bernanke and the goldilocks economy on. We all know in hindsight that the 5% Ten-Year Note yield was enough to collapse the entire real estate market, banking system and economy. Because of the lofty debt levels, all it took to kick start the Great Recession was a 10-Year Note that yielded just 5%.
The truth, which belied Wall Street’s ebullience, was that the massively overleveraged private sector was teetering on collapse. And when the interest rate trigger was pulled, the economy fell apart. At the end of 2007 the aggregate level of debt in the economy was $49 trillion, or roughly a staggering 330% of GDP.
That aggregate level of debt has now surged to $55.5 trillion at the end of 2013, which is still about 330% of our economy. We have not deleveraged at all. In fact, the nominal level of debt has exploded by over $6 trillion. This onerous level of debt is merely being masked by low interest rates and an unstable economy that is being levitated by producing renewed asset bubbles. An overleveraged consumer and banking sector—which was the case in 2007--is certainly not a more beneficial condition than having an insolvent government. Once interest rates rise it will again reveal the fragile state of the economy.
There hasn’t been any structural reforms made to this economy and no viable solutions have been offered to remedy the cause of the great recession. No tax, educational or entitlement fixes were put into effect; only our ability to sustain consumption through re-inflating equity, bond and real estate bubbles. The government accomplished this by substantially increasing the amount of outstanding debt and having our central bank monetize most of it.
The Ten-Year Note has already climbed from 1.5% last year, to 3% today. We are now only 200 basis points away from another complete meltdown in stocks and real estate prices. The Fed will learn a painful lesson this year. Namely, that it does not control the long end of the yield curve. A zero percent Fed Funds Rate does not preclude a 5% Ten-Year Note from being realized. Once the Fed’s monthly allotment of asset purchases dwindles to around $25 billion per month, I expect the benchmark interest rate to approach that key 5% level.
The Fed can still keep short-term rates low as long as it wants, but that will eventually create runaway inflation, ravage the economy and push the long end of the yield curve higher. Or, it can alternatively stop QE and raise the Fed Funds Rate, which will prick asset bubbles, cause government revenue to plummet and send debt service payments soaring. In either the case, the two immutable facts are that the U.S. has a historically-unprecedented level of debt and interest rates must soon mean revert. Much the same case can be made for Japan and the Eurozone as well. That toxic combination is what Wall Street describes as a “Goldilocks scenario.”
How all this ends up is sadly very clear. The Fed’s next major undertaking will not be how it can gradually raise interest rates in the context of an improving economy—which is the current consensus view, but rather, how much money it will have to print to keep borrowing costs from spiraling out of control.
Gold is a nearly perfect form of money. It is one of the few things on planet earth that contains all of the following attributes; beauty, scarcity, virtual indestructability, and is also transferable and divisible. However, even after five thousand years of utility as a store of wealth, gold is still completely misunderstood by most on Wall Street.
This is why most money managers wrongfully predict another disastrous year for the yellow metal. These advisors have never realized the simple truth that the value of gold never changes; only its expression in dilutable currencies changes. Therefore, it always preserves its purchasing power over time and is the best hedge against a fiat currency that is headed down the pathway of destruction. Gold prices increase when the market presages a currency will lose its purchasing power—it’s just that simple.
The reason why the dollar price of gold soared from $200 per ounce in the beginning of the last decade, to nearly $2,000 per ounce by the year 2011, was because many feared skyrocketing deficits in the U.S. would soon lead to massive money printing and debt monetization on the part of our central bank. Even though the debt monetization did materialize, as many had feared, the government has also managed to manufacture a temporary “recovery” in the economy by forcing interest rates to zero percent and thus producing bubbles in bonds, stocks and real estate. Theses asset bubbles led to a consumption bubble, which brought about an ersatz resurgence in government revenue. Deficits then fell hundreds of billions of dollars (although they are still gigantic and unsustainable), which has in turn caused the price of gold to undergo a correction from its decade-long advance and to consolidate at the $1,200 per ounce range.
However, there are now only two outcomes for the current fiscal, monetary and economic conditions; and they are both bullish for gold.
The Unlikely Scenario
The Fed will stop buying $85 billion per month of bank debt and will be completely out of the bond-buying business by the fall of 2014. Nevertheless, this will have an inconsequential effect on bank lending, money supply growth and economic growth. The continued condition of negative short and long-term interest rates will lead to a rapid expanse of the fractional reserve lending system and inflation. The fear on the part of gold investors about the Fed’s taper will then quickly fade away, as rising inflation sends bullion prices higher, just as it did in the middle of the last decade.
The Realistic Scenario
On the other hand, the Fed’s taper leads to spiking longer-term interest rates, falling asset prices and a faltering economy. Those rising interest rates cause the economy to slip back into a recession and deficits to once again spiral out of control. This will force the Fed to adopt a more substantial and protracted QE program than at any other time before, as it desperately seeks to keep long-term rates low in the context of soaring debt and deficits. Money supply growth in this case would be significant because the Fed would yet again be back in the business of monetizing trillion dollar deficits.
In either case the secular bull market in gold will re-emerge in 2014. I believe the yellow metal will approach $1,600 per ounce by the end of next year. I further contend that mining shares have already bottomed in anticipation of a failed Fed exit and will offer investors significant returns in the year ahead.
Mr. Bernanke, in a move made mostly to bolster his legacy, stated in his final press conference as Chairman of the Fed that he would start to reduce asset purchases in January of 2014. Nearly every advisor on Wall Street took the news as evidence the Fed can now remove its manipulation of interest rates with complete economic immunity. However, what these pundits fail to realize is that the Fed's economic recovery strategy was based on artificially boosting bond, equity and real estate prices. Now our central bank is promising to remove its support of asset price. Therefore, the lesson we are all about to learn is that bubble-based economies always fail.
As 2013 year draws to a close, the Ten-Year Note yield has climbed above 3%, from its 1.5% level in the spring. This move higher is occurring despite the fact that the Fed's tapering of bond purchases has yet to even begin. And, even when the taper starts in January the Fed will still be buying $75 billion of MBS and Treasuries. Therefore, Wall Street's ebullient reaction to the taper announcement is both premature and misguided.
Interest rates will rise significantly in the first half of next year, which will send bonds, stocks and home values into a sharp correction. The real estate market (the corner stone of the Fed-engineered recovery) is already starting to see cracks in its foundation. According to the Mortgage Banking Association, the index for applications to purchase and refinance a home fell 6.3% last month, sending the index to its lowest level in thirteen years. Further evidence of waning demand for homes came from the National Association of Realtors (NAR). Existing home sales fell for the third straight month to its lowest level in a year. The NAR also reported that sales were down 4.3% from October to November and were lower by 1.2% YOY. The weakness in housing extended to new home sales also, as they fell 2.1% in November.
Weakening demand for homes hasn't stopped builders from ignoring the fundamentals (much like they did during the housing bubble in the middle of last decade) and continue to increase inventory. New home starts were up 22.7% in November and were up 29.6% YOY. Existing home inventories were also up 5% YOY.
In normal market conditions falling demand and increasing supply would cause prices to fall. However, prices for new homes are up 10.6% YOY, while existing home prices rose 9.4% YOY, according to the NAR. Other measures of home prices, like S&P/Case-Shiller National Index, shows overall home values climbed 13.3% YOY. Why would prices be soaring double digits when demand is plunging and supply is on the rise? The only viable answer is QE!
Turning to the equity market, the S&P is up 25% this year while real GDP has advanced only about 2%? You just can't have strong and sustainable revenue and earnings growth when real GDP is growing at 2%. And, you certainly should not be able to post equity market returns of 25% if growth in the economy is so small. How did investors achieve such lofty gains this year? The only answer can be QE!
Finally, the 10-Year Note is yielding 3%. How could that benchmark yield be offering a return that is four hundred basis points below its 40-year average while the nation's publicly traded debt is up $7.2 trillion (140%) since the start of the Great Recession? You guessed it, QE!
Without the Fed's intentional manipulation of interest rates and money supply, the real estate and stock markets would be in a significant correction. This is because the Fed's debt monetization efforts have distorted all free-market indicators of where prices ought to be.
Keep in mind Mr. Bernanke's taper has yet to begin, and once commenced, it will be diminished only marginally. Nevertheless, if Janet Yellen continues to attenuate asset purchases by $10 billion each month, investors should expect an equity market correction in the first half of next year of at least 15%, as benchmark yields soar past 4%.
My primary market prediction for 2014 is that the Taper of asset purchases will be terminated, and then most likely be reversed by the end of Q2; but only after investors experience a massive correction in asset values and economic growth. This change in monetary policy will mark a significant turn in the U.S. dollar, international equities and commodity prices. Most importantly, the best opportunity for next year is to buy what no one else on Wall Street owns at this juncture. I can't think of anything more hated than the shares of precious metal mining companies. Therefore, the contrarian trade of the decade is to fade the equity market rally that is based on the overwhelmingly accepted, but false assumption, of a successful Fed taper.
On Monday, October 18th 1987, the Dow Jones Industrial Average lost 508 points (22%). There are many theories as to why the crash occurred, but the simple truth is that the panic stemmed from a sharp rise in interest rates. Likewise, another stock market crash awaits investors on the other side of tapering.
Rising interest rates twenty six years ago were a direct result of surging inflation. The year 1987 started out with very benign inflation. Consumer Price Inflation in January of that year showed that prices were up just 1.4% from the year ago period. However, CPI inflation surged to an annual increase of 4.4% by October. Rapidly rising inflation put fear back in the minds of the bond vigilantes, who remembered vividly how the former Fed Chairman, Paul Volcker, had to raise the Fed Funds Rate to nearly 20% in order to vanquish inflation just six years prior. The worry was that the new Chairman, Alan Greenspan, would soon be forced to follow in his predecessor’s footsteps and start aggressively raising the Funds Rate. That fear helped send the Ten-Year Note yield surging from just above 7%, in January 1987, to over 10.2%, the week before Black Monday.
The stock market had soared by 22% in the 12 months prior to the crash of ’87. In similar fashion, the Dow Jones Industrial Average has risen 21% since December of 2012, and is up nearly 150% since March of 2009. Of course, many pundits like to claim the market is not as overvalued now as it was then--the PE ratio was 23 in ’87, while it is 16 today.
But, what those same gurus neglect to realize is that the “E” in the PE ratio is far more artificially derived today than it was before the great crash. Back in 1987, the range for the Fed Funds Rate was a far more reasonable 6.4%-7.2%. And the total non-financial debt of the nation was 176% of GDP—lofty, but still manageable. That compares with a Fed Funds Rate of 0.08% today, and total debt of 245% of GDP. Therefore, since interest rates are dramatically lower and debt is significantly higher than during 1987, it seems logical to conclude that the earnings of corporations and indeed the economy itself are in a far more unsustainable condition.
The same stock market carnage awaits investors just around the corner if the Fed decides it is time to end QE. Only this time the spike in rates won’t be caused by inflation but by the central bank itself. It doesn’t matter if inflation causes investors to fear that the Fed will raise rates (as it did 1987); or if borrowing costs increase due to the fact that the Fed has to stop its indiscriminant and massive manipulation of the yield curve--the result will be the same.
The Doves at the helm of the Fed realize this and that is why they are extremely reluctant to end QE. Investors most likely have at least until March of next year before they have to worry about a genuine tapering of Fed asset purchases...if at all; because the economy should take another turn downward due to the implementation of the Unaffordable Care Act and interest rates that have already increased. Nevertheless, it is essential to have a plan in place to preserve your assets and profit from the equity market crash in the unlikely event the Fed does go down the tapering road early next year.
If the Fed does not begin winding down QE by the early part of 2014, the markets will understand that the central bank will be in the debt monetization business for many years to come and risk assets will soar. On the other hand, if the Fed begins tapering assets within the next few months the markets and economy will tumble. The global economy sits on a narrow ledge. On the one side there exists massive asset bubbles and inflation; and on the other side there lies a deflationary depression. It is now crunch time for the Fed to choose which way we fall.
The most important question for investors at this time is to determine how high interest rates will rise; if indeed the Fed’s artificial suppression of yields is truly about to end. To accomplish this we first must consider where yields last were outside of central bank debt monetization, a recession and the Eurozone debt crisis. Then, we need to factor in the increased risks to inflation and solvency, in order to arrive at an appropriate estimation for the level of interest rates during 2014.
The last time there was; no QE is session, no flight to safety in U.S. Treasuries from European debt insolvency, and the economy was not contracting, was in the spring of 2010. During that time, the U.S. Ten Year Note offered a yield just below 4 percent. But it is not accurate to then assume that rates will just gradually rise back to where they were before all three conditions were in place. Here’s why.
Credit Risks Have Increased
It is crucial to understand why the Fed’s inflationary campaign will not succeed in bailing out the economy. The reason for this is while it is true that inflation makes easier for an over-indebted economy to pay down debt, it also (because of ultra-low low borrowing costs) tends to truncate the deleveraging process. And, if those low interest rates stay in place for a protracted period of time it causes the economy to become even more leveraged than it was prior to the crisis. This is precisely what we find today.
The proof for this can be found in the borrowing habits of corporations, consumers and the government after the credit crisis unfolded. It is true that immediately after the collapse of the real estate market, consumers and businesses began to pay down debt. However, the government immediately began piling on new debt in record fashion. Corporations then started to accumulate more debt in the spring of 2010. And consumers have now fully reversed course as well and are happily adding to their debt loads.
Thanks to the nearly-free money offered by the Fed during the past several years, publicly traded U.S. Treasury debt has soared by $4 trillion (46%) since the spring of 2010. debt has increased by $1.6 trillion (8.2%) during that same timeframe. And, in the third quarter of 2013 consumer debt jumped by $127 billion, to reach a total of $11.28 trillion—the largest quarterly increase since Q1 2008. Household debt was up across the board with mortgage debt, auto loans, student loans and credit card balances all increasing substantially.
The significant increase in aggregate debt outstanding in the economy equates to a substantial increase in the credit risk of owning U.S. sovereign debt.
Inflation Risks Rising
The last time the 10-Year Note was trading at 4%, interest rates had been near zero percent for just over one year. Now, money has been nearly free for a total of five years. In addition, the size of the Fed’s balance sheet has soared from $2.3 trillion, to just under $4 trillion (an increase of over 70%). The inflation risks in the economy have vastly increased given the facts that the supply of bank credit (high-powered money) is at an all-time record high, and at the same time the level of borrowing costs are at a record low.
So How High Will Rates Go?
The bottom line is the interest rates offered on sovereign debt are mostly a function of the credit and inflation risks associated with owning that debt--not the level of growth in the economy, no matter what Wall Street likes to claim. Given the above data, it is clear that the 4% yield on the Ten-Year Note seen back in early 2010 will be eclipsed. Since inflation pressures and the solvency risks to the nation have increased by an average of about 50%, it would seem logical to assume the Ten-Year Note should trade 50% higher than where it was back in early 2010. This would put the Ten-Year in the 6% range, which is still about 100 basis points below the forty-year average. Of course, this is providing the Fed is actually going to end its artificial manipulation of long-term interest rates next year.
Don’t be Fooled by the Consensus
The overwhelming consensus on Wall Street is that the economy will slowly improve and the Fed’s taper will cause that benchmark interest rate to rise gradually back towards 3.25% over the course of 2014, from its 2.83% level today. However, the real risk is that rates do not rise slowly and by a small increment. Don’t forget, the Fed is has been buying 80% of all new Treasury debt, and it is a buyer that is totally indifferent to price.
A genuine attempt by the Fed to exit QE will cause interest rates to quickly soar back above 4%, and then perhaps as high as 6% in just a few months after the taper is concluded.
Therefore, it is prudent to assume the new Fed Chairman, Janet Yellen, will abort the tapering process shortly after it begins. That’s because rapidly-rising interest rates would be devastating to real estate, equities and the overleveraged economy in general. The shock for Wall Street will be that the Fed reverses tapering its asset purchases and begins adding to the total amount of QE next year. This would mark a significant turning point for the dollar, international equities and commodities.
The money supply as measured by M2 is now rising at a 12.1% annualized rate, which is causing the fickle Fed to renew its threats about ending QE. The minutes released from the latest FOMC meeting indicate the tapering of asset purchases could once again begin within the next few meetings.
Could it be the Fed is finally getting concerned about the asset bubbles it so desired to create? The robust increase in money supply has pushed stock prices higher; you could also throw in diamonds, art, real estate and Bitcoins to name just a few assets that are in raging bull markets. All those items just mentioned are not counted in the CPI measurement and therefore allow most on Wall Street and in D.C. to claim there is no inflation.
But despite promises from the Fed that tapering (when and if it ever comes) isn’t tightening monetary policy, the Ten Year Note just isn’t a believer. That benchmark yield was trading below 2.70% before the FOMC minutes were released, and then shot up to 2.84% within 24 hours of learning the taper talk was back on again; clearly illustrating the enormous pent-up pressure on bond yields.
So what you may say? Aren’t rising yields a sign of a healthy economy? Perhaps under normal conditions that is true. But in sharp contrast, today’s rising yields are the result of the combined forces of inflation and tapering fears. In reality, ending QE is all about the government relinquishing its utter dominance of the bond market.
However, the fear over the imminent end of easy money is for the most part unfounded. And even if the Fed were to curtail QE sometime in the near future, it would only last briefly; and the tightening policy would have to be quickly reversed, as I believe the entire globe would quickly sink into a deflationary depression. Precious metal investors may have to wait until the attempted exit from QE fails before a major, and indeed, record-setting advance can occur.
In addition, the odds are also increasing that Janet Yellen (whom I have dubbed the counterfeiting Queen) will allow asset bubbles to increase to a much greater degree than her predecessor, Ben Bernanke ever did. And that should drag commodities along for a nice ride. After all, the gold market has been busy pricing in the end of QE for multiple quarters. There is a good chance that the beginning of tapering would lead to a reversal of the trade to sell gold ahead of the news. But the major averages have priced in a sustainable recovery on the other side of QE, which will not come to fruition. For the Dow, S&P 500 and NASDAQ the end of QE will be especially painful.
But the truth is the U.S. economy is more addicted to the artificial stimuli provided by the Fed and government than during any other time in our nation's history. Aggregate debt levels, the size of the Fed's balance sheet, the amount of monthly credit creation and the low level of interest rates are all in record territory at the same time. This condition has caused the re-emergence of bond, stock and real estate bubbles all existing concurrently as well.
A unilateral removal of stimulus on the part of the Fed will send the dollar soaring and risk assets plunging—you could throw in emerging market equities and any other interest rate sensitive investment on planet earth. The Fed is aware of this and that is why it is desperately trying to deceive the market into believing ending QE will not cause interest rates to rise. This is a silly notion. Since QE is all about lowering long-term rates how can it be that ending QE won’t cause the opposite to occur? This is why the FOMC minutes released today show that the Fed is debating different tactics to run in conjunction with the taper; such as charging banks interest on excess reserves in an attempt to offset the deflationary forces associated with tapering asset purchases.
Nevertheless, the most important point here is most money managers on Wall Street are convinced this is an economy that is on a sustainable path—but they are completely wrong. Disappointingly, it is much more probable that the government has brought us out of the Great Recession only to set us up for the Greater Depression, which lies just on the other side of interest rate normalization.
Sadly, the Fed has killed the buy and hold theory of investing for many years to come. Having an investment strategy for both rampant inflation and sharp deflation is now essential at this juncture.
The central banks of Japan and the U.S. are killing the private market for government debt. The massive and unprecedented bon-buying programs for Japanese Government Bonds (JGBs) and Treasuries have driven yields so low that investors are now simply stepping aside from involvement in that market entirely.
Monthly trading of JGBs has fallen to just $385 billion, the lowest level on record, clearly illustrating that private institutions are no longer comfortable holding Japanese debt. Perhaps because the bench-mark Ten-Year Note yield has dropped by 55% during the last three years and now offers a yield of just 0.6%. This paltry yield exists solely because of the BOJ’s 7 trillion Yen per month worth of debt monetization. Be assured, if the free market were allowed to dictate bond yields, Japan’s 2% inflation target coupled with its quadrillion Yen worth of outstanding debt (244% of GDP) would cause interest rates to soar in that island nation.
Similarly, the U.S. Federal Reserve is on pace to purchase 80% of our annual deficits. The central bank has crowed out and scared away private investors with our $17.15 trillion debt and a zero percent interest rate policy--that will probably be in effect for at least eight years. Investors are very much aware that our massive debt and a $4 trillion Fed balance sheet pose huge credit and inflation risks that is not at all reflected by a Ten-Year Note trading below 3%.
But market fundamental don’t matter in the short run when central banks completely overwhelm the private sector. However, with each passing day these bond markets—and indeed entire economies—become more addicted to these artificial rates. And, as money printing succeeds in creating rising inflation, interest rates are becoming more and more negative. Negative real interest rates that are falling over time are cause investors to eschew sovereign debt ownership by ever-increasing numbers.
Rising inflation rates, massive outstanding debt and zero percent interest rate levels are completely antithetical to free markets. Therefore, what the Fed and BOJ have created is an interest rate vacuum. The BOJ and Fed may eventually step aside from debt monetization programs once inflation targets are reached. But this will create a sudden and tremendous move upward in yields, as bond prices to plunge to a level that begins to once again attract the interest of private investors.
I have warned many times in the past and even written a book about the coming bond market collapse. These central banks will have to continue in perpetuity being the dominate buyer of government debt, which will lead to hyperinflation, or choose to step away from debt monetization and allow interest rates to soar, which will lead to a deflationary depression. Either decision will carry with it incredible ramifications to investors.
Nevertheless, the major point being overlooked by the Fed and the markets is If the Fed, ECB or BOJ were to decide to move away from quantitative easing they will have to coordinate that tightening amongst all three banks. If any one of these central banks acts unilaterally, it will cause a humongous and disruptive move in currencies. For example, if Janet Yellen were to start tapering the Fed’s QE program while the BOJ and ECB kept its monetary policies intact, the dollar would soar. This would cause the new Chairman to panic about deflation (deflation is public enemy number one, according to this new era of Keynesian central bankers), while the stock market crumbed due to downward pressure on earnings from U.S. based multinational corporations. Of course, the chances of getting the Fed, BOJ and ECB to agree on tightening monetary policy in the near future are about the same as their target rate on interest rates—zero.
Therefore, expect interest rate manipulations on the part of these central banks to last far longer than most on Wall Street anticipate. This means inflation is now the primary threat to investors’ portfolios. The need to own hard assets should become even more pronounced next year, as markets gradually come to realize that central banks have totally killed the private market for sovereign debt. And any resuscitation of government bonds will require a rise in interest rates that will be, unfortunately, catastrophic.
By now we have all heard it many times before…the Fed’s mantra about ending QE is starting to sound just like a broken record. Our central bank is aware it has to stop manipulating credit and interest rates some day, and on a basic level it really wants to end that game, but the right time never seems to come. Sort of like someone who wants to quit smoking is often heard exclaiming that this will be his last pack of cigarettes. But a hundred cartons later he’s still puffing away. He knows it’s wrong, so he vows to stop. However, soon everyone realizes he’s just full of smoky-hot air.
Likewise, the Fed is quickly losing all credibility with investors. Very soon its threats to stop QE will be laughed at in the same way as we do the empty promises to quit from a chain smoker. After all, QE is all about lowering long-term interest rates for the purpose of encouraging more borrowing and forcing investors to purchase more risk assets. Therefore, it is the height of hypocrisy and stupidity on the part of the Fed to maintain that ending QE will not force the long end of the yield curve higher and cause a massive selloff in equities and real estate.
The Fed keeps insisting this won’t happen and is trying to convince the market that it has things wrong. However, they know rates will rise; and that is why it is so reticent to start tapering bond purchases. So, all Mr. Bernanke can do is make repeated threats about tapering and hope the bond market’s reaction will be different this time around. But it won’t…and the longer the Fed waits to end QE the more drastic the move higher in interest rates will be.
Tapering talk started on May 22nd during Mr. Bernanke’s congressional testimony. In it, he claimed the Fed could start to reduce QE by year’s end. That first salvo sent the 10-Year Note on a journey higher from below 2%, to 3% by September 5th. However, like a good addict, the Fed saw the ensuing slowdown in the economy caused by those rising rates as an excuse to keep printing money. Its no-taper surprise delivered at the September 17-18th meeting saw the 10-Year Note drop from 2.9%, to below 2.5% in a month. The excuse given for not tapering was “tightening financial conditions”, which were of course caused by the Fed itself! Then, at this latest meeting held on October 29-30th the Fed stated that some imaginary improvement in economic conditions has been recently achieved. Despite the fact that the economic data has been mixed, the bond market took the Fed’s exuberance as a signal the taper was back on and to once again sell Treasuries. The Ten-Year Note climbed from 2.47% to 2.62%, just two days after Bernanke’s statement was read and it has now reached 2.75%.
So let’s get all this straight, the Fed threatens to taper its asset purchases and that causes the entirely rational response to sell bonds, which sends rates higher; and that soon causes the Fed to panic and to once again promise to keep the printing presses rolling, which causes interest rates to fall; and that then allows the Fed to find the courage to talk about tapering again…wee! Aren’t you glad these people are in charge?
Of course, the Fed knows that buying $85 billion worth of government debt each and every month without end and without regard to price has sent bond prices and risk assets far higher than they would ever possibly be if they were instead driven by free-market forces. This is what the Fed set out to do in the first place. Therefore, the Fed knows ending its QE program equates to a massive tightening of credit conditions no matter what it would otherwise have you believe. Mr. Bernanke claims tapering isn’t tightening, which is about as credible as President Obama’s claim that, “If you like your insurance plan you can keep it…period.”
Wall Street would also like investors to believe the stock market is being powered by strong earnings that are the result of a vastly improved economy. But if this is true then why does the market tank each time the Fed threatens to end buying over $1 trillion worth of government debt per year?
The real truth is the Fed will not end QE until consumer debt is once again dwarfed by the phony wealth created through asset bubbles. It is at that point the consumer will start to desire more debt accumulation and the private banking system will then be able to expand the money supply. This will bring inflation up to where the Fed is comfortable and can persist without the continued expansion of its balance sheet. Once banks are lending money again to consumers that can’t pay it back, the money supply will grow without having to grow the monetary base. And all will be well once again just as it was before the economy collapsed in 2008.
Therefore, investors that are worried about inflation have great reason to be fearful. The Fed will not stop expanding credit until the purchasing power of money is under great duress and debt levels in both the public and private sectors are at incredible extremes. The Fed wants you to believe once it is successful in creating massive bond, stock, real estate and debt bubbles it can then allow interest rates to rise from zero percent—where they have already been for the last 5 years-- with economic impunity. Nevertheless, investors would be wise to reach an entirely different conclusion and prepare their portfolios now for the coming economic chaos. That means having the ability to anticipate intractable inflation and or a deflationary depression, the inevitable bond market crisis; and being ready to deploy an investment strategy for each outcome.
The market averages continue to set record highs, as investors are forced by the Fed into stock market speculation due to artificially-suppressed interest rates. But neither our central bank nor corporate measures deployed solely to increase earnings per share while ignoring revenue declines (see IBM’s announcement of a stock buyback) can hide the fact that the underlying economic growth is deteriorating.
In the past few days alone stocks have had to ignore a spate of bad economic data. For example; Durable Goods Orders for capital expenditures fell 1.1% in September, Pending Home Sales plunged 5.6% last month and were down four months in a row, and the ADP Employment Report for October showed that just 130k private sector jobs were added last month. This is just a small snap shot of the overall data that clearly shows the economy has been growing below trend—at best.
However, despite falling home sales, durable goods orders and disappointing employment trends the stock market is powering higher. In fact, not only are investors undaunted by the anemic economic data but they are enthused to the degree that it has sent NYSE margin debt to an all-time record high.
It should be abundantly clear to any unbiased observer that the Fed has succeeded in creating an economy fueled by debt, money printing and asset bubble creation. And, as history has clearly demonstrated, any such economy based on those conditions eventually falters.
Unfortunately for us Americans, Washington is merely proposing snake-oil solutions for the economy. The elixirs prescribed are the Affordable Care Act and more Fed-induced inflation.
Obama care is projected to force about 80% of the 14 million consumers who buy their insurance individually to get a cancellation notice because their current policies do not meet ACA mandates. These individuals, who are mostly small business owners, (the generators of job growth) will see an increase of nearly 100% on average for their new premiums. Obama care will also thrust over 25 million people on to the health care system through government assistance. Providing premium support for millions of individuals will place a huge burden on debt and deficits that are already at a disastrous level. And, placing more than 25 million individuals onto the health care grid without increasing the supply of health care can only serve to drastically push the cost curve up instead of down. Obama care will not fix the economy; rather, it will only exacerbate its decline.
Adding to the health care woes is the view on the part of the Fed that inflation will be our panacea. The NY Times reported recently that President Obama’s nominee to head the Fed, Janet Yellen, believes a little inflation is desirable when the economy is weak. Economists like Yellen maintain that rising prices help companies increase profits and rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly. The article stated that some prominent economists desire inflation to rise by 6% for several years! It also quoted Charles Evans, President of the Chicago Fed, who went on record saying, “Let me just remind everyone that inflation falling below our target of 2 percent is costly,” And, the paper quoted Fed Chairman Ben S. Bernanke saying, “The evidence is that falling and low inflation can be very bad for an economy.”
However, the truth is inflation destroys profit margins, as the costs for crude and intermediate goods tend to rise faster than finished goods. The view that rising wages should come from inflation is faulty as well. Rising wages should be the result of increased productivity and not from depreciating money. The fact is that salaries tend to fall in real terms when overall prices are rising. Also, as the article stated, inflation does encourage consumers and governments to take on more debt; but this is exactly the wrong approach when the overall economy is in drastic need of deleveraging. Deflation causes asset prices and debt levels to fall. And, as a result, the end product is a rising standard of living and a viable economy.
But be assured our central bank won’t quit expanding the supply of money and credit until inflation is well entrenched into the economy. If QE alone doesn’t serve to dramatically expand the money supply the Fed may force banks to lend the excess reserves by relaxing capital requirements and/or through charging interest on those reserves.
Unfortunately, the bottom line here is to look for health care costs to soar, debt and deficits to rise, inflation to surge and economic growth to falter. Investors should prepare their portfolios first for a massive increase in asset bubble levels first and then for economic chaos to follow.
I have long predicted that our central bank’s debt monetization efforts would be of greater quantity and duration than most everyone at the Fed and on Wall Street expected. The reason; it is simply pure economic fallacy to try to engender viable economic growth through the process of creating inflation. Japan is trying the same failed economic strategy as well; and it will end in disaster…just as it will here in the United States.
Here’s why. Each of the past five years Wall Street and Washington has repeatedly offered a rosy forecast of a second-half recovery that has not come to fruition. Latest case in point, the NFP report for September (before the government shut down) showed that just 126k private sector jobs were added last month. However, the answer we get from government is to do more of the same thing that isn't working. More debt, more money printing and a further extension of asset bubbles are the only solutions they provide.
It doesn't matter that five years of zero percent interest rates and QE have failed to spur real growth. Their prescription only leads to a zombie economy that limps along because it is based on creating consumption through rising asset prices and not through resolving structural issues like; allowing the economy to deleverage, simplifying the tax code, fixing our educational system, reducing regulations, or through stabilizing interest rates and the value of the dollar.
Therefore, five years and over three trillion dollars later, investors are clamoring to learn if the Fed will finally acknowledge that QE is actually preventing a return to healthy GDP growth; or will it merely persist in the folly of printing money without end.
That vital question was answered in a recent interview with Chicago Fed President Charles Evans on CNBC. Mr. Evans was asked a specific question about the boundaries of money printing and how much new credit the central bank is willing to create. The incredible exchange went as follows:
CNBC: “Does the fed have a limit to its balance sheet? Charlie, is there a limit? You’re headed towards $4 trillion. Could it be $5 trillion, could it be $12 trillion? What limits the size of the Fed's balance sheet?” Charles Evans: “Well, I think the Fed needs to do whatever is necessary to help meet our dual mandate objections…is there a limit, I don’t really think about it that way because I think there is a tremendous amount of capacity, we can go on as long as necessary…”
The Fed President shares the same sentiment as the soon to be appointed Chairman Janet Yellen. Those statements assure investors that the central bank is far more concerned about deflation than it will ever be about inflation; and that it will not stop printing money until it creates the latter.
So, what will be the effects of ever-expanding money supply and credit creation? Interest rates will be negative in real terms and that condition will only worsen over time. Public and private sector debt levels will explode higher as the artificially-low interest rate environment encourages the economy to lever-up to record highs. Cheap money will continue to force intractable speculation in stocks, commodities and real estate, which will further impoverish the middle class and lead to the exacerbation of asset bubbles that are already at dangerous levels.
While there is some anemic economic growth generation based on the building and servicing of asset bubbles, it is a miserable tradeoff for the massive debt bubble being created--which is setting up the economy for a devastating crash.
The total amount of public and private sector debt already amounts to 350% of our unsustainable GDP. The central bank’s monetary policies will cause this level to grow both in nominal and GDP terms. These debt and asset bubbles should all implode in unison once interest rates normalize. It is prudent for investors to ride the asset bubble wave higher for now. But it is also imperative to have an escape plan in place before the inevitable crash occurs.
The gradual erosion of the U.S. dollar’s status as the world’s reserve currency has been greatly hastened of late. This is due not only to the perpetual gridlock in D.C., but also our government’s inability to articulate a strategy to deal with the $126 trillion of unfunded liabilities.
Our addictions to debt and cheap money have finally caused our major international creditors to call for an end to dollar hegemony and to push for a “de-Americanized” world. China, the largest U.S. creditor with $1.28 trillion in Treasury bonds, recently put out a commentary through the state-run Xinhua news agency stating that, “Such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated.” In addition, Japan (our second largest creditor holding $1.14 trillion of U.S. debt) put out a statement through its Finance Minister last week saying, “The U.S. must avoid a situation where it cannot pay, and its triple-A ranking plunges all of a sudden.” It is both embarrassing and hypocritical to be lectured by Japan about an intractable debt situation. However, the sad truth is we have become completely reliant on these two nations for the stability of our bond market and currency.
We arrived at this condition because our central bank has compelled the nation to rely on asset bubbles for growth and prevented the deleveraging of the economy by forcing down interest rates far below a market-based level. For example, instead of allowing debt levels to shrink, the Fed’s virtually-free money has now caused consumer credit to surge past the $3 trillion mark by Q2 2013; that is up 22% in the past three years. And of course, the Federal government massively stepped up its borrowing beginning in 2008, piling on over $6.8 trillion in additional publicly traded debt since the start of the Great Recession.
While most are now celebrating the end of government gridlock (however ephemeral it may be), the truth is few understand the consequences of our addictions. The real problems of government largess, money printing, artificial interest rates, asset bubbles and debt have not been addressed at all. Rather, Washington has merely agreed to perpetually extend its lines of credit and to have the central bank purchase most of that new debt.
Instead of placating the fears of our foreign creditors we have cemented into their minds that the U.S. dollar and bond market cannot be safe repositories of their savings. The eventual and inevitable loss of that confidence will ensure nothing less than surging prices and a complete collapse of our economy.
The fear of an economic meltdown was the genesis of a constitutionally-based third-party political movement. The Tea Party was formed to prevent runaway inflation and an economic depression resulting from a crumbling currency and devalued debt. It appears by the absolute and universal vilification of its members by both republicans and democrats indicates that U.S. citizens are not yet ready to undergo the pain associated with the removal of our pernicious addictions. Since there appears to be no political solution is site, it would benefit investors to take steps now to protect their portfolios from the de-crowning of the U.S. dollar as the world’s reserve currency.
Former Treasury Secretary Hank Paulson weighed in on the budget and debt ceiling gridlock in Washington and offered a solution last week by saying, “I hate the whole concept of a debt ceiling”. He also indicated that putting a legal limit on our nation’s borrowing authority is a “flaw in the system”. In other words, if we just did away with the strictures of a debt limit our problems would go away. Unfortunately, this view is shared by most in our government.
As usual, the majority of those in D.C., regardless of their party affiliation, have it exactly backwards. The problem isn’t that we have a law which caps the total amount of our nation’s public obligations. The real issue is that our leaders consistently pass spending bills which breach our legal borrowing limit. In fact, D.C. has raised the debt ceiling 74 times since 1962 alone.
The majority of politicians in both houses of congress believe that not raising the debt ceiling would impugn the full faith and credit of U.S. Treasury Debt. In sharp contrast, it is our habit of raising the debt limit without getting our deficits and entitlement obligations under control that poses the most threat to Treasury prices.
Of course, no sane person advocates defaulting on our sovereign obligations; but that is exactly what we are doing right now anyway through the Fed’s massive monetization of bonds. And if we do not finally address our addiction to debt, our default level will increase dramatically as real interest rates plummet. Therefore, what a few rational members in government are trying to accomplish is preventing the inevitable spike in nominal interest rates and an even greater surge in inflation stemming from the loss of confidence in our nation’s ability to service our debt through taxation. By adhering to the current $16.7 trillion debt limit the U.S. can greatly reduce the need for debt monetization on the part of our central bank.
It is a fact that the current level of revenue is not enough to pay down the amount of total debt outstanding because our annual deficit for fiscal 2013 will be $750 billion. President Obama likes to claim he cut our deficits in half from the $1.4 trillion deficit incurred during 2009. However, this distorts the truth because the deficit for 2008, the year before his first term, was $458 billion, and the year before that the deficit was just $160 billion. So, we are growing the debt because we are increasing the deficits and, most importantly, we are still growing the debt as a percentage of GDP.
These debt and deficits should soar in the coming years to an even greater degree because the premium support provision in the Affordable Care Act (ACA) is another huge entitlement that will provide a government subsidy for millions of Americans that cannot afford health care insurance. In fact, the Congressional Budget Office recently raised the cost for the ACA to $2.6 trillion over the first 10-year horizon. The ACA is the law of the land; but the debt ceiling is as well. Washington cannot claim that some laws are malleable and others which are not.
Nevertheless, it is our addictions to debt and inflation that will eventually collapse Treasury prices, not having a legal borrowing limit on our nation’s debt. It is a travesty that many in D.C. are claiming the failure to raise the debt ceiling will lead to Treasury default. Quite the contrast, it would be tantamount to adopting a balanced budget amendment, which would serve to dramatically boost confidence in Treasury ownership.
The tremendous amount of outstanding debt, unchecked deficits and intractable entitlement program spending virtually guarantees that the Fed will have to increase its monetization of Treasuries at an even greater level than the incredible trillion dollar annual pace. This unfortunately means that inflation and our addiction to asset bubbles will be growing in ever-increasing fashion over time.
The sad truth is that the primary function of the Fed and Treasury has now become the sustention and expansion of disastrous asset bubbles. In fact, while Mr. Bernanke officially acknowledges QEs one through three, the truth is he has embarked on QE V. What's QE five all about? Putting a lid on U.S. Treasury yields.
The reason for this is our anemic economic recovery has been predicated upon artificially boosting consumption, which is 70% of US GDP. That consumption is, in turn, predicated on borrowing; because we don't have any real income growth on the part of the consumer. The borrowing has been predicated on government's ability to build upon the asset bubbles in stocks, bonds and real estate. And the creator of all these bubbles is our central bank, which is the progenitor of this deadly-addictive cycle. The Fed does this by providing ultra-low interest rates and through the massive monetization of government debt.
To prove we have learned nothing from the previous Great Recession; we now have a situation where the FHA will most likely need a $1 billion bailout for the first time in its 79 year history. But why do taxpayers have to bail out the FHA, which provides insurance to lenders such as banks and other financial institutions? The reason is because our government has once again compelled lenders to make loans with next to nothing for a down payment, to individuals who cannot afford to purchase a home-doesn't this all sound chillingly familiar? Therefore, we have subjected ourselves to yet another bubble in housing, where home prices are once again rising at double-digit rates and marginal home owners are just a few points higher in interest rates from foreclosure.
It's not just house prices which are in back in a bubble. Stock prices are also growing at double-digit annual rates. These double-digit gains in stocks are taking place in an environment of little earnings and revenue growth. Meanwhile, Treasury bonds offer only half of their average yields going back over 40 years. So, for the first time in our lives we have three bubbles that exist together -- equities, bonds and real estate. But the real catastrophe this time is that these bubbles will become exponentially larger than previous episodes. Therefore, when they burst the devastation will be many times worse.
For those that believe the Federal Reserve is soon going taper its asset purchases, what they fail to understand is that the central bank has devolved into an institution that now exists solely for the perpetual expansion of stock, bond and home prices. Last week, Minneapolis Fed President Narayana Kocherlakota stated the central bank must be, "…willing to use any of its congressionally authorized tools to achieve the goal of higher employment, no matter how unconventional those tools might be." He continued, "Doing whatever it takes will mean keeping a historically unusual amount of monetary stimulus in place -- and possibly providing more stimulus -- even as the medium-term inflation outlook temporarily rises above the Fed's 2 percent goal and asset prices reach unusually high levels."
What he is saying is that the central bank of the United States should draw a line in the sand and take the opposite stance of former Fed Chairman Paul Volcker, who once stated the Fed will do whatever it takes to crush inflation. In sharp contrast, this Federal Reserve is now saying we will do whatever it takes to create sustainable inflation and asset price bubbles.
The bottom line is that the Fed has now launched QE5, which is in reality QE-to-infinity. This latest round of QE is absolutely unprecedented because it attempts to permanently cap long term interest rates.
Banana Ben Bernanke will soon be succeeded by the Queen of the Counterfeiters, Janet Yellen. There will be no significant winding down of bond purchases as far as the eye can see and the Fed's balance sheet will be expanding for many years to come. And if there were to be any small tapering in the future, it will be inconsequential in nature because the Fed is on record stating rising interest rates will not be tolerated
The free market will eventually trump our government's desire to constantly push asset prices to an artificially-high and unsustainable level. If investors thought the collapse of home prices was devastating in 2008, just imagine what will occur once real estate, equities and bonds prices collapse concurrently. That is why government needs to end its manipulation of asset prices, suppression of interest rates and superfluous credit creation now!
The President of the Europe’s central bank said back in July of 2012 that it would fight rising borrowing costs by doing “whatever it takes” to ensure sovereign bond yields do not spiral out of control. This past week Mr. Bernanke took a page from Mario Draghi’s playbook and tacitly indicated that the Fed will now also promise to keep long-term interest rates from rising by any means necessary.
Starting from its inception, the Fed influenced the economy by adjusting the interbank overnight lending rate and providing temporary liquidity for financial institutions. However, in the modern era of central banking (post 1971) the Fed has resorted to unprecedented and dangerous manipulations, which are increasing by the day.
The Fed began in November of 2008 to purchase longer-dated assets from banks. Bernanke’s plan was to greatly expand the amount of banking reserves, put downward pressure on long-term interest rates and to boost the value of stocks and real estate assets. He has since succeeded mightily in accomplishing all three. But since viable and sustainable economic growth cannot be engendered from artificially manipulating interest rates and boosting money supply, GDP growth and job creation have been anemic at best.
Therefore, the Fed has resorted to trying yet another unprecedented “solution” to fix the economy. Mr. Bernanke stated in his press conference following this week’s FOMC meeting that the level of asset purchases would remain at $85 billion per month because,” the rapid tightening in financial conditions in recent months could have the effect of slowing growth…” The only possible meaning Bernanke could have in mind when saying “the rapid tightening in financial conditions” is the increase of interest rates. The shocking part is that the rise from 1.5% to 2.9% on the Ten-Year Note does not even bring borrowing costs to half of the average level going back to the time when Nixon completely unpegged the dollar to gold.
What the Fed has done is historic in nature and yet it has received nearly zero attention in the main stream media. Bernanke has essentially admitted that just the threat of reducing QE—let alone actually bringing it down--was enough to send interest rates rising to the point in which economic growth is severely hampered. In other words, the Fed was forced to acknowledge that tapering is tightening and is now obligated to expand the balance sheet without end or be willing to allow a deflationary depression to reconcile the imbalances of its own creation.
This is because the price of risk assets and level of aggregate debt are so far above historic measures that even the slightest increase in borrowing costs renders the economy insolvent.
Investors would be wise to ignore the Fed’s rhetoric about ending QE and concentrate only on what it actually does. Hard assets offer the best protection against a central bank that is incapable of extricating itself from monetary manipulations.
Wall Street is now reflecting upon the fifth anniversary of the Lehman Brothers bankruptcy and the start of the Credit Crisis. In fact, most are celebrating the belief that the complete collapse of the American economy was avoided thanks to a massive intervention of government-sponsored borrowing and money printing.
However, it is much more accurate to maintain that the Great Recession was only temporarily mollified by our proclivity to re-inflate old bubbles. Therefore, the Great Recession should not be thought of as something that is behind us. Quite the contrary; the last five years have been spent creating the conditions conducive for producing a depression.
It was our reliance on asset bubbles to generate economic growth that caused the Great Recession of 2007. Therefore, to believe that we have truly overcome our problems we should have already weaned the economy from its addictions to debt, low interest rates and inflation. But nothing could be further from the truth.
Our central bank pushed down interest rates to one percent during 2002-2003 and that was the primary contributor to the creation of the housing bubble. Now the Fed has resorted to providing a zero percent overnight lending rate from December of 2008 until today. The monetary base has jumped from just $800 billion, before the start of the Great Recession, to $3.7 trillion-and it's still growing at a rate of one trillion dollars per annum. The money supply is back to the same growth rate as witnessed during previous bubbles. Our nation's debt is now at 107% of GDP and the aggregate debt now stands at 350% of our annual output-the same level as it was at the start of the Credit Crisis. Home prices are back rising at the same double digit clip as they were during the height of the real estate bubble and stock prices are up nearly 20% YOY on little or no earnings and revenue growth. And, keeping in line with our tradition of lending money to people who can't pay it back, subprime auto loans now make up 36% of all car financings.
Yet despite of all the above facts, most investors now believe our problems are behind us and interest rates can rise without causing a slowdown in growth. But if that were indeed the case, why is it that the Fed is still conflicted over whether or not the economy can withstand even a slight reduction in its $85 billion worth of monthly counterfeiting? It seems they are tacitly admitting that our GDP growth (anemic as it may be) is still contingent on the perpetual growth of asset bubbles, debt, low interest rates and money printing.
The truth is that the U.S. economy is more addicted to the artificial stimuli provided by government than during any other time in our nation's history. Aggregate debt levels, the size of the Fed's balance sheet, the amount of monthly credit creation and the low level of interest rates are all in record territory at the same time. This condition has caused the re-emergence of bond, stock and real estate bubbles all existing concurrently. If investors choose to believe this is an economy that is on a sustainable path they can do so at their own peril. Disappointingly, it is much more probable that the government has brought us out of the Great Recession only to set us up for the Greater Depression, which lies on the other side of interest rate normalization.
Gold mining shares are currently struggling under the weight of rising real interest rates. However, the steadily weakening economy should soon end the Fed's talk of reducing its asset purchases. If that is indeed the case the PM sector is getting set to make a significant and substantial advance.
After being bullish on equities for most of 2013, back on July 16th I warned that the U.S. stock market was due for a significant correction. Allow me to briefly expound on why another 10% selloff in the averages is highly likely from now until the end of October.
It was announced recently that the nation of Japan has finally produced the highest annualized rate of inflation that it has seen in the last five years (.7%). Therefore, it makes no sense that their 10-Year Note now offers the same yield as their inflation rate-especially given the fact that their government wants inflation to increase significantly from current levels.
No sane investor would loan money to a regime that has promised, and is delivering, a higher rate of inflation than what can be garnered from owning its debt going out ten years. This means the only buyer of JGBs at the current rate will be the BOJ (Bank of Japan). The sad truth is that Japan is very close to experiencing extreme chaos in its bond market and economy. This chaos will send shock waves throughout the globe. Investors should take heed.
Adding to the downward pressure coming from Japan is the chaos happening in emerging markets. Many of these formerly booming economies have recently suffered falling growth rates, equity market debacles, and currency collapses, which have gone virtually unnoticed by most of the developed world up to this point.
For example, the talk of Fed tapering its bond purchases has helped send the Rupee down 20% verse the USD; and the BSE (Bombay Stock Exchange) SENSEX down 10% in the last three months. Other countries such as Thailand, Turkey, Brazil, Indonesia, and the Philippines (just to name a few), have suffered the same fate or even worse. The U.S. markets cannot continue to ignore the carnage taking place in the emerging world for much longer.
Despite the recent move towards a peaceful resolution to the crisis in Syria, oil prices remain well above a hundred dollars a barrel. Consumers are already suffering from falling real incomes and a job market that mostly offers part-time work. Stubbornly high oil prices will crimp consumer spending and hurt GDP growth. Unless oil prices drop significantly in the near future, it would be improbable to expect corporations to meet earnings expectations under this scenario. Look for earnings and multiple contractions to be the result if oil prices remain elevated.
Political gridlock in Washington D.C. has to be resolved within the next 60 days. The debt ceiling must be raised and government agencies need to have funding authorized through a Continuing Resolution by mid-October, or the U.S. government will be effectively shut down. The last time this situation arose was the summer of 2011. During that time, the Dow Jones shed 2,000 points in just 30 days. It would be prudent to anticipate a similar result from another round of government gridlock.
Finally, the Fed still believes the size of its balance sheet determines interest rate levels. Therefore, it may start to gradually bring down the level of its monthly asset purchases toward zero beginning next month. However, the mere threat of tapering bond purchases has already caused long-term rates to spike over 100 basis points. The Fed doesn't believe tapering is tightening but the free market disagrees.
The 10-Year, which is now yielding 2.8%, has already contributed to causing business spending and home sales to fall. Durable goods dropped 7.3%, and capital spending fell 3.3% in July, while new home sales plunged 13.4% in the same month. A significant reduction in the Fed's asset purchases will send the benchmark 10-Year Note towards 4%, which should cause the economy to fall back into recession.
Investors must realize that any one of the factors listed above could send this over-valued stock market much lower and the odds are low that they all will be resolved innocuously. Nevertheless, Wall Street continues to promote the fantasy of a second-half economic rebound, and is currently pounding the table on stocks. In sharp contrast, I recommend going mostly into cash and owning physical gold and silver as insurance against the imminent turmoil and chaos which could take place in global markets in the near future.
While officials from the Federal Reserve gather recently in Jackson Hole Wyoming to bemoan that inflation isn't yet high enough for their liking, the truth is that inflation is already ravaging the middle class.
To prove my point, the government's official reading on core CPI inflation (one of the Fed's preferred metrics that removes food and energy prices) increased just 1.7% from July 2012. So, in the mind of those who control the value of our currency, inflation is well below their target of 2%; and therefore needs to be increased.
Nevertheless, let's try another, more real-world way of calculating the data. The labor department correctly judges that prices paid for shelter should be a significant proportion of the core CPI calculation (about a 40% weighting). According to the Labor Department, prices for shelter increased only 2.3% from July of last year. When the government uses such an incorrect assessment of home price appreciation it is then able to report only a slight increase in core inflation.
However, according to the National Association of Realtors, existing home prices surged 13.7% YOY. And new home prices jumped 8.5% YOY, according to the Commerce Department. If you include the increase in the other items in core CPI ex-housing (up 1.2% YOY) a more accurate measurement of core CPI can be achieved. Consumer prices would be up 5.1% from the year ago period--assuming you simply average the cost of purchasing a new with that of an existing home. In reality existing home purchases exceed the number of new home sales and would therefore increase the core rate reading. Of course, the difference between the government's data and what is collected from private sources is that the Bureau of Labor Statistics measures the imputed rental value of homes, instead of actual increases in what consumers have to pay for real estate.
A core rate of inflation that is rising north of 5% YOY should send shivers down the spines of those at the Fed and consumers alike. Amazingly though, Mr. Bernanke is still debating if a $3.6 trillion Fed balance sheet and the $85 billion worth of new credit creation each month is doing enough damage to the value of the dollar. The Fed's inflation is especially painful to the middle class due to the fact that real median incomes have fallen 6.1% since the start of the Great Recession, which began in December 2007.
Our economy is so addicted to money printing that the Fed can't agree on when, or even if, it should reduce the level of its asset purchases. Mr. Bernanke's confusion over monetary policy is evident despite the fact that he has built up a stock, bond and real estate bubble. This trifecta of asset bubbles exists concurrently for the first time in American history.
Our central bank will soon have to decide whether or not it will continue allowing these bubbles to grow to a more dangerous level (intractable inflation); or to start selling trillions of dollars worth of bonds and send interest rates soaring. We already have witnessed what a mere one percent increase in mortgage rates did to new home sales (down 13.4% in July, the lowest level in 9 months). This occurred without the Fed tapering its purchases of MBS and Treasuries by even one dollar. Just imagine what will happen to interest rates when the Fed not only stops buying that debt; but also starts unloading its balance sheet.
It seems apparent that we should prepare for fireworks in the bond, currency and equity markets across the globe in the very near future no matter what Mr. Bernanke decides to do. Therefore, it would be prudent to purchase portfolio insurance in the form of precious metals to help mitigate the fallout that is sure to come from massive central bank manipulations.
Wall Street and Washington love to spread fables that facilitate feelings of bliss among the investing public. For example, recall in 2005 when they inculcated to consumers the notion that home prices have never, and will never, fall on a national basis. We all know how that story turned out. Along with their belief that real estate prices couldn't fall, is one of their favorite conciliatory mantras that still exists today. Namely, that foreign investors have no choice but to perpetually support the U.S. debt market at any price and at any yield.
But, unlike what their mantra claims, the latest data show weakening demand in oversees purchases of Treasuries. According to the U.S. Treasury Department, there was a record $40.8 billion of net foreign selling of Treasuries in June. That was the fifth straight month of outflows in long-term U.S. securities. China and Japan accounted for $40 billion of those net Treasury sales. Those two nations are important because China is our largest foreign creditor ($1.27 trillion), and Japan is close with $1.08 trillion in holdings.
This shouldn't be a surprise to those who are able to accurately assess the ramifications from the Fed removing its massive bid for U.S. debt. In truth, yields currently do not at all reflect the credit, currency or inflation risks associated with owning Treasuries. If the Fed were not buying $45 billion each month of our government bonds, investors both foreign and domestic would require a much higher rate of return. Investors have to be concerned about the record $17 trillion government debt (107% of GDP), which is growing $750 billion this year alone. In addition, holders of U.S. debt must discount the inflation potential associated with a record $3.6 trillion Fed balance sheet, which is still growing at $85 billion each month. Also, foreign investors have to factor into their calculation the potential wealth-destroying effects of owning debt backed by a weakening U.S. dollar.
Of course, some people may claim that Japan has more debt outstanding as a percentage of its GDP than we do and yet the nation's interest rates are much lower than ours…so what's the problem? But, unlike the U.S., Japan has a long history of deflation and only 10% of its debt in foreign hands. The U.S. has not enjoyed any such history of deflation and is also a country that has only 50% of its debt held domestically. Therefore, there hasn't been any real concern about foreigners abandoning the Japanese bond market because of a fear that the yen may collapse. But the tremendous number of foreign U.S. creditors need to be constantly vigilant of the dollar's value. However, due to its foolish embracement of Abenomics, Japan will also have to fear a collapse of its debt market from rising inflation in the near future, just as we do in here.
If the free market were allowed to set interest rates and not held down by the promise of endless Fed manipulation, borrowing costs would be close to 7% on the Ten Year Note. Let's face it, the only reason why anyone would loan money to the U.S. government at these levels is because of a belief that our central bank would be there to consistently push prices up and yields down after their purchases were made.
Our central bank has now adopted an entirely new paradigm. Fed intervention used to be about small changes in the overnight interbank lending rate, which has averaged well above 5% for decades. However, not only has the Fed Funds rate been near zero percent for the last five years, but long term rates have been pushed lower by four iterations of QE. The latest version is record setting, open-ended and massive in nature. Since QE is mostly about lowering long-term rates, it shouldn't be hard to understand that its tapering would send rates soaring on the long end.
When the Fed stops buying Treasuries, foreign and domestic investors will do so as well. This means for a period of time there won't be any one left to buy Treasuries unless prices first plunge. The effects of rising rates will be profound on currencies, equity prices, real estate values and economies across the globe.
It would be wise to prepare your portfolio for a massive interest rate shock in the near future.
I generally shy away from making time-specific economic and stock market predictions simply because they are extremely difficult to accurately pinpoint. During 2006 I warned about a coming real estate collapse that would cause a severe recession in 2007. Back in January of 2009, I urged investors to start buying the stock market because I felt the majority of the selling was behind us. In general, making such predictions is a dangerous game and should be avoided in most cases because odds are very low you’ll be correct on both the prediction and the timing.
However, there are certain times when the environment is conducive for a prediction that comes along with an expiration date. Today is one of those times. Therefore, the following 3 reasons are why I believe the stock market and the economy could be in for some serious trouble by the end of October.
The fiscal dysfunction and discord in Washington comes to a head once again in late September and into October. There is an October 1st deadline for funding the government and a debt ceiling that needs to be raised around that same time. Such acrimony in D.C. has caused major disruptions in the stock market in the past. In the summer of 2011, Congress attempted to use the debt ceiling as leverage for deficit reduction. The delay in raising the debt ceiling led to the first ever downgrade in the U.S. government's credit rating. The Dow Jones Industrial Average dropped 2,000 points from July 7th to August 8th. And the very same day of Standard and Poor’s downgrade on August 5th, the DJIA had one of its worst days in history (down 635 points). There is a high probability of more such action over the next few weeks because the gridlock in D.C. has only become worse.
The Japanese stock bubble has been extremely volatile of late, as the nation sprints towards a bond and equity market crisis. The Nikkei Dow surged over 70% in less than 6 months on the back of Abenomics—an economic system that is predicated on raising taxes and creating inflation by destroying your currency. However, the benchmark index has since peaked in mid-may. The relatively new Abe regime has already been able to create inflation even after the Japanese economy witnessed years upon years of falling prices. The problem is, this new paradigm of perpetually rising prices must very soon be reflected by rising bond yields as well. The Japanese Ten-Year note is trading at 0.76% even though the nation now has accumulated over one quadrillion Yen in debt. The interest rate level is far below the 1.5% yield it displayed just prior to the Great Recession of 2008. It should be noted that the yield was twice as high as it is today, despite the fact that Japanese CPI was near zero percent. Nevertheless, we have recently viewed the YOY change in inflation rising from -0.9% in April, to +0.2% in July. At this current pace, the rate of inflation will be close to 1.0% within three months. This should cause a significant back up in yields and force the nation to use most of its revenue just to pay the interest on its debt; leading to extreme turmoil in Japanese equities. Depending on the response from the BOJ, investors may see a reversal of the Yen carry trade, which will also lead to extreme disruptions in currency values and equity exchanges worldwide. The tenuous situation in Japan is not currently being factored into global markets and is another shock that could hit the system within the next 90 days.
Perhaps most importantly, the start of Fed tapering in the fall will send U.S. Treasury prices lower and pop the bubbles that exist in stocks and home prices. I say bubbles in stock values because the S&P 500 is up 23% since last August, despite the fact that there hasn’t been any revenue growth to accompany that move. And home prices are up double digits YOY (the same growth rate seen at the height of the real estate bubble) primarily because interest rates have been artificially suppressed to record lows for the past 5 years. Money printing and interest rate manipulation are the reasons why we have re-ignited those two asset bubbles. Markets are currently extremely confused about when the tapering will commence and how much Mr. Bernanke will reduce his purchases of bonds. But who can blame investors for feeling this way? The Fed seems to swing between dovish and hawkish stances with every economic data point and the subsequent stock market reaction. However, I believe Bernanke wants to start unwinding his purchases before his tenure is completed this year. Wall Street is currently miscalculating how important the Fed’s bond purchases are to the continued bull market in equity and real estate. An extremely high percentage of investors either believe tapering won’t start this year; or believe if such a reduction of bond purchases occurs, the effect on asset prices and bond yields will be inconsequential. The truth is that the removal of the Fed’s bid for bonds could cause a stampede out of fixed income products and cause interest rates to soar. The free market wants no part of a U.S. Treasuries at current yields unless investors can be sure that the Fed will continue to be the dominant buyer. A spike in bond yields would put more pressure on the real estate sector, which has already witnessed increased order cancellations for new homes and a 30% hit to the stock prices of home builders since the tapering talk began in May. And without $85 billion worth of newly created credit stuffed into banks’ coffers each month, a significant bid in the stock market will be removed as well. Of course, I have to mention the government’s fiscal duress that will come from ballooning deficits caused by increased debt service payments on U.S. debt. Whether or not the bond market crashes before November cannot be known for certain. Nevertheless, the bond market will eventually collapse with devastating consequences whenever it does occur.
Although there are no guarantees in this game of investing, I find it imperative to understand that the odds of a correction in the magnitude of around 20% for the major averages have greatly increased during the next three months. The economic turmoil resulting from any one of the above scenarios should bring central banks around the globe into a new money printing spree that would dwarf anything investors have seen to date.
Each of the last five years Wall Street pundits have predicted, and our government has promised, that a second half recovery in the economy will occur. Since 2009, they have come up with different reasons why GDP would boom in Q3 & Q4 of that year; and that this time a different and better outcome is in store. This year, the reason we are supposed to believe in a second half recovery is because the damage from the Sequester cuts will wear off starting in…drum roll…July.
But the truth is there hasn’t been any significant damage to the economy from the Sequester. This is because cutting government spending leaves more money in the hands of the private sector. Also, the Fed has continued to pump $85 billion into the economy even though there has been a small contraction in the deficit. So there hasn’t been any drag on GDP from which we will rebound. However, what is news is that there has been a surge in bond yields and oil prices, which will crimp consumers’ ability to spend. But those cheerleaders choose to ignore these facts.
The release of the NFP report for July is already dashing hope of a second-half rebound. There were only 162k jobs created last month. What’s worse is that more people left the workforce, aggregate hours worked fell and average hourly earnings declined. These aren’t numbers that would even hint that the economy was going to rebound from the pitiful 1.4% growth rate experienced in the first six months of this year.
Of course, the answer we get from government is to do more of the same thing that isn’t working. More debt, more money printing and a further extension of asset bubbles are the solutions they provide. It doesn’t matter that five years of zero percent interest rates and QE have failed to spur real growth. Their prescription only leads to a zombie economy that limps along because it is based on creating consumption through rising equity and home prices and not through sustainable income growth.
The strategy deployed by government prevents the economy from undergoing a genuine healing. Deflation (which has now become the archenemy of the Fed) is the real solution. We must allow our total debt—which stands at 350% of GDP—to contract to a more sustainable level (somewhere well below 200% of our economy). In order to bring aggregate debt levels down to size, we must first let the free market set interest rates, shrink the money supply and allow asset prices to fall.
This would bring about real and lasting growth because it would not only ameliorate our debt burden but also; stabilize the dollar, keep interest rates low, reduce our tax burden, and eliminate the threat of runaway inflation. Those conditions are the only real progenitors of a healthy economy.
Unfortunately, since this real solution would also include a short but nasty depression, politicians won’t allow it to occur. Instead, our government and Fed would rather continue to promulgate, to a Wall Street community that is more than willing to believe, that a recovery in GDP is just around the corner. And that it would be foolish to stop borrowing and printing money now that growth (in their opinion) is about to achieve “escape velocity”—whatever that means.
More debt and more inflation are constantly being shoved down our throats without our consent. Nevertheless, the market always trumps government interventions…and eventually it will eschew our debt and currency. This means investors must protect themselves by owning PMs from the inevitable economic chaos that is sure to come soon.
As someone who cheers for the success of this great country, I desperately want to believe in the concept of America’s energy independence. In the past decade we have been inundated with predictions of the U.S. becoming the next Saudi Arabia of oil and natural gas production. Fracking, tar sands, shale gas…et al, are supposed to bring about a manufacturing renaissance and trade surplus in the near future. But, as of now there isn’t much evidence we are headed in that direction.
It is true that the U.S. is importing much less oil than in the past. During 2005 we imported 60% of our oil consumption--that dropped to just 40% last year. The fact is we are producing more oil and natural gas--so why aren’t we enjoying any of those real benefits?
Natural gas prices have plunged from the low double digits in 2008, to $3.5/mcf currently; most of which was caused by the overwhelming belief that we would be suffocating in natural gas by now. However, prices bottomed 18 months ago and now seem to be headed higher. Conversely, in the case of oil, prices have been rising over the past four years from below $60, to over $105 per barrel today. Therefore, so far at best it’s been a mixed picture on seeing reduced energy prices from the oil and gas revolution we were promised.
But has the increased energy production boosted our manufacturing sector or helped with our balance of payments deficit? The short answer is no. Manufacturing as a percentage of GDP was 11.9 for last year. That figure is down from 12.1% during 2007. And, most importantly, there was an average of 13,879,000 persons employed in the manufacturing sector during 2007. The average number of persons employed in this sector by 2012 plummeted to just 11,919,000. This trend is continuing, with the U.S. losing 52k manufacturing jobs Y.O.Y. from June 2013. It’s simply hard to come up with a story about a domestic manufacturing renaissance when we lost nearly 2mm jobs in just the last five years. Also, there hasn’t been any significant improvement in our trade deficit since the Great Recession ended. The downturn in the economy and global trade occurred in the summer of 2009. The U.S. trade deficit was $32 billion in July of 2009; it has slowly climbed back to over $45 billion in May of this year.
It is my hope that our increased energy production will lead to: low natural gas prices that are sustained; much lower oil prices from where they are today; a boom in manufacturing jobs, and a trade surplus in the near future. Nevertheless, we don’t seem to be headed in that direction at this time. Perhaps the best explanation for this is that a revival of the goods-producing sector of the U.S. economy requires much more than just an increase in domestic energy production. If we don’t also reform our tax structure, reduce regulations, lower labor costs, boost the educational system, stabilize interest rates and strengthen our nation’s balance sheet it won’t fix the problem…even if we had all the energy production in the world.
A major determinant for U.S. GDP growth is the state of the real estate sector. The construction of new homes contains only small section of the total picture. New appliance purchases and home furnishings go hand in hand with all the ancillary employment surrounding the housing market. Real Estate brokers, banking and legal functions are all necessary to support the buying and selling of new and existing houses. Most importantly, rising real estate prices increase the net worth of consumers, which in turn boosts credit creation, consumption and economic activity. These points were overlooked back in 2007; and the major reason why nearly everyone on Wall Street and in Washington was blindsided by from the fallout of collapsing real estate prices.
The real estate debacle was the cause of the Great Recession and it is also now being credited for bringing it to an end. But the lynchpin behind this economic recovery has been the government’s ability to increase home prices through the process of artificially creating record-low interest rates and by having the Fed purchase impaired loans from banks’ balance sheets.
However, this ersatz and temporary recovery is now running into trouble.
The affordability of homes once caused by plunging prices and record low borrowing costs caused investors to flock into the housing sector. According to the Case-Shiller Home Price Index, real estate prices dropped 35% from peak to trough. Speculators scooped up foreclosed properties that were being dumped on the market without much regard to price. Private Equity firms and hedge funds purchased properties mostly with cash; and whatever extra money they desired to borrow came nearly for free.
Those days have now past.
Home prices had been plummeting up until 2009, but then started to stabilize during 2010. However, now they have returned to their growth rates experienced during the bubble era of 2000-2006. The National Association of Realtors reported that median existing home prices increased 13.5% from June of last year. What’s more, formerly plunging bond yields have also started to increase. Freddie Mac reported that rates on thirty-year fixed mortgages have soared nearly 35% since early May.
Perhaps this is why the NAR reported last week that investor purchases made up only 15% of June sales, which is the lowest percentage since the realty association began tracking the data in 2008.
Investors are now saturated with foreclosed properties and much of the easy money has been made. So it is up to first-time home buyers to take up the slack. However, with real median incomes rising just 1.1% YOY (far below the increase in home prices) there isn’t much hope for individual consumers to supplant the hedge fund community…especially since first-time home buyers cannot pay cash and will be required to meet the now tightened lending standards of banks.
What’s more, a recent report from the Special Inspector General of the Troubled Asset Relief Program indicated that 46% of distressed home owners that received loan modifications from the government during 2009 had re-defaulted. Therefore, expect hundreds of thousands of foreclosed properties to hit the market in the near future. Perhaps the increased inventory and rising mortgage rates will bring down prices and eventually cause speculators to jump back into the picture. Nevertheless, this probably won’t occur until property values decline significantly first.
Evidence of this slowdown can already be found in the earnings reports of major home builders. PulteGroup reported that rising borrowing cost have already started to hurt sales. The largest U.S. home builder by market value reported that orders decreased 12% for the second quarter.
Back in 2009, plunging mortgage rates and home prices allowed the real estate market to bottom. In contrast, we now have rising borrowing costs, soaring homing prices and little income growth. Those factors are all working against the affordability of real estate.
It is also important to understand that rising interest rates are not affiliated with a surge in economic growth. The Bernanke Fed has recently indicated that a reduction in MBS and Treasury purchases may occur in the next few months, causing investors to fear the eventual removal of the Fed’s bid on fixed income. If such tapering occurs, the rate on the thirty-year fixed mortgage could go north of 6% in very short order.
Soaring mortgage rates will cause the housing market to undergo another leg down. Of course, the economy will go along for the ride and a severe recession will ensue. Once the Fed realizes how addicted the real estate market and the economy are to artificially-low interest rates, it will end the tapering of QE and dramatically increase the allotment of monthly purchase. I expect a significant increase in hard assets and a protracted bull market in PMs once the central bank makes the proclamation that the size of its balance sheet is without limit.
The S&P 500 is trading at all-time nominal high, despite the fact that revenue growth has been hard to come by. So, where is the U.S. economy headed and what does it mean for earnings and equity prices?
The U.S. Ten-Year Note yield has been rising of late. Absent another recession, or renewed European debt crisis that threatens the existence of the Euro currency, or the Fed launching QEV; the yield should approach 4% by the end of this year. How much should we be concerned about yields rising to that level? Well, the surge in yields from 1.6%, to 2.6% since the beginning of May has already caused purchase applications for new homes to plunge 28% month over month. Mr. Bernanke predicated the economy's healing on saving the real estate market. Since the Fed is now threatening to begin removing its stimulus programs, that primary support column for the economy is being eliminated
One has to question what rising rates will do for this so called recovery. The U.S. economy (and indeed the rest of the globe as well) is already suffering from anemic growth. Now we are told by the puppet masters of the economy that the manipulation of long-term interest rates is finally going to end. Or at least that's the plan; until those in charge realize how addicted the economy has become to artificially low rates.
There's plenty of evidence that the global economy is just treading water. Base metal prices have fallen sharply in the last six months. Chinese exports were down 3.1% in June on a YOY basis, while exports to Europe plunged 8.3%. The IMF lowered its growth forecast for the U.S. to just 1.7% in 2013. And the European recession is deepening (unemployment rising to 12.2%) with Greek unemployment hitting a record 26.8%. Emerging market economies are suffering, while Japan is headed towards a complete collapse of its currency and bond market. And, U.S. GDP growth in Q2 should be close to zero, which will be down from the already anemic growth rate of just 1.8% during Q1.
So, where do we go from here? Now we have to add to this global malaise; the surge in oil prices, Middle East revolutions, an attempt at ending QE, and most importantly, rising borrowing costs in the United States. But yields aren't just rising in the United States. For example, the Portuguese 10 Year Note jumped from 5.2% in the middle of May, to 7.5 by early July%.
The rise in debt service payments and cost of money will cause the already fragile global economy to fall sharply lower. Revenue and Earnings growth will suffer as a consequence. Look for a correction of at least 10% in the S&P 500 by the end of this summer.
To best answer the question as to where U.S. Treasury yields are headed in the next quarter or two, it is important to know where they would be without the manipulation of our central bank, where they would be in a growing economy and, also, absent the threat from an imminent collapse of a major foreign currency. The current yield on the Ten-Year Note is 2.6%, up from 1.6% less than two months ago. True, that rate has surged of late but it is still far below its 40-year average of around 7%. But just prior to the beginning of the Great Recession (in fall of 2007) the yield on the Ten-Year Note was 4%--150 basis points higher than today.
And in the spring of 2010; a year after the recession ended, the conclusion of QEI and prior to the Greek bailout, the Ten-Year posted a yield of 3.8%. Therefore, it isn’t at all a stretch to anticipate yields going back toward 4% in the very near future--If indeed it is true that we are not currently in a recession, the Fed will soon start to winding down QE and there is no mass piling into Treasuries from a collapsing foreign currency.
What’s more, the Fed now holds over $3.5 trillion worth of securities on its balance sheet, $1.9 trillion of which are U.S. Treasuries. That compares with just $800 billion at the start of 2008. This means if the market now believes the Fed has started down the path of eventually unwinding its balance sheet the selling pressure will be immensely magnified as compared to several years ago. In addition, due to banking distress in China and a back up in yields in Japan, these sovereign governments may not be able to support Treasury prices to the same extent as they did in the past. These two nations already own $2.3 trillion of the current outstanding $11.9 trillion worth of Treasury debt.
Meanwhile, the Fed persists in sophomoric fashion to scold the market for misinterpreting its mixed messages about tapering the amount of asset purchases. But the big surprise for Mr. Bernanke and co. will be the realization that they have much less control of long term rates than they now believe.
I’ve been on record warning that once the market perceives the exit for QE is near, yields will rise. Nevertheless, expect most on Wall Street to claim the increase in rates has its basis in a growing economy and, therefore, represents good news for markets. But the true fallout from interest rate normalization will not be pretty; for it will reveal a banking system and an economy that is perilously close to insolvency.
I have warned investors in the past that the Fed’s rapid expansion of credit would cause the U.S. economy to enter a period of unprecedented volatility between inflation and deflation. This would lead to violent moves in most markets, especially interest rate sensitive investments. That time has now arrived.
The easy monetary policy from most central banks has led to low interest rate addictions and global imbalances on a massive scale. Therefore, any threatened removal of central banks’ liquidity would cause the pendulum to swing intensely from inflation to deflation. Recent communications from the People’s Bank of China and Fed (although a parade of FOMC members has been trying to recant Bernanke’s comments) have tried to wean the market’s dependency on free money.
The problem is markets have become so addicted to low interest rates and liquidity injections that even a hint at preparing markets for the eventual increase of rates caused massive repercussions. Perhaps that is the message plunging commodity prices have been telling us.
In China, the threat of withdrawing stimulus caused their interbank lending rate (SHIPOR) to spike from 3%, to over 10% within a week. This tells us Chinese real estate assets are in such distress that banks do not trust each other’s collateral when making overnight loans. Sort of reminds you of our LIBOR market debacle the U.S. suffered through back in 2008 before the S&P 500 plunged 60%. The manipulation of money supply and investments by the Chinese government caused runaway inflation in their housing sector. Now, the attempt at normalization in the real estate market by the new Xi Jinping regime has revealed its insolvent condition and helped send the Shanghai Stock Market down 15% in the last month.
Some countries have just begun the pursuit of record-breaking inflation. In Japan, the Abe regime is not pursing policies that promote viable economic growth; but has instead based a recovery on currency destruction and inflation. Europe has already aggressively tried the growth model that is based on deficit spending and inflation. And by all accounts their problems continue to mount, with Ireland falling back into a recession; just as Italy’s recession protracts and deepens. Emerging markets continue to suffer slow growth. The Emerging Market Index, which is down 16% YTD alone, shows the condition is only getting worse. These countries depend on supplying materials to the developed world for growth. However, as these established economies suffer through the devastating effects from massive inflation and deflation, demand for imports suffers greatly.
But the Fed seems convinced that the U.S. economy is strong enough to withstand the negative effects from a global economic malaise. Despite the chaos that is brewing all over the globe, Ben Bernanke still provided the markets with a timeline for ending his QE program and predicted the economy will magically recover in 2014. If that is indeed the case, it will be the first accurate forecast made since the Federal Reserve was created in 1913.
Why should the U.S. economy strengthen next year? It wouldn’t come from strong exports to a vibrant global economy. There hasn’t been any reduction in taxes or regulations and the dollar has become very unstable. And, most importantly, it appears the thirty-year bull market in Treasuries has ended quite abruptly. The yield on the Ten-Year Note soared from 1.6%, to 2.67% in a matter of days. The Fed seems oblivious to the fact that markets have become completely reliant on perpetual inflation; and merely indicating the intention of stopping to manipulate interest rates causes a violent move upward.
Despite all this, I believe the Fed has realized QE can’t go on forever and is desperate to start winding it down. However, I am even more convinced the U.S. economy will dramatically slow this summer (from an already anemic 1.8% growth rate) and cause a reluctant Ben Bernanke to hold any tapering of asset purchase in abeyance. In fact, he may even increase the current monthly $85 billion allotment.
This means, unfortunately, investors and consumers will suffer yet more violent moves between inflation and deflation in the future. Gold miners are now in the process of putting in a bottom and telegraphing the fact that in the near future central bankers will acknowledge their addictions to low interest rates and credit creation; and probably print even more.
The incredibly confused Fed is desperately trying to maintain its unprecedented control over the most important price signal in our economy, which is the level of interest rates. But it is failing. Mr. Bernanke not only doesn’t control long-term interest rates (as he now believes) but he is also unaware that the economy has become completely addicted to Fed’s level of credit creation and its ability to create asset bubbles.
Some on the Fed contend inflation is too low, while others want to begin tapering immediately.
From the Fed’s Statement released last week: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”
Mr. Bernanke also stated that if the economic conditions continue to improve, the Fed would begin tapering QE in the fall and could terminate the program by mid-2014. However, that very same day, the Federal Reserve also trimmed its growth forecast for 2013 and slashed its inflation outlook…going against both its mandates!
The economy is now expected to grow at an annual rate of 2.3-2.6 percent, slightly below the 2.8 percent top-end growth previously forecast. It also projected inflation would come in between 0.8-1.2 percent in 2013, instead of 1.3-1.7 percent seen in March. Keep in mind, Mr. Bernanke thought inflation and growth were so anemic only six months ago that the he started buying $85 billion worth per month of unsterilized MBS and Treasuries. And now he wants to start taking all that QE away, even though he has simultaneously downgraded the outlook for growth and inflation.
Bernanke is completely confused; but markets are not. The yield on Ten-Year soared to 2.67% by Monday.
The aggressive tapering laid out by the Fed would crush bonds, real estate, equities and the economy because the $54 trillion in total U.S. debt cannot be easily serviced without perpetually low interest rates. Investors should now be laser focused on future economic news. Unless the data is profoundly weak, the Fed’s taper will begin on schedule in the fall. I believe Mr. Bernanke wants to leave at year’s end and is now working on his legacy. Bernanke wants to say he started to reverse his unprecedented stimulus and returned the economy on a path towards free markets. But our central bank would not be tapering into strong economic growth, as they would like you to believe, but instead because of the fear that Fed has simply gone too far.
Bernanke may be making a tacit admission that five year’s worth of interest rate manipulation and credit creation has done all it is able to do for the economy and the size of the Fed’s balance sheet has become too daunting.
Investors need to be on red alert and get defensive until the data turn decidedly negative. Expect violent moves between deflation and inflation going forward. When the next recession looms (perhaps in early 2014) the Fed will announce the tapering strategy has been put on ice and the rebuilding of the Fed’s balance sheet has recommenced. Asset bubble blowing will once again become in vogue and the markets can start to celebrate the re-inflation of equity prices. However, the middle class will once again suffer, as they witness their purchasing power and standard of living further erode.
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.