In the last two full weeks of September, a significant breakout occurred in the currency markets. Throughout the entire summer, I have been pounding the table, expecting a Japanese Yen breakout on the upside. This was a topic of discussion on my trip to France, as my esteemed host thought a Yen rise would be so dire, that the Bank of Japan would never permit it. I countered that the BOJ was helpless to hold back the tide, and a 20% Yen rise was coming. I expect a painful blow to the US economy, which is suffering from serious imbalances and dependence problems. Following a G7 Meeting in Dubai which concluded on Sept 20th, feces hit the FOREX fan. Calmly delivered exit communiqués trailed contentious internal debate. Finance ministers intend to allow the USDollar to find its freely floating value without interference. What is clear to all experienced hands is that Asians will no longer bear the brunt of responsibility (and enormous expense) of defending the USDollar. They will manage the dollar decline now, rather than prevent that decline. Implications of the Yen rise are being widely misread and misinterpreted as a positive event; they signal severe risk and damage. For every benefit (mainly for multi-national firms) there are 20 big harmful systemic effects (import prices). The US and Japanese central banks are losing control of free markets. The monster at the back door: imported price inflation and higher interest rates, with no repair to pricing power.
Phase #1 of the currency market correction process was totally ineffective. The last 18 months accomplished absolutely nothing in the way of remedy. No trade imbalance of substance exists between the USA and the European Union, yet this initial completed phase was marked by a 30% appreciation in the euro versus the USDollar. The USA endures a truly monstrous trade gap with Asia, yet adjustments to all Asian currencies have been resisted. In fact, the word "monstrous" could be substituted with colossal, significant, spectacular, and in reality serve to minimize the situation. No effect whatsoever was realized on reducing the size of the US trade gap with Asia.
Phase #2 is when the real damage is done, when severely harmful effects are felt inside the US Economy, when the press & media are awakened from slumber, when the public outcry for government action is called for, when job loss accelerates, and when dim-witted (but politically favorable) official financial and executive decisions are made. In this more dangerous phase, watch for the USDollar and USTBonds to decline together, unlike in the initial phase. The dragon is at the back door, but few have noticed.
The primary characteristics of the damaging phase #2 will be many :
My constant refrain has been and continues to be: the level of economic understanding, policy, and counsel is so abysmal that a galloping recession (or worse) is the most probable scenario, accompanied by price inflation in certain sectors. This country does not admit its errors. It does not detect nor correct its errors. Instead, it compounds its errors by more serious errors. We have no understanding of money or inflation or currency. We regard money much the same as water in pipes to irrigate a field, rather than the output of a day's work. Hence, our fields are flooded, and we urge more water to be delivered. The costs and consequences of many years of ineptitude, speculation, fraud, and political sellouts are soon to demand correction by the powerful free markets, which are more powerful than any set of governments. Reconciliation is overdue.
All signals so far point to more counter-productive policy, high-level desperation, and fruitless responsive action. Here is precisely where politics will interfere with remedy. The last two years have aggravated all imbalances and excesses, have not corrected them, and certainly have not laid the foundation for any economic recovery. We now are seeing the beginning of public outcry. Calls for China trade tariffs and industry protection make for one signal. Calls for rollback of federal tax cuts make for another. Escalation of war costs, together with preservation of prescription drug coverage closes the issue on the direction in fiscal distress relief. All these outcries will result in more mistakes in economic policy, since politics universally makes for bad economics.
Dire effects resulting from Asian currency appreciation run the gamut from imported product price inflation, reduced Asian willingness to fund our credit markets, central bank hedging of their Asian reserves, unwinding of a decade-long Yen carry trade, culminating in higher long-term interest rates. The timing should coordinate in close proximity the arrival of delayed price inflation, structurally lagged behind the reckless monetary expansion perpetrated by the US Federal Reserve. The Federal Reserve has misled bond speculators on their intention to monetize purchases of long-dated govt bonds. But Greenspasm has done even worse, by misrepresenting the inflation versus deflation situation. We are suffering the engrained structural consequences of perennial monetary expansion (inflation) policies over decades of abuse. Price deflation is now a structural problem, which cannot be treated by his available monetary mechanisms. The newly constructed bond bubbles are most visible in residential real estate, and most vulnerable in mortgage bonds. Their dissipation will hurt the economy.
We have the confluence of reactive effects simultaneously emerging. The bond bubbles have begun to give off gas, pricked by their chief architect Chairman Greenspasm himself. The European economy is fighting recession. Stock valuations have returned to nosebleed levels not seen since early 2000, driven in part by a five-fold increase in margin debt. And finally, the Asians now throw in the towel on playing the role of "bag holder" in the currency markets. The most likely new role for Asian Central Banks is to manage the long overdue appreciation of their currencies, which is supported by all fundamentals, and has been resisted for several quarters in true mercantile fashion, but to no avail and great expense. Meanwhile, Asians are left holding a significant amount of USTBonds. Perhaps Asian Central Banks could be convinced to trade a large portion of their horde in exchange for the entire state of bankrupt California.
The confluence of effects will be most felt with profitless price pressures and long-term interest rates. Unprecedented and inevitably destructive systemic price inflation is soon due to emerge from the monetary pipeline, which the press & media are fast asleep in recognizing. Inept messages from mainstream economists have been written on billboards, proclaiming that some inflation will offset the persistent decline in prices. Nothing could be further from the truth. Upward pressures will be seen in costs, while downward pressures will continue on pricing power. By early 2004, the US Economy will be the only industrialized economy in the world to be suffering from price inflation, rising rates, and job loss. The forces acting upon our economy will be both internal and external. Govt policy and central bank policy have been rendered ineffective, futile, and toothless.
Once again, the press & media, together with certain economist corners, are anticipating a repeat of phase #1. For the last 18 months, every time the USDollar faltered, our USTBonds enjoyed a rally to produce lower interest rates. That support was provided by the Bank of Japan. In phase #2, Asian support will not be as strong at first, then vanish altogether. They will be diversifying away from dollar-denominated reserves, as rising rates and rising Asian currencies deliver a double whammy to their reserves. They will not work to prevent the Yen appreciation. Instead, they will work to hedge against its damaging effects. Confusion is already evident during interviews of supposed experts. They expect the same pattern to continue, despite a change in the structural forces. Bonds will see a brief assist initially, providing a double-top in the USTBond.
CNBC does have on retainer two smart people. They have weighed in on the currency issue. Art Cashin said last week "since 46% of US Treasurys are owned by Asians, we may see interest rates rise, despite what the Fed tries to do." Also, Rick Santelli from the bond pits in Chicago suspects that "the falling dollar might throw a monkey wrench into the economic recovery." I have found both to be highly proficient over the years. My personal opinion is stated all through this document. I expect liberal numbnut economists to receive an education in Economics 501, an advanced course. However, I expect them to sleep through the lectures, then blame their low grades on politics.
In sharp contrast, expect moronic cheerleading by intelligent people like Robert Hormatz of Goldman Sachs. He should know better than to claim during a CNBC interview that three benefits come from the rising Yen :
Given that US manufacturers are $90 billion behind Japan in net trade, $120 billion behind China in net trade, and around $60-70 billion behind the rest of Asia in net trade, the real story is higher import prices rather than a rescue of uncompetitive American mfg. Excuse me, but what the hell does this country build for export anyway? We have largely abandoned and forfeited our mfg base to Asia. The pain of higher Asian currency exchange rates will be 10-20 times greater than the benefit. Hormatz should be ashamed of his salesman motivations. He further embarrassed himself by saying that our exporters will benefit, provided Asian economies assist by lowering their interest rates. How does Japan lower rates that lie in the half of one percent range? Lastly, exactly how do rising energy, commodity, and import prices offset price deflation stemming from bankruptcies, liquidations, and debt default. Diminished pricing power is the end result, as China embodies the boot heel on the neck of US mfrs. We have rising production costs and household costs, amidst nearly nonexistent pricing power. Corporate profit margins and discretionary household budgets will each suffer. Let me not mince words. Hormatz stands as the epitome of economic stupidity (or political sellout) coming from an intelligent American icon. He perceives inflation as a commodity without location. Other analysts unfortunately share this incorrect kindergarten view of inflation.
Numerous characteristics will be manifested in the dangerous phase #2. They follow.
A) IMPORTED ASIAN PRODUCT PRICE INFLATION EFFECT
Since the middle of year 2001, the USDollar has topped out, rolled over, and descended with noticeable momentum. The chief defenders of the world reserve currency have clearly been the Asians, in particular the Bank of Japan. They reported recently having pissed into the wind over $70 billion in this calendar year, a quixotic exercise to resist a truly monstrous river (trade surplus) current. The cost has grown with each passing intervention episode. Japan has chosen to prolong their primitive mercantile approach to manage an economy, in an absurd display to preserve their export business with the United States. The list of Asian foreign dependences is vast, including capital (for supply of federal, mortgage, corporate credit), manufacturing (for supply of consumer electronics, cars, computer equipment, industrial components), and for currency intervention rescues (to prevent the Yen from its certain rise).
The Yen has broken out of its range, bound for many months between 115 and 120. Implications are huge.
Next up on the FOREX dance floor is for the Japanese yen, sporting a face lift in the eyes of many, but suffering from a heavy handed father at the Bank of Japan. Its annual $90 billion trade surplus versus the US Economy creates a capital flow too large to overcome. In a matter of weeks or months, a rise in the yen relative to the USDollar is inevitable. . .
The Japanese Nikkei stock index has moved strongly upward, breaking a longterm downtrend. First their bonds fall, then their stocks rise, next their currency rises. Note the clear longterm "head & shoulders" bullish pattern in the yen currency, a very reliable pattern in its weekly chart. Note also the nearterm "ascending triangle" bullish pattern in the same chart, which appears to be in a tough struggle for resolution. The Bank of Japan is in the fight of its life. . .
The list of Japanese brands selling into our economy reads like a "to-do list" before a long vacation or a house sale. Sony, Kenwood, JVC, Hitachi, NEC, Sanyo, Canon, Ricoh, Kyocera, Nikon, Fuji, Komatsu, Toyota, Nissan, Honda, Mutsubishi, Bridgestone, and more. A rise in the Yen will first see Japanese exporters scramble to eat profit margins, for the purpose of preserving market share and distribution contracts. After they tire of kicking each other in the shins, they will allow the inevitable price increases in stores, showrooms, and supply chains. Now, it will be incumbent upon exporters to employ the necessary survival tactic, currency hedging on forward contract sales. Alert American consumers will mark time for higher prices on Japanese imported products. This road has no detour, only delay. The Consumer Price Inflation index was designed to take advantage of falling import product prices. A Herculean effort will be required by the USGovt statisticians to put a pretty face on this index, as it rises. Expect steady erosion in the Treasury market.
Currency experts anticipate the Bank of Japan will now manage the Yen appreciation, rather than stubbornly prevent it. So where is the next most likely exchange level range? The multi-year chart indicates the Yen will find resistance at 92-93 and continue long-term until it hits parity at 100. In dollar terms, this means 107.5 to 108.5, then eventually parity. I propose the next managed range will be 101-106, but only after some volatility at and near the next resistance level. The Yen is above 90 at the time of this writing. Americans have remarkably little knowledge of currencies, their behavior, trends, and tendency to run well beyond what is considered rational. We build carry trades, but tend to overlook the enormity of their reversals. For over ten years, the Yen carry trade made for brisk financial commerce, as USTBonds and S&P stocks were direct beneficiaries. I now expect the Yen to be the beneficiary, and our dollar & bonds to suffer. Not only trade surplus, but unwinding of Yen short positions will power the Japanese currency much higher.
Leading players in defending Asian currencies have been Japan, China, Taiwan, Korea, and Hong Kong. It has been long believed that when one leader breaks ranks with the pack, that other currencies would soon follow suit and allow appreciation. China operates off a currency regime, enforced in a Yuan pegged at 8.3 to the USDollar. If they were to repeg 10-20% upward, other Asians would follow. However, it took a G7 Meeting of finance ministers, and the power of the FOREX to shatter the great wall of their defended currencies. In just a matter of time, most Asian currencies will also begin the upward revaluation process, including the critically important Chinese Yuan. They will operate off a plan which dictates minimal disruption to their own continent and its commerce. If the Yen alone is to rise, and no others follow, then massive adjustments will be forced upon the eastern continent. Given that the Chinese have such a large trade surplus with Japan, we are likely to see continued pressure on the Yen before other Asian currencies follow suit. Most major Asian exporters have to some extent, or soon will, hedge by using the only major fully liquid FOREX vehicle, the Japanese Yen. For this reason, the Asian Central Banks will most likely act together in concert as they manage their individual currencies higher.
In a most amazing field trip in mid-September, Treasury Secy Snow traveled to China for the expressed purpose of requesting that Chinese leaders raise the prices on their entire portfolio of exported products to the Untied States. Inept economists and workers alike harbor some deranged notion that a higher Yuan exchange rate will both reduce our bilateral trade gap and restore jobs. No such thing will occur. Instead, the trade gap will increase, even as imported products rise in price, signaling the arrival on price inflation. Over two decades of monetary inflation has been exported to Asia, which has paid for our federal deficits and trade gaps. The end result is that they now own significant portions of our entire debt structure. More importantly though, with the end of the USTBond bubble and the end of the Asian Central Bank defense of the highly overvalued USDollar, we have entered phase #2. We next import inflation. The rise of Asian imported product prices marks the beginning of the reversal of that monetary inflation export.
B) RISKS DUE TO ASIAN DEPENDENCE UPON CAPITAL AND MFG
Since 1980, the US business executives have made conscious decisions to pursue lower cost labor. They have dispatched manufacturing operations to Asia. They have made massive commitments to Asia for new mfg plant and equipment. They have largely abandoned our homeland. Yet instead of being called un-American, they are praised by share holders, whose interest conflicts with the labor force. "Jobless recovery" is a betrayal to our nation and its workers. Plenty of jobs are being created by US firms. The majority of them require speaking Chinese, Japanese, or Korean, and maintaining residence in those countries. This trend shows no signs of changing. If anything, China and India are accelerating their job creation, as they become international workshops and service centers. The outflow of a wider array of white-collar jobs is now the newer trend, including accounting, software development, legal services, and more.
The end result of this disastrous practice has been two-fold. The United States depends heavily upon Asia for finished products, component supplies, and other mfr'ed items. The practice is so complete, that many car engines are made in Japan, shipped to Detroit, and installed during the assembly line process. However, neither General Motors nor Ford can turn a profit. Import product brand names cover the spectrum, from consumer electronics to computer equipment to photocopiers to cell phones to cameras to construction machinery to cars to tires. The list does not end there. A more complete list of imports must include contracted mfg under private label through outsourced vendors. For instance, your Verizon or Nokia cellphone is made in Japan or Korea or Taiwan, without clues on the label. When with a friend checking PC's for his new "college boy" son, I had an opportunity to verify that monitors were made in Korea or China. I checked the serial ID tag in back for the country of origin. Peter Lynch would be proud of me.
The other crucial dependence is for Asian capital. In the 1970 decade, the USA coerced recycling of OPEC petro surpluses into USTBonds. That practice was met with huge losses within just a few years. In the 1980 and 1990 decades, Asian trade surpluses have been recycled into USTBonds, GSE agency debt, US corporate debt, and elsewhere. We as a nation here in the United States now find ourselves requiring $3 billion per day in foreign capital in order to maintain federal govt operations, and to make payments on the trade accounts. In addition, the US requires substantial additional capital for the residential real estate mortgage finance bubble. The recycle of Asian trade surplus into our credit markets does not negate the trade gap; it instead creates two unsolvable problems.
C) ASIAN CENTRAL BANK RESERVE HEDGING RESPONSE
So far, the Asians have kept their currencies debased to sufficient levels so as to avoid serious losses to recycled portfolios. USTBonds held in reserve have actually risen in value during this Fed-inspired bond bubble. The US Economy has slowed, inviting a natural shift in investment funds from stocks into bonds. Speculative fever has been orchestrated by the Greenspasm, who has implicitly guaranteed an unimpeded path to speculative profiteering. However, the effective cost to Japan has been severe. Over the years of the entire Japanese banking system and real estate sector have failed to recover in health. Their economy has been hollowed out of its mfg capacity. China has not only enjoyed large-scale mfg expansion, but has benefited from Japanese migration to off-shore sites in China.
Asian Central Banks soak up almost all surplus USDollars from their commercial banks, thereby absorbing the currency risk on a systemic basis. Unfortunately, their individual economies must now share that risk incurred. Asian Central Bank reserve holdings represent the lion's share of USTBonds held outside our shores. In the last two years, Asians have moved from purchasing 45% of new US Treasury issuance, to roughly 60% now. Never mind that the source of a sizeable amount of these USTBond reserves originated from printing presses with Yen label and stamping molds. What is created so easily from thin air is not so easily disposed of into the same mist. Japan and China now uncomfortably find themselves as "bag holders."
The Bank of Japan and the People's Bank of China are not eager to watch their vast combined $550-600B central bank holdings decay. Some people I speak with privately mention that marginal purchases of new USTBond issuance is the key, and that core holdings in reserve will simply rise and fall with currency shifts in the exchange rate. This is a very serious false assumption to make. Given that at least Japan practices fractional banking, copied from the USA model, they will not sit by idly and watch their vast horde reduce in value. They will instead hedge against it, and diversify. That means they buy fewer US Treasurys, and quietly sell in reallocation as the opportunity is presented.
China, as far as I know, does not practice fractional banking, and has a much more responsible and responsive banking system than the more mature United States. They do not expand the monetary base via intermediary banks so loosely. Translation: their private banks do not underwrite loans in insane fashion in order to create and then sustain bizarre consumption levels. People's Bank of China tightens reserve requirements more readily (like recently from 6% to 7%), in response to emerging new bubbles, such as seen in their urban real estate. In the face of the USDollar decline which began last year, the PBOC announced a planned diversification away from near total USTBond reserves, and into EuroBonds and Gold bullion. China has already reacted to shifting exchange rates.
Asian Central Banks would be foolish not to diversify into rising reserve assets. Observers would be foolhardy to expect anything otherwise. The implications of sitting idly by extend into domestic economic expansion. Reserves lost represent capital not lent out for that expansion. Progress inhibited by irresponsible reserve asset management could mean industries inadequately fostered and nourished, jobs inadequately produced. Preservation of capital is not just a western concept. In no way will core holdings be left exposed to decay during a USDollar decline versus Asian currencies. Inaction would essentially expose them to "economic margin calls" originating from lost value of their reserves.
Asia's finance ministers met in the spring months of this year to discuss their own vested interests. They may be planning some credit markets of their own soon, to provide capital for growing economies in Thailand, VietNam, Malaysia, and China. Such a development would have large consequences to US credit demand emanating from Asia. Their ministers are pondering an Asian Currency Unit, to counter the USDollar (serving North America) and the Euro (serving the European Union). The ACU might emerge sooner than we expect. I propose the official name "Azho" for any new pan-Asian currency. I wish I could patent the name. The Japanese Yen has suffered too much damage for to serve as the currency across the entire Asian economy. Why not a fresh new one?
The "red herring" in the mix is trade wars, sanctions, and conflict that permeate the political specter. Recent Congressional legislation hopes to repeat the disastrous Smoot-Hawley trade restrictions from 1930. There is no end to political stupidity, since grandstanding and tapping into voter emotions clearly supercedes intelligent study of economics and its history. A 27.5% trade tariff on Chinese imports is in the planning stages. We actually believe we might win back jobs in a trade war. Such incredible shallow thought. If China does not revalue their currency, then we will. Instead, every conceivable ill effect would follow. They would lose much of their appetite for USTBonds and GSE agency debt. They might oblige us and enable a 10-15% price rise in our imports. WalMart, beware !!! They might accelerate their planned diversification out of our Treasury debt and into Gold. They might move forward any plans for a Gold-convertible Yuan currency. All of these potential reactions would qualify as retaliation. Can Congress think ahead? Do they recognize the power held by our Chinese creditor masters?
D) LAGGED FEDERAL RESERVE MONETARY EFFECT ON PRICE LEVELS
Seemingly lost in the shuffle, with all the nonsensical talk of "deflation" is the Federal Reserve expansion of money supply. In the last three years, we have witnessed monetary expansion rivaling the 1920's Weimar Republic itself. In certain shorter stretches of time, the MZM has been allowed to rise at annualized rates of growth exceeding 20%. Few younger investors or financial industry watchers can remember evidence that general price levels rise after a multi-month lag in time following huge money supply increase. How short their memories !!! Lack of understanding is matched by lack of historical study.
There has never been a planned and executed Federal Reserve monetary expansion without a resultant systemic price inflation episode. The current environment is no exception, although it bears a severely different smell and taste. The fact that debt default and liquidations are so great does not preclude or eliminate the eventual arrival of the monetary stimulus response. The Fed has grown money supply at rates never seen before in the history of the United States. In the late 1990 decade, the Fed departed from a stated objective to increase the monetary base at a rate not to exceed the GDP growth rate. They opted to implement a reckless new objective, which targeted the observed price inflation rate. Tragically, they chose the Consumer Price Inflation as their guiding meter. It does not include a host of costs from daily life, but more importantly, it failed to reflect the effects of a free Fed monetary spigot seen in the stock market. Thus we grew a stock bubble, and suffered a wealth loss from the bust. To gain perspective on the sheer magnitude, consider this. The Fed has increased the money supply since 1995 by an amount greater than the entire existing 1977 money supply. Our economy has not grown by the same proportions. Bubbles have grown instead !!! Yet few seem to comprehend the source of the problem. It is the Federal Reserve, which I call the Dept of Inflation.
Given the powerful forces offsetting the intended inflationary attempts, and the equally powerful forces continuing to pressure price levels, the verdict will come in with some systemic price inflation. The only question is when. The location of this nascent price inflation will most likely coincide with current locations where it is now evident, namely the commodities, certain services such as health, and other areas. Surely, any windfalls or other significant realizations of cash arrivals will be delivered to banks, to retire some debt. This is expected. But on a systemic basis, some truly awesome powerful forces are at work. Price levels within the entire system will react, but without a remedy realized within profit margins. Costs will rise even faster than prices. By next year, we are going to see some price inflation with lagged arrival, marked to time following the Fed expansion policies and practices. To expect otherwise is to ignore history, and to overlook the inflation process. So far, the financial sector is the principle beneficiary of credit extension and monetary expansion. But as the bond bubbles and housing bubbles dissipate and release capital, the general economy will see a flood of money spill over.
E) INCIPIENT TWO-SIDED PRICE INFLATION THREAT TO USTBONDS
In July of this year, we saw the USTBond suffer a 1.2% rise in yield. The market responded violently to Greenspasm's betrayal, reneging on a promise to speculators to support the 10-yr TNotes. Severe damage was done, which exposed the risk to the bond market outside the threat from incipient price inflation. We simply witnessed an abandonment of speculative bond positions, amplified by GSE agency convexity risk. Many regard this as a watershed event, only to mark the bond top and interest rate bottom. A second market force represents danger to USTBond demand. As discussed previously, when Asian Central Banks decide to hedge or diversify their holdings, we may see an effect from the demand side influencing prevailing long-term interest rates. Even a slowing of Asian demand would cause a slight rate rise. A third market force comes from growth in USTBond supply. With Iraq war costs rising more than expected, with payroll withholdings on the wane from job losses, with added security costs, and with the sneaky killer to the Medicare obligations in prescription drug coverage, we will next year see a worsening in USGovt federal deficits, not a reduction. Our federal supply needs are growing leaps and bounds. Interest rates will be forced higher and higher, even in the face of economic weakness.
A complementary threat to bonds exists. Completely absent in the last decade has been a climate of rising price levels on a systemic basis. Market forces from unwound speculation and curtailed foreign demand comprise a clear and present danger. The arrival of widespread, sustained, systemic price level increases is written in stone. Those stones rest down the road, to be sure. Commercial traffic must pass those stones sooner or later, but eventually the writings will be visible for all to read. The sources of this incipient price inflation are monetary expansion from
The resulting two-sided price inflation effect is total. It comes from inside the monetary system, and from outside in the currency markets. Inside, we see it in the form of counterfeit Fed money fueling bond bubbles, as well as credit extensions throughout the entire system. Money coming out of these bubbles will be released into the economic system. I expect production costs to rise faster than general price levels on a systemic basis. All indications are for rising price levels without remedy to profit margins. Credit will be desperately extended in order to preserve jobs and cash flow, which is necessary for continued floating of debt. Outside, we see it in the form of rising import prices. Our economy depends on foreign importers to supply finished products and components for between 40% and 60% of our needs, depending upon the sector in question. The two-sided threat embodies the most dangerous risk to our credit markets and economy since the 1970 decade. Fanny Mae has a ringed target on its back now, with survival at stake.
A return of systemic price inflation within our economic and financial environment makes mandatory a risk premium for bond investors. This means higher interest rates, to offset erosion of capital placed in custody of the USGovt. This nation is behaving like a "Banana Republic" in its financial operations and management. Sooner or later, we will earn significantly higher prevailing long-term interest rates. We will surely deserve them. Many believe the bond rally will resume, since it was so easily orchestrated by federal intervention. Many believe that economic sluggishness is automatically tied to low interest rates. They are not. Harken back to the 1970 decade, when stagflation was the sign of the times. That is precisely where we are headed. In that decade our cost structure rose in price from crude oil events. Now our costs are rising on a wider basis from a declining USDollar. Expect bonds not to benefit in this dangerous phase #2 when Asian currencies join forces with the Euro in gaining ground versus our USDollar. Money will want to chase bonds, but rising price inflation levels will require higher yield premiums. Money will exit bonds at the same time that money will seek out bonds. Incipient price inflation will see sellers easily prevail, since price inflation is anathema, a dreaded curse.
F) LIKELY ERRORS WITHIN FED RESPONSE, DESPERATION SETS IN
In January of 2001, any alert observer could detect sudden desperation by Chairman Greenspasm. He suddenly embarked on a path which has seen 12 interest rate cuts of the Fed Funds target. While he has flooded the system with money, innocuously called "liquidity," he has lowered rates below the native price inflation level felt inside the economy. Some have called it the "Greenspan Gambit." Since November of 2002, short-term interest rates have plunged below that native level to allow multiple months of negative real rates. Such allowance is the essence of promoting a policy of inflation. In most world economies, the ultimate outcome is sheer destruction.
The Federal Reserve has chosen to keep interest rates low, despite some urgent signals clear for all to see. Gold and Silver have commenced a new long-term bull market. Or at least one can claim without dispute, that they have reversed a long-term bear market. The commodity indexes have also reversed their long-term bear market. The sudden bond revolt this summer was a warning. All continents participated. A trade gap in excess of 5% of US GDP now exists, with no sign of correction. Government Sponsored Enterprises have shown signs of distress, from under-capitalization to accounting fraud. The result has been executive resignations and oversight changes. Residential real estate has risen at a double digit rate for a few years now. Yet no stopping the monetary presses. In the 1970 decade $1.5 new dollars generated $1 new dollar in GDP. In 2001, the ratio was $5.0 new dollars to one. In Q2 of 2003, the ratio has grown to $6.5 new dollars to one. What I call the "Monetary Futility Index" is growing to dangerous Weimar-like levels.
Greenspam has been more than clear in his intention to keep monetary policy relaxed and loose, as he inflates beyond all expectations. He speaks incessantly and ridiculously about threats of deflation, even as he produces the greatest monetary inflation known in recorded history. Well, actually Nero in ancient Rome extracted 95% of the gold from their coinage, only to set off a 1500% price inflation episode in the third century. Inflation is an old concept. In my opinion the knighted chairman periodically tests the system with exhibited restraint in the money supply, seen for instance recently in a MZM slowdown. He must know of the risks in unrelenting expansion. He has shown extreme willingness to go overboard, in the face of all warning signals. He must be extremely fearful of a systemic implosion if he stops the presses.
If the Fed slows the monetary spigot and restrains the liquidity flow, he invites the monster to come through the front door. Namely, we would quickly see recession, job cuts, real estate decline, reduced consumption, and severe outcomes to the financial markets on which we have come to depend. Public outcry would be loud with criticism, since it would be quickly traceable to the Fed restraint. This is not an acceptable option. This is a man who has shown no restraint in good times, and no restraint in bad times. If he becomes confused, which I believe he has been for over a year, I believe he will err on the side of continued monetary open heavy flow. He has provided us all the necessary signals to plan for a predictable future path.
If the Fed senses trouble with an economic stall, even if the origin of the stall can be identified as originating from a declining USDollar, I seriously doubt Greenspasm will allow the money supply to slow down. He is all too clear about the threat of the monster at the front door, and can control it. But he cannot at the same time control the monster at the back door. Something must give, either the USTBond or the USDollar. I believe the Fed actions indicate beyond a doubt that the USDollar will be sacrificed. By continuing the monetary stimulus year after year in the current environment, and hearing reassurance by the Bank of Japan, he apparently feels immune to "back door price inflation." It is my long considered opinion that Greenspasm hopes for a sustained economic recovery free of price inflation BEFORE the monster arrives at the back door, in the form of imported product price inflation coupled with Asian selling of USTBonds.
The central threat to Greenspasm's ponzi scheme is the monster at the back door. It is now knocking, since the Japanese Yen upside breakout marks a watershed event. Other Asian currencies will invariably follow suit. Within a few months we are undoubtedly going to see a rise in prices for a host of imported finished products and component supply products. At the same time, the Asian appetite for our debt supply is surely to wane. We are now at the doorstep to a horrible combination of economic sluggishness and rising price inflation. The dragon monster at the back door is blowing hot breath. Few seem now to be noticing. In time the breath will scorch our economy and financial markets. This is precisely what Kurt Richebächer feared as devastating.
The financial zone is now subject to lost monetary control by the Federal Reserve, fully indicated, and very predictable, with encouraged speculation, and desperate unremitting money pumping. In time even his supporters will object to his policies. This Greenspasm knows only one response tactic, to print more money. He will respond to any USTBond threat by monetizing more purchases of the same, even as foreigners and Americans are selling. He will attempt to offset their large-scale selling. In time, I expect an all-out panic by Greenspasm and the entire Federal Reserve institution. Their power has been eroded. Their policies are fast becoming ineffective. In the future, I expect them to be widely regarded as toothless and powerless to stop the crisis. Everything they do now contributes to conditions which are due to develop into crisis, intensify the pressure gradients, and to fan the flames of fires which will engulf the USDollar.
G) MULTIPLICITY IN POSITIVE EFFECTS ON GOLD
A bifurcation process has been underway within the US Economy for over a year. Few have noticed. The main body of alert observers hails from Bear and Gold crowds. The production zone will continue to be vulnerable to deflationary pressures, from liquidations and debt defaults, and simple failure to compete against foreign rivals including China. Little if any progress is evident in a true recovery. So a severe low-pressure zone has been created and has been prolonged. Prices continue to fall in certain productive sectors, such as computer equipment, cars, furniture, and clothing. Numerous factors are at work. Cost cutting is not working. Cutting of capital investments and cutting of jobs remove critical catalysts for work and valuable agents for innovation, which serve as leverage within the business model. These reductions perpetuate the cash flow reductions which threaten debt service. The low pressure zone might be intensifying.
The commodity and supply cost side of the equation is showing clear signals now of shortage and rising price. This side is much less subject to debt foundations. Mining functions are at operating at 95% capacity now. So a severe high-pressure zone has been created and will soon develop further. The unfortunate effect of declining prices for 20 years has been shutdowns of mines across the globe. Environmental movements add to the pressure to conduct business "not in my back yard." Regulatory obstacles add to the many hurdles necessary to achieve robust production. Since aging operations are prolonged in an inefficient manner, sustaining profitless jobs, all supported by a vast debt structure, the commodity industries are ripe ground for legitimate price increases. Rising prices would encourage new production. Joining the process is the speculation crowd, whose imprint is most easily seen in the energy markets. US oil production has been in decline for many years. A falling USDollar means higher energy costs. China is a commodity customer, not a supplier. They are consuming more crude oil on an annual basis, with growth at roughly 5%. The high pressure zone might be intensifying.
I expect the Monetary Futility Index to reach $10 new dollars to generate $1 new GDP dollar, all in time. When in doubt, Greenspasm will print more money. A world monetary crisis is coming, and the USDollar will be at its epicenter. The powering force will be the uncontrolled growth in the supply of money. Incremental Fed monetization now equals new consumer credit extensions, which happens also to equal the rise in the bilateral Chinese trade surplus. So the Federal Reserve response to duress is building a juggernaut in China. This nation will be in the news on a regular basis throughout this decade.
This entire scenario is the centerpiece of Puplava's Perfect Storm hypothesis. The events in the last two years are unfolding according to script. The engine powering the low-high pressure differential gradient is the USDollar in continued oversupply. As trouble develops on multiple fronts, from the front door, through the back door, we will see both economic sluggishness and rising long-term interest rates. Futility of policy has so far been met with more of the same discredited methods and amplifying upward their force.
The last piece to the Gold bull market acceleration is the decline (however rapid) of the US Treasury market, the mortgage finance market, and residential real estate. All bonds are dependent upon the Treasury market. Threats to price inflation and long-dated bonds have been cited. They are pervasive, powerful, and will grow in strength. The rising long-term interest rates will expose real estate as an appendage to the bond bubble. Housing will be revealed as a "hard asset impostor" when it declines in value, while commodities like gold and oil/gas continue to gain in price.
The last bubble will be in Gold. The Fed has run out of options; it has no more beneficial bubbles to inflate. Gold has recently flirted with the $400 level. It did so following two critical events. The G7 Meeting concluded with discontinued plans to levitate the USDollar. The OPEC Meeting in Vienna concluded with stated plans to curb crude oil production by 900,000 barrels per day. The rise in Gold price will continue until it shatters the $400 level. The writing is on the wall:
A move in Gold bullion past the $400 level will turn heads, change views, alter policy, and scare many people. It is written in stone. Prepare for it. Exploit it. Many dismiss the possibility of a damaging short squeeze inflicted upon the criminal Gold Cartel, who surreptitiously sold off our national gold treasure for their personal profit. If that is not treason, I do not know what is. In the summer of 2002, a "line in the sand" was drawn at $330 gold. By autumn, that line was surpassed and redrawn at $370. Now it appears to be redrawn once more at $400. The cartel is transparent in its reaction to the assault on the Gold price. They appear to rachet their highly leveraged options, futures contracts, and spreads at incrementally higher levels, as a desperate defense of a naked short gold position which exceeds two years worth of world gold production. In this manner, they deliver unto themselves a Chinese water torture. They suffer continued smaller painful blows, instead of a massive short squeeze and meltdown. At the same time, gold miners have steadily reduced their forward sales hedge books. Observers to this tragedy should not lose sight of the fact that the USGovt is probably bailing them out quietly. The Dept of Treasury is likely gradually purchasing the Gold Cartel's hedge book. Official actions and bullion banker actions are effectively ensuring the gold bull will run for a long time.
Purists can contact Swiss American Trading Corp in Phoenix Arizona (see Fred Goldstein) at 800-BUY-COIN. He sells current mintage gold and silver coins, as well as collector coins. Recent year coins rise and fall with the bullion price, whereas collector coins are rising almost every single month in recent years. Conservative investors can purchase shares of the Tocqueville Gold Fund (TGLDX). Its +200% performance over the last three years makes a mockery of the more publicized S&P, although few seem to be aware. Risk-adopting investors can purchase the larger miner shares such as Newmont (NEM), Kinross (KGC), AngloGold (AU), or Harmony (HMY). Those who favor greater risk can purchase shares of the medium-sized miners such as GoldCorp (GG) or Royal (RGLD) or Pan American Silver (PAAS). Investors with strong appetite for both risk and reward should consider a portfolio of Canadian Juniors, known as explorers. Their gains are often breath-taking, as can be their occasional declines. When properties are elevated to producing status, and then acquired by larger mining companies, a big payoff occurs for investors.
The HUI unhedged miner stock index confirms a magnificent new trend, a bull market in gold. Its gains are over 400% since January 2001, when the Fed embarked on its panicky monetary easing, following a few years of tightening late in the last decade. They built the stock bubble, broke it, then proceeded to build even bigger new multiple bond bubbles. What an incredible roller coaster the Fed has set in motion since 1971 when we abandoned the gold standard, an effective reliable tether to our USDollar. We opened Pandora's Box. Financial stability has become a thing of the past ever since. The best possible outcome the Fed can engineer in the current mess is near endless stagflation akin to the 1970 difficult decade, identified by a sluggish economy amidst rising price inflation, for as far as the eye can see. The worst possible outcome is unimaginable and dreadful. I think we will see an outcome in the middle, which will be somewhat more damaging and painful than what we experienced 30 years ago. It has to be worse. We have at least three times as many dollars now sloshing around the globe. Debt levels are triple what they were back then. The trade gap is five times what it was back then. The consequences must therefore be greater than what we experienced back then. The primary beneficiary will be GOLD. In several months, the next Fed move on short-term interest rates will be up !!!
by Jim Willie CB
Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a Ph.D. in Statistics. His career has stretched over 22 years. He aspires to one day join the financial editor world, unencumbered by the limitations of economic credentials.