A Financial Storm Approaches

It is so easy for a country to print money… Said another way, it is so easy for a government to create inflation.

Because it’s so easy, nobody believes that DEFLATION – the opposite of inflation – is possible.

But it is

Financial StormEarlier this week, Republican politicians proposed a bill that would limit the powers of the Federal Reserve.

We are all for limiting the powers of government… But if the Fed’s powers are limited, its ability to print money would be limited… If this happens, persistent deflation could be an outcome – and that could trigger a financial storm that nobody is expecting.

“The most likely path of the Federal Reserve policy in the years ahead is the continuation of massive money printing to fend off deflation,” Jim Rickards writes in his excellent book The Death of Money. However, “the Fed may reach the political limits of printing.”

This is a scary thought for the Fed.

“Deflation is the Federal Reserve’s worst nightmare for many reasons,” Rickards explains. The new bill proposed by the Republicans is an example of the Fed reaching the political limits of money printing.

For one, “Deflation increases the value of government debt, making it harder to repay. If deflation is not reversed, there will be an outright default on the national debt, rather than the less traumatic outcome of default-by-inflation.”

Even worse, deflation “feeds on itself and is nearly impossible for the Fed to reverse.”

If deflation actually takes hold, how can we get out of it?

Rickards explains it: “The only way to break deflation is for the United States to declare, by executive order, that gold’s price is, say, $7,000 per ounce, possibly higher.”
Deflation can be broken when the dollar is devalued against gold, as occurred in 1933 when the United States revalued gold from $20.67 per ounce to $35.00 per ounce… If the United States faces severe deflation again, the antidote of dollar devaluation against gold will be the same, because there is no other solution when printing money fails.”

To be clear, Rickards isn’t actually predicting deflation…

He says we’re in an epic battle between inflation and deflation… where the government desperately wants to create inflation.

Conventional wisdom dictates that the government will succeed in creating inflation. But Rickards’ book describes an eye-opening, credible argument on deflation could actually take hold.

The actions this week by House Republicans suggest that Rickards is right – there is a legitimate risk that the Fed “may reach the political limits of money printing.”

We highly recommend you pick up  The Death of Money… It will open your eyes…

Roadblocks to Recovery in America

The number one problem in this country is excessive debt, debt at all levels – consumer, business, financial and government.

The bottom line, and despite all the plausible arguments to the contrary, we have too much public and private debt relative to the nation’s gross domestic product (GDP). Worse yet, an increasing portion of this debt is unproductive or even counter-productive.

In simple terms, the purpose of taking on debt is to generate future income. Part of that future income is productive, part of it is used to service and, presumably, pay down the debt. But the debt incurred today, especially at the government level, is taken on solely for the purpose of “propping up” the status quo. It is unlikely we will be able to generate the future income necessary to service this debt.

RoadblockIt is already affecting us. In the last fifteen years, debt-to-GDP ratio has risen from roughly 250 percent to more than one hundred points higher, 360 percent today, and our standard of living is no higher. I define “standard of living” in this case as median household income. We’ve taken on the debt, it’s bought modest gains in GDP, but it has not improved the welfare of the majority of our people.

This isn’t the first time the United States has been here before. We’ve seen three periods of excessive government debt:

In the 1820s and 1830s

Again in the 1860s

The early part of the 20th century

We survived those situations which probably seemed quite impossible at the time. This is really the fourth episode of extreme indebtedness to face our nation. These periods have occurred at very long, irregular intervals. That’s one of the difficulties, people weren’t alive at the time of the prior ones.

The first period of government indebtedness occurred in the 1820s and the 1830s, when we were building our early transportation infrastructure – canals, turnpikes and steamship lines. Initially, there was good value derived from the debt. But then the infrastructure was overbuilt and the credit available was used to finance living beyond our means.

The panic occurred in 1838. The bubble burst and speculative real estate prices collapsed. The economy experienced a difficult time all the way to the American Civil War. But we eventually saved, paid down the debt, and recovered.

The next major episode was in the 1860s – building the railroads. Initially the debt accumulation served a good purpose. Frist, we built what was known as the central route. Then we built northern and southern routes, and a whole host of feeder lines. A host of abuses followed – real-estate and stock market speculation, lavish consumption and living beyond our means. All of the railroads failed except one, and it was the one that was not financed by the government. Government involvement was significant in developing the rail system. Government created the incentives, but the private sector bet on the incentives. Government-manipulated incentives drove over-investment. Government incentives drove over-consumption and speculation.

The most infamous debt related crash occurred in the 1920s. Again, the incentive for the over-speculation was excessive liquidity created by the Federal Reserve. The Federal Reserve was newly established at that time, it had just come into existence in 1913. Interestingly, there were some Federal Reserve officials that were aware that the problem was out of control, but they were drowned out, because everybody was having too much of a good time. The Great Depression followed. The US economy didn’t recover until we entered World War II.

The forced austerity of World War II pushed the saving rate up to 25 percent. We repaid the debt, and this laid the foundation for the post-World War II boom.

The fourth episode has occurred in the last 20 years. Again, the incentives came from the government sector, mainly the Federal Reserve. The federal government also played its hand through two government-sponsored corporations – Fanny Mae and Freddy Mac. The perceived safety these agencies provided in the mortgage business allowed the bundling and “slicing and dicing” of mortgages. This created the façade that the mortgage was safe and secure regardless of how poor the fundamental characteristics of any individual loan were. Of course, that was a false notion, and so we have now had another very difficult time period and we are certainly not getting a normal recovery. The standard of living is continuing to fall, in spite of gains in GDP. We have a much more dramatic monetary and fiscal response, but therein lies the problem. We are not achieving a rise in the saving rate, the austerity that’s needed.

Roadblocks to Recovery in America

The number one problem in this country is excessive debt, debt at all levels – the consumer, business and government. 

Let’s face it – we have too much debt, both public and private, relative to the country’s gross domestic product (GDP). An increasing portion of this debt is unproductive or even counter-productive.

In the simplest of terms, the purpose of taking on debt is to generate future income and profit. But the debt incurred today, especially at the government level, is taken on solely for the purpose of “propping up” the status quo. As a nation, we are likely not going to be able to generate the future income necessary to service this debt.

The debt burden is already affecting us. In the last fifteen years, total debt-to-GDP ratio has risen from roughly 250 percent to a more than one hundred points higher, 360 percent today, and our standard of living is no higher. By “standard of living” I mean the median household income. We’ve taken on the debt, it’s bought modest gains in GDP, but it has not improved the welfare of the majority of the people.

Looking back in time, this isn’t the first time the United States has been here before. We have seen three periods where we had excessive government debt:

  • In the 1820s and 1830s
  • Again in the 1860s
  • The early part of the 20th centuryI suspect each of these occurrences seemed like the end of the financial world. Yet, we managed to climb out of those situations. This is really the fourth episode of extreme indebtedness to face our nation. Unfortunately, these periods have occurred at very long, irregular intervals. That’s one of the difficulties, people weren’t alive at the time of the previous one.

The first occurred in the 1820s and the 1830s, when we were building the canals, the turnpikes and steamship lines. Initially, there was good value derived from the debt. But then the infrastructure was overbuilt, and the credit available was used to finance living beyond our means. The panic occurred in 1838. The bubble burst, speculative real estate prices collapsed and debt-fueled living standards fell. The economy experienced a very difficult time all the way to the American Civil War. But we eventually saved, paid down the debt, and were able to recover.

The next major episode was in the 1860s, which was the building of the railroads. Again initially a good purpose. Frist, we built what was known as the central route. Then we built northern and southern routes, and a whole host of feeder lines. Abuses followed – real estate and stock market speculation, lavish consumption and living beyond our means. All of the railroads failed except one, and it was the one that was not financed by the government. Government involvement was significant in developing the rail system. Government created the incentives, but the private sector bet on the incentives. Government-manipulated incentives drove an overinvestment in a particular area of the economy – the rail system. Government incentives drove over-consumption and over-speculation.

The crash years were 1838, then 1873 – then the 1920s. Here the incentive for the over-speculation was the excessive liquidity of the Federal Reserve. The Federal Reserve was newly established at that time, it had just come into existence in 1913. Interestingly, there were some Federal Reserve officials that were aware that the problem was out of control, but they were drowned out, because everybody was having too much of a good time. And then we had a very difficult time – called the Great Depression. The U.S. economy didn’t recover until we entered World War II.

Forward to today. The mal-investment incentives came from government, mainly the Federal Reserve. But the federal government also played its hand through two government-sponsored corporations – Fanny Mae and Freddy Mac. Government backing of mortgages and the subsequent bundling of those mortgages created the façade that a mortgage was secure regardless of how poor the fundamental characteristics of any individual loan were.

Of course, that was a false notion. We have now have another very difficult time. The standard of living continues to fall, in spite of gains in GDP.

If you are over-indebted (as we are), and you try to cure the indebtedness by taking on more debt, you may buy some short-term gains, but ultimately your balance sheet and the economy as a whole becomes that much weaker.

That’s like a family taking on excess debt. If you have ten thousand dollars in credit-card debt, and you decide to pay that debt by borrowing another five thousand in credit-card debt, you can get by pretty well in the short term, but eventually you will be worse off.

One of the problems for the U.S. today is that we are not increasing the saving rate. This is exactly what Japan has done in the last 23 years – since 1989. Their saving rate was 25 percent. It is now zero. They are trying to continue to live beyond their means. They are not willing to correct the problem, and so if we try to fix our indebtedness with more debt, we buy a little bit of happiness for a short-term period, and then we add to the problems down the road. Bad things will happen.

Government response to over indebtedness is to take on more debt. The government, believing in Keynesian economics, is trying to boost liquidity in the economy. Theory says that increased liquidity increases investment and increased investment increases productivity and stimulates growth.

Unfortunately, economic stimulus has stopped working as it intended. When the Fed expands its balance sheet or the European Central Bank expands their balance sheet, they inject liquidity into their respective economies. Over the short run that liquidity will boost stock prices and it will boost commodity prices but it no longer translates into increased economic growth.

The Next Economic Disaster Might be Closer Than You Think

We are believers in the “from the outside in” principle of markets: When trouble starts, it nearly always does so out in the weaker periphery before creeping towards the core.

We saw this in the run-up to the 2007 housing bubble collapse as sub-prime mortgages gave way before prime loans. You can see it again in Europe, as smaller, weaker economies like Greece, Ireland, and Cyprus have fallen first and hardest.  We see this today in accelerating food stamp use among poorer U.S. households.  In each case, the weaker economic parties give way first before being followed, over time, by the stronger ones.

Economic CollapseUsing this framework, we can sometimes get weeks or months of advance notice before trouble erupts closer to the center.

Today we’re receiving a number of new warning signs.  The periphery is giving way.

Ever since the current economic “recovery” began, we’ve been warning of the high risk of a renewed financial crisis.  That risk is now uncomfortably high.  This is because nothing that led to the first round of troubles was actually resolved.  Instead, those troubles were simply papered over with central-bank liquidity, leaving structural weakness intact for instance, our “too big to fail” banks are just as big (or even bigger), and our sovereign debt levels are even worse than they were pre-2008.

The next crisis will be larger and more damaging than the last one, principally because nothing got fixed, lots of capital – both political and financial has been spent and trust has been eroded, leaving everyone depleted and ready to bolt for the financial exits.

With the periphery failing, we may have weeks perhaps a month or two until the next big dislocation hits.

Déjà Vu (All Over Again)

We’ve been here before.  We’ve seen trouble start on the outside and progress inwards, and not all that long ago.

In 1999 and 2007, we saw the financial markets blithely trundle along higher, even as clear signs of trouble at the margins were abundant.

One of the common myths about the stock market, often repeated in the press, is that it peers into the future.  The market is the ‘great discounting machine.’

But the stock market powered higher into the new millennium, despite being the most overvalued it had ever been in history, before diving violently in 2001.  So much for peering into the future.

And again, the stock market went to new heights in 2007, even as the housing market was obviously deteriorating and about to suffer a truly historic break after an unprecedented and bubbly run to the upside.  The great discounting machine ended up reacting to trouble rather than anticipating it.

Despite these two obvious failures, many still hold to the belief that the stock market is a useful indicator of future health or distress, which means this view is more a matter of faith than fact.

Our view has always been that the stock market is a “great liquidity detecting machine” – something that fits the data very well – and that it’s reacting to liquidity in the system more than anything truly fundamental.  This has not always been the case, but ever since Alan Greenspan opened the Federal Reserve printing presses to each and every minor financial sniffle in the mid-1990s, Fed-supplied liquidity has been the dominant driver of equity prices.

To tilt the conversation slightly, one of the enduring mysteries to me is how we have managed to experience not one, not two, but three full bubbles in the space of less than 15 years.  Tech stocks, then housing, then all stocks and bonds; three bubbles, each bigger than the last.

The current all-time highs in both bond AND equity prices (with bonds collectively including everything from 1-month T-bills to the worst junk paper you can buy), is nothing more than the biggest financial asset bubble in history.

In order to believe this will all turn out well, you have to believe that this time will be different… not just a little bit different, but 180 degrees away from literally every single other financial bubble in all of history.

This is precisely what is being asked of us each day by the financial press, the Federal Reserve, the Bank of Japan, the European Central Bank (ECB), and the politicians in the Western power centers.

It is never different.  To that we’ll add:

  • A crisis rooted in too much debt cannot be “solved” by creating more debt.
  • Prosperity cannot be printed out of thin air.
  • Rigged systems and markets destroy trust.
  • Nothing can grow forever, except for the number of zeros printed on your currency.

Collectively, the above list boils down to Anything that cannot go on forever…won’t.

Deficits and Debts Do Matter

Deficits don’t matter! Dick Cheney once famously growled, putting to words the belief system that envelops the U.S. today, especially its financial and monetary authorities.  Because we’ve managed over the past three decades to dodge any serious consequences from racking up debts, these folks believe that will always be true. Absence of evidence becomes evidence of absence.

Sticking just to the economic “E” (leaving aside energy and the environment), our diagnosis of the current difficulties is simply that the OECD economies left reason aside and instead embarked on a sustained period of borrowing at a rate nearly twice as fast as underlying economic growth.

That is, we collectively fell for the idea that one could simply borrow more than one earned… forever.  It is surprising by how an entire culture can collectively believe in something that no individual would ever hold to be true.

We know that we cannot individually borrow more than we earn forever.  And we are equally sure that this remains true if we pool ten people together.  But we accept the idea that a sovereign nation can somehow magically pull this off.  This either represents a profound inability to apply logic, or a form of cultural schizophrenia, or both.

Hot-Money Bubble Dynamics

For years now, ever since central banks embarked on the global rescue plan that involved little more than flooding the world with historically unprecedented amounts of freshly printed money (a.k.a. “liquidity”), that money has been sloshing around looking for things to do.

With interest rates on “safe” investments at 0% (or close enough), that “hot” money has been looking for anything that resembles a decent yield.  This “yield chasing” went to every corner of the globe and piled into any and every market that it could.

Some of these markets were the headline U.S. and European equity and bond markets, and some of them were so-called “emerging markets”, such as Brazil, India, Thailand, the Philippines, and Indonesia.

As this hot money flowed into these emerging markets, the respective countries in order to prevent their currencies from rising too much did the usual and recycled the money-flows back into U.S. Treasury paper, German Bunds, and other sovereign debt instruments.

Now, all of this is being undone.

It is a hot-money machine running in reverse, and it is creating the usual distortions, difficulties, and hardships for the afflicted countries.  Currencies are plummeting, as are local equity and bond markets.

In short, to understand where our financial markets are and where they are headed, you don’t need to know much about fundamentals at all.  Earnings, GDP, job growth, etc. are secondary to liquidity flows.  That’s why the various markets are so keyed on the Fed’s next statements and when and how extreme the “tapering” might (or might not) be.

That’s all that really matters. Well, that’s not entirely true.  For reasons that cannot be entirely explained nor controlled, sometimes bubble dynamics just end.  People stop believing.  And what was once a virtuous cycle suddenly morphs into vicious one.

I believe that moment is near.  And, as always, it’s starting from the outside in.

Debt: Cheap and Easy

Borrowing and lending is all the rage again.

The financial crisis was five years ago this fall, and nobody is letting us forget it. According to ex-FDIC Chair Sheila Bair, financial soundness isn’t much improved. She says, “I think our system is still somewhat fragile, a lot more needs to be done.”

Indeed… Wall Street hasn’t been reformed, although it operates with a bit less leverage.

Meanwhile, Bernanke’s ZIRP medicine may finally be seeping into the economy’s vital organs. No job growth.  But per the Fed chair’s wish, investors are taking more risk. Paper assets prices are high and stocks are rockin’.

Debt Ceiling With apologies to James Carville, drag cheap money through a trailer park and you never know who might borrow.

Junky Sovereign Debt

Less-than-financial-juggernauts Russia and South Africa borrowed $9 billion between them this week. Putin’s Place took the majority with $7 billion. Investor response was overwhelming, with orders for $16.5 billion of the dollar-denominated Russian debt at a rate of 5.1%.

South Africa sold $2 billion in debt with orders for $7.5 billion. The notes have a 12-year term and yield 6%.

The two countries have several things in common. Both Russian and South African debt is rated a junky BBB by Standard & Poor’s. Both countries are run by thugs, and both economies depend heavily on mineral extraction.

Being mineral dependent isn’t necessarily a bad thing, except neither country executes particularly well. Resource investment legend Rick Rule points out that South Africa “produced 73% of the platinum and 37% of the palladium in the world in 2012, but the mining industry there is going broke.”

Dirt-Cheap Corporate Debt

A considerably better-quality borrower, Verizon, recently made news with the largest bond offering ever, floating $49 billion of debt. That’s larger than Luxembourg’s GDP. Verizon had intended to sell $20 billion worth, but the orders kept coming in—to the tune of $100 billion—and the telecommunications company couldn’t say no. After all, it needs $130 million to buy Vodafone Group out of their Verizon Wireless joint venture, and will be borrowing another $12 billion from banks.

The 10-year bonds were priced to yield 2.25% over Treasuries, or about 5.2%, but quickly traded down to 4.85%. This despite Verizon now having nearly $100 billion in bond debt outstanding.

Apparently that doesn’t matter, because investors couldn’t wait. “The demand for bonds is coming in part from investors who have spent months keeping their investments in cash or cash equivalents while interest rates hovered at record lows,” reports the Wall Street Journal.

Imagine, investors licking their chops over a 5% yield.

Subprime Mortgage Debt

There’s also evidence that the more, shall we say, “creative” mortgage lenders are back in business. The jump in mortgage rates and increased government pressure has put the kibosh on the refinance frenzy. Plenty of mortgage grunts are getting the axe. Wells Fargo announced that it is cutting 2,300 jobs, Citi 2,200, BoA 2,100, and Chase as many as 19,000 through 2014.

But The Center for Public Integrity is keeping track of the management teams that ran the top 25 lenders that originated $1 trillion in subprime loans. Editor Daniel Wagner speculates a new housing bubble is on the way. He writes, “Today, senior executives from all 25 of those companies or companies that they swallowed up before the crash are back in the mortgage business.”

Since the crash, mortgage origination has been plain vanilla, and has conformed to government lending standards. But as interest rates and home prices rise, lenders will have to offer more specialty loan products.

The days of stated income, pick-your-payment, 100% financing are over. But as mortgage company entrepreneur John Robbins says, the new environment “creates some opportunity to lower the bar a little bit and allow consumers the opportunity to buy homes [who] really deserve them.”

On a year-to-date basis, jumbo originations were up 17.7% from the first half of last year.

And while non-prime debt originated by non-bank lenders is just 5% of the market, the industry is again “mushrooming in size,” according to Wagner. “Companies are expected to issue more than $20 billion of the non-guaranteed bonds this year, up from $6 billion in 2012, according to an April report from Standard & Poor’s.”

That’s a far cry from the $1.19 trillion in unbacked mortgages bundled in 2005, but the industry is clearly rebounding. Guy Cecala, publisher of the trade magazine Inside Mortgage Finance, says, “You’re going to see a little more risk coming into the system” as lenders permit smaller down payments and finance more investment properties.

“Five years down the road and we’re back in the thick of it again. It’s a weird place to be,” says Cliff Rossi, who was a high-level risk management executive at Countrywide, Washington Mutual, and Freddie Mac before the crisis. “In that intervening 20 years, we forgot what we learned in the ’80s,” he says. “I fear right now, human nature being what it is, that downstream we could find ourselves in the same situation.”

And Of Course, Uncle Sam

Finally, the biggest borrower in history—the United States government—is currently borrowing for less than 3% for 10 years. Its obligations, says hedge fund titan Stanley Druckenmiller, are not the $12 trillion or $16 trillion the government shows on its books, but $200 trillion. That number includes the present value of the obligations made to America’s seniors. It cannot be repaid.

There are a number of pins searching to pop the debt bubble. At the top of the list is the Fed. Druckenmiller told Bloomberg that without the Fed’s QE, asset prices have to fall. He is laying low until he gets a sign the Fed is done buying $85 billion in bonds a month. “It is my belief that QE has subsidized all asset prices, and when you remove that, the market will go down,” said the billionaire investor.

James Grant of Grant’s Interest Rate Observer likes to say, “Knowledge in finance is cyclical, not cumulative.” Druckenmiller echoes this view with, “…a necessary condition to have a financial crisis, in my opinion, is too loose monetary policy that encourages people to take undue risk and go on the risk curve and do silly things.”

Big bets with low rates always make sense until reality bites. Then, what made sense suddenly looks silly. These high bond prices and low rates are an illusion created by the Fed. Soon, Bernanke or his successor will be viewed as having no clothes.