The Bear's Lair
Interest Diverging Like It's 1929
by Doug Noland

September 07, 2012

Spanish 10-year yields dropped 123 bps this week to 5.57%. Yields are now down 194 bps from July 24 highs (7.51%). Italian 10-year bond yields sank 80 bps this week to 5.02%, and are down 153 bps from July highs (6.55%). Spanish stocks (IBEX) have rallied 34% off July lows, slashing its 2012 loss to only 8%. And after its 32% rally from July lows, Italian stocks (MIB) now sport a 6.8% y-t-d gain. The German DAX has gained 14% from July lows, increasing its 2012 gain to 22.3%.

Here in the U.S., tens of Trillions of (government, corporate, and mortgage-related) bonds are priced at or near record high levels (low yields). The S&P 400 Mid-Cap equities index, up 14.3% y-t-d, is only 0.4% below its all-time high. The small cap Russell 2000 (up 13.7% y-t-d) is 0.6% below its record high. The S&P 500 traded this week to the highest level since May 2008. The Nasdaq (“NDX”) 100 now enjoys a 2012 gain of 24.0% - and traded this week to its highest level going all the way back to 2000. Junk bond spreads traded this week to a 13-month low.

As regional and global economic downturns gain momentum, the ECB this week significantly lowered its forecasts for Eurozone growth. ECB staff now project 2012 economic activity to contract in the range of between 0.2% and 0.6%. Thursday the Organization for Economic Cooperation and Development (OECD) revised downward its estimates for G7 economic growth. The German economy is now projected to slip into recession, with Q3 GDP forecast at an annualized negative 0.5%. Economic activity is expected to weaken further to negative 0.8% in Q4. The French economy is expected to contract 0.4% in Q3, before recovering for 0.2% growth in Q4. The Italian economy is forecast to contract 2.9% during Q3 and 1.4% in Q4. The British economy is seen contracting 0.7% in Q3, before recovering for 0.2% growth in Q4. Japan’s economy is now expected to contract 2.3% (annualized) in Q3. U.S. growth is expected to improve mildly to a 2.0% rate during Q3 and 2.4% in Q4. Outside of the G7, the Greek and Spanish economies are unmitigated disasters.

With the financial world fixated on Draghi, Bernanke and endless QE, global markets now wildly diverge from economic fundamentals. Many are content to celebrate, holding firm to the view that financial conditions tend to lead economic activity. Markets discount the future, of course. And, traditionally, an easing of monetary policy would loosen Credit and financial conditions - spurring lending, spending, investing and stronger economic activity.

Importantly, traditional rules and analysis no longer apply. Monetary policy has been locked in super ultra-loose mode now entering an unprecedented fifth year. Here in the U.S., financial conditions can’t get meaningfully looser. The Federal Reserve has pushed corporate and household borrowing costs to record lows. Liquidity abundance will ensure near-record 2012 corporate debt issuance. “Loose money” has already had too long a period to impact decision making throughout the economy – with decidedly unimpressive results. Arguably, previous unfathomable monetary measures some time ago created dependencies and addictions that are increasingly difficult to satisfy.

Clearly, monetary policy is exerting a much greater impact on the financial markets than it is on real economic activity. In the U.S. and globally, market gains are in the double-digits, while economic growth is measured in dinky decimals. The vulnerability associated with elevated securities markets has tended to only compound the issue of systemic fragility, and policymakers have responded to heightened stress with only more extraordinary policy measures. Recent weeks have provided important confirmation of the Bubble Thesis.

Amazingly, in the face of exceptionally buoyant securities markets and an expanding economy, the Federal Reserve is apparently about to embark on yet another round of quantitative easing (“money printing”). Few expect this to have much impact on the real economy, but it is clearly having a major impact on already speculative financial markets.

I’ve always feared such a scenario: Severely maladjusted Bubble Economies responding poorly to aggressive monetary stimulus, spurring policymakers into only more aggressive stimulus measures. Meanwhile, financial fragility mounts, as Credit systems continue to rapidly expand non-productive debt. Securities markets become dangerously speculative and detached from underlying fundamentals.

Students of the late-1920s appreciate how late-cycle policy-induced market and economic distortions laid the groundwork for financial collapse and depression. Especially in 1928 and early-1929, highly speculative financial markets diverged from faltering global economic fundamentals. Our nation’s business came to be precariously dominated by “money changers,” financial leveraging and market speculation.

But we don’t have to look back to late-cycleRoaring Twentiesexcess for examples of the danger of markets disconnecting from fundamentals. From April 1997 to July 1998 the Nasdaq Composite jumped 90%. The marketplace had turned quite speculative, although excesses were beginning to be wrung out during the August-October 1998 Russian collapse and LTCM crisis. Fatefully, the Federal Reserve bailed out LTCM and the leveraged speculating community, while orchestrating a liquidity backstop for financial markets generally. The consequences continue – and they’re no doubt momentous.

Rather than chastened, the speculator community was emboldened back in late-1998. Not surprisingly, loose monetary policy combined with a central bank market backstop had the greatest impact on the fledging Bubble at the time gathering momentum in technology stocks. The Nasdaq Composite then rose from about 1,000 in early-October 1998 to its historic March 2000 high of 4,816.

It’s certainly not uncommon for individual stocks - or markets - to enjoy their most spectacular gains right as they confront rising fundamental headwinds. Indeed, whether it was the Dow Jones Industrial Average in 1929 or technology stocks in late-99/early-2000, deteriorating fundamentals actually played an instrumental role in respective dramatic market rallies. In both cases, bearish short positions had been initiated in expectation of profiting from the wide gulf between inflating stock prices and deflating fundamental backdrops. In both cases, short squeezes played a prevailing role in fuelingblow offspeculative rallies.

Actually, the most precarious backdrops unfold during a confluence of serious fundamental deterioration, perceived acute systemic fragilities, aggressive monetary policy easing and an already highly speculative market environment. This was the backdrop during 1929 and 1999, and I would argue it is consistent with the current environment. Excess liquidity and rampant speculation drove prices higher in ’29 and ’99, as the unwinding of short positions (and the attendant speculative targeting of short squeezes) created rocket fuel for a speculative melt-up. Over time, intense greed and fear and episodes of panic buying overwhelmed the marketplace. Would be sellers moved to the sidelines and markets dislocated (extraordinary demand and supply imbalances fostered dramatic spikes in market pricing and emotions). Market dislocations - and resulting price jumps - were only exacerbated when those watching prudently from the sidelines were forced to capitulate and jump aboard.

The technology Bubble was spectacular – but it was also more specific to an individual sector than it was systemic. Today’s Bubble is unique in the degree to which it encompasses global markets and economies. Systemic fragilities these days make 1999 appear inconsequential in comparison. The backdrop has more similarities to 1929 – and, not coincidently, policymakers are absolutely resolved to avoid a similar fate. Thus far, policy measures have notably succeeded in fostering over-liquefied and highly speculative markets on a manic course divergent from troubling underlying fundamentals.

The Draghi Plan was unveiled this week, and expectations have the Fed coming imminently with QE3. I don’t anticipate measures from the ECB or the Fed to have much effect on economic fundamentals. At the same time, Drs. Draghi and Bernanke already have had huge impacts on global risk markets. Their policies have dramatically skewed the markets in the direction of rewarding the “bulls” and severely punishing the “bears”. History will not be kind. Policies have, once again, incentivized speculation and emboldened speculators. Policymakers have further energized the expansive globalgovernment finance Bubble.

There are many articles discussing the details of the Draghi Plan. I will instead focus my attention on the interplay between ECB and Federal Reserve policymaking and dysfunctional global markets.

The markets’ immediate response to Friday’s weak U.S. payrolls report was telling: bonds rallied strongly, the dollar weakened, gold jumped, and the stock market melt-up ran unabated – as markets readied for QE3. Ongoing dollar devaluation is critical for sustaining the inflationary bias throughout global commodities and non-dollar securities markets - not to mention incredibly inflated bond and fixed income prices. Fed policymaking seemingly ensures ongoing enormous trade deficits that expel liquidity around the globe. Fed-induced weakness also works to stemsafe haven” and speculative inflows to the dollar, flows that have risked inciting problematic capital flight and risk aversion in markets around the world.

For some time now, the global speculator community has been successfully positioned for ongoing dollar liquidity abundance and devaluation. For the past two years, the unfolding European debt crisis has repeatedly been at the precipice of unleashing powerful global de-risking/de-leveraging dynamics. The Draghi Plan is being crafted specifically to backstop troubled Spanish and Italian debt, faltering markets that were in the process of inciting a catastrophic crisis of confidence in the euro currency.

In unsubtle terms, the Draghi Plan has directly targeted those with bearish positions in European debt instruments and the euro. In this respect, it has been both effective and destabilizing. Draghi has dramatically skewed the marketplace to the benefit of the longs and to the detriment of the shorts – throughout European debt, equity and currency markets. And with simultaneousopen-ended QErhetoric from the Bernanke Federal Reserve, shorts have suddenly found themselves in the crosshairs worldwide. A huge short squeeze has unfolded, fomenting market dislocation – and an only wider divergence between inflating market prices and deteriorating underlying fundamentals. Panicked covering of short positions and the unwind of derivative hedges has thrown gasoline on already wildly speculative securities markets.

In previous CBBs I have noted how asymmetrical central bank policymaking and market backstops over the past two decades nurtured a multi-trillion global leveraged speculating community. I have also explained how massive central bank liquidity injections have bypassed real economies on their way to be part of an increasingly unwieldy global pool of speculative finance. I have further noted how global markets have regressed into one big dysfunctionalcrowded trade.” And now the Draghi and Bernanke Plans have dealt a severe blow to those positioned bearishly around the globe. We can now contemplate the behavior of highly speculative and over-liquefied markets perhaps operating without the typical checks and balances provided by shorting and bearish positioning.

Draghi and European policymakers must be giddy watching the bears get completely run over. The truth of the matter, however, is that the shorts are in no way responsible for what ails Europe. Indeed, the deep financial and economic structural deficiencies were created during environments where long-side debt market speculation was rife – and the resulting over-abundance of mispriced finance sowed the seeds for future crises. Regrettably, this process remains very much alive, as policymaking ensures Bubble Dynamics become further embedded in all corners of the world.

From my perspective, the key issue is not whether the ECB finally has a (Draghi) plan that will resolve Europe’s debt crisis - the coveted big bazooka. Monetary policy won’t solve Europe’s deep structural problems anymore than QE will resolve U.S. economic maladjustment and global imbalances. Indeed, there is little doubt that the Draghi and Bernanke Plans will only exacerbate global systemic fragilities. They have bought some additional time, but at rapidly inflating costs. We desperately needed global policymakers to work assiduously to extricate themselves from market interventions and manipulations. They’ve again done the very opposite.

September 10, 2012 7:54 pm
Democracy loses in struggle to save euro
Ingram Pinn illustration

The European Central Bank has fired its magic bullet. By promisingunlimitedpurchases of sovereign bonds, Mario Draghi, the ECB’s president, may have kept his pledge to dowhatever it takes” to save the euro. But in rescuing the currency, Mr Draghi’s magic bullet has badly wounded something even more importantdemocracy in Europe.

As a result of the ECB’s actions, voters from Germany to Spain will increasingly find that crucial decisions about national economic policy can no longer be changed at the ballot box. In Germany, in particular, there is a growing realisation that the ECB, an unelected body that prides itself on its independence from government, has just taken a decision that has profound implications for German taxpayers – but one that they cannot challenge or change.

Previous European bailouts had to be approved by the German parliament and were subject to review by the German courts. Indeed the German supreme court will rule on the constitutionality of the most recent bailout on Wednesday. But the ECB’s decision to accept unlimited bond purchases is immune to such democratic controls. The bank cannot be overruled by the German parliament. And because it is an EU institution, the ECB cannot be checked by the German courtsonly by the European Court of Justice.

At the ECB, the president of the German central bank has just one vote – the same as the presidents of the central banks of Malta or Slovenia. Jens Weidmann, the head of the Bundesbank, cast the sole vote against the bond-buying plans.

Angela Merkel, the German chancellor, may well have given tacit consent to the ECB’s actions and one German member of the ECB council voted with the majority. But opinion polls and media comment suggest that Mr Weidmann’s position reflects majority opinion in Germany. After the ECB decision, the Bundesbank issued a statement arguing that the ECB’s plans are “tantamount to financing government by printing banknotes” and “redistribute considerable risks among various countries’ taxpayers”. Translation: the ECB’s action are illegal and dangerous, and German taxpayers could end up with the bill.

Of course, the Germansabove all – have always revered central bank independence. Under normal circumstances, it is a fine tradition. But in the euro crisis, the ECB is suddenly behaving in a way that veers wildly from the Germanic view of prudent central banking.

It is not just Germans who have reason to feel nervous about the democratic implications of what the ECB has done. To access the ECB’s unlimited firepower, the Spanish or Italians would have to agree to “enter a programme – which sounds unpleasantly like the kind of condition that is laid down for a wayward drug addict. In reality, Madrid or Rome would have to accept International Monetary Fund-style supervision of their national budgets, directed from Brussels and Frankfurt. Such a humiliating and overt loss of national sovereignty, combined with a deep recession, would be the perfect formula to drive voters to the political extremes, as Greece is demonstrating.

Of course, European idealists would argue that talk of a loss of national sovereignty is outmoded. The euro is a pan-European currency so its fate should be decided by European voters and institutions not by individual nations.

In practice, however, the eurozone crisis is increasingly polarising European politics along national lines. In Italy and Spain there is now something close to a national positionuniting leftist and rightwing partiesagainst what are regarded as arrogant and self-centred German policies. In Germany, however, there is a left-right consensus that austerity in southern Europe must be the price of bailouts.

So why has Mr Draghi done it? The answer is that he faced a truly hideous dilemma. It was clear that the hundreds of billions of euros committed to European bailout funds have not been enough to ward off the threat of collapsing banks and sovereign defaults across the eurozone. A financial calamity could lead to another Depression, followed by political radicalisation – and a threat to democracy that is much more direct and unsubtle than the menace posed by the ECB.

By contrast, if Spanish and Italian borrowing costs come back under control – and their governments are prodded into making important structural economic reforms – then the ECB’s actions last week could yet be vindicated. Mr Draghi would not only have saved the euro – he would have bought Europe the time it needs to return to growth.

However, a great many things now have to go right simultaneously for Mr Draghi’s plan to work. It is rather more likely that political and economic unhappiness will grow in Europe over the next year – as Germany slips into recession and Italy and Spain (not to speak of Greece) struggle with ever deeper austerity. If the euro were ever to break up, the direct financial cost to Germany and other creditor nations – and the resulting backlash – could also be much higher, because of the ECB’s bond-buying programme. Certainly, for anyone with a sense of history, the sight of the German representative on the ECB being isolated and outvoted should be chilling. Since 1945, the central idea of the European project was never again to leave a powerful and aggrieved Germany isolated at the centre of Europe. We are now dangerously close to that point.

Copyright The Financial Times Limited 2012.

A Decade of Volatility: Demographics, Debt, and Deflation

By Harry S. Dent, Jr., author of The Great Crash Ahead and editor of Boom & Bust

Most of you reading this expect inflation in the years ahead, right? Well, I don't. In fact, I am firmly in the deflation camp.

Just think about it. What has happened after every major debt bubble in history? What happened after the 1873-74 bubble? Or after the 1929-32 bubble? Did prices inflate or deflate?

We got deflation in prices every time.

This time around, with the latest bubble peaking in 2007/08, the outcome will be exactly the same. There is deflation ahead. Expect it. Prepare for it.

But the bubble-bust cycle that history has allowed us to see is not the only reason I'm so certain we're heading for deflation and a great crash ahead. I have other, irrefutable evidence.

For one, there is the most powerful economic force on Earth: demographics. More specifically, the power of the number 46. You see, that's the age at which the average household peaks in spending.

When the average kid is born, the average parent is 28. They buy their first home when they're 31 after they had those kids. When the kids age into nasty teenagers, the parents buy a bigger house so they can have space. They do this between the ages of 37 and 42. Their mortgage debt peaks at age 41. And like I said, their spending peaks at around 46.

From cradle to grave, people do predictable things and we can see these trends clearly in different sectors of our economy, from housing to investing, borrowing and spending, decades in advance.

This demographic cycle made the crash in the '30s and the slowdown in the '70s unavoidable. Now it is happening again... with the biggest generation in history – the Baby Boomers.

Consumer spending makes up more than two-thirds of our gross domestic product (GDP). So knowing when people are going to spend more or less is an incredibly powerful tool to have. It tells you, with uncanny accuracy, when economies will grow or slow.

Why Deflation Is the Endgame

Think of it this way: the government is hellbent on inflating. It's doing so by creating debt through its quantitative easing programs (just for starters). But what's the private sector doing? It's deflating.

And the private sector is definitely the elephant in the room. How much private debt did we have at the top of the bubble? $42 trillion. How much public debt did we have back then? $14 trillion.

That looks like a no-brainer to me. Private outweighs public three to one. And the private sector is deleveraging as fast as it can, just like what happened in the 1870s and 1930s. History shows us that the private sector always ends up winning the inflation-deflation fight.

Now, I will concede that this is an unprecedented time. Today governments around the world have both the tools and the determination to fight deflation. And they are desperate to keep it at bay because they know how nasty it is (they, too, are students of history).

How bad is it? Think of deflation like what your body would do with bad sushi. It would flush it out as fast as possible. That's what our system is trying to do with all the debt we accumulated during the boom years. It's what the system did in the 1930s. Back then we went from almost 200% debt-to-GDP to just 50% in three years. It hurt like hell. The government doesn't want this painful deleveraging.

The problem is, the longer the government tries to fight this bad sushi, the sicklier the system becomes. I know this because it's what happened to Japan.

Japan's bubble peaked in the '80s. When the unavoidable deleveraging process began, the country did everything in its power to stop it. How is Japan doing today, 20 years after its crash? It is still at rock bottom. Its stock market is still down 75%.

Japan has gone through everything we'll go through in the next few years. Does Japan have an inflation problem? That's a rhetorical question. Did its central bank stimulate frantically? Also a rhetorical question.

Think of it another way: what is the biggest single cost of living today? Is it gold? Oil? Food? It's none of these. It is housing. And what is housing doing? Dropping like a rock. It can't muster a bounce, despite the lowest mortgage rates in history and the strongest stimulus programs anywhere ever.

The Fed is fighting deflation purposely. It will fail.

Why the Fed Will Fail in All Its Efforts

There is simply no way the Fed can win the battle it's currently waging against deflation, because there are 76 million Baby Boomers who increasingly want to save, not spend. Old people don't buy houses!

At the top of the housing boom in recent years, we had the typical upper-middle-class family living in a 4,000-square-foot McMansion. About ten years from now, what will they do? They'll downsize to a 2,000-square-foot townhouse. What do they need all those bedrooms for? The kids are gone. They don't visit anymore. Ten years after that, where are they? They're in 200-square-foot nursing home. Ten years later, where are they? They're in a 20-square-foot grave plot.

That's the future of real estate. That's why real estate has not bounced in Japan after 21 years. That's why it won't bounce here in the US either. For every young couple that gets married, has babies, and buys a house, there's an older couple moving into a nursing home or dying.

I watch this same demographic force move through and affect every other sector of the economy. The tool I use to do so is my Spending Wave. This is a 46-year leading indicator with a predictable peak in spending of the average household. .

Here's how it works: the red background in the chart above is the Dow, adjusted for inflation. The blue line is the spending wave, including immigration-adjusted births and lagged by 46 years to indicate peak spending. If you ask me, that correlation is striking.

The Baby Boom birth index above started to rise in 1937. It continued to rise until 1961 before it fell. Add 46 to 1937, and you get a boom that starts in 1983. Add 46 to 61, and you get a boom that ends in 2007.

Today demographics matters more than ever because of the 76 million Baby Boomers moving through the economy. That's why I don't watch governments until they start reacting in desperation. Then I adjust my forecasts accordingly.

Don't Hold Your Breath for the Echo Boomer Generation

But all this talk about Baby Boomers inevitably births the question: "Surely the Echo Boom generation is coming up right behind their parents. They'll fill the holes, right?"

Let me make this clear. If I hear one more nutcase on CNBC say, "The Echo Boom generation is bigger than the Baby Boom," I might go ballistic. They are wrong. The Echo Boomer generation is NOT bigger than the Baby Boom generation. In fact, it's the first generation in history that's not larger than its predecessor is, even when accounting for immigrants.

It's not all doom and gloom, though. We will see another boom around 2020-23. But for now, all the Western countries will slow, thanks to the downward demographic trend sweeping the world. Some are slowing faster than others are. For example, Japan is slowing the fastest (it actually committed demographic kamikaze, but that's a discussion for another day). Southern Europe is next along in its decline. Eastern Europe, Russia, and Asia are following quickly behind.

Which brings me back to my point: there is no threat of serious inflation ahead. Rather, deflation is the order of the day. The Fed thinks it can prevent a crash by getting people to spend. To that I say, "Good luck." Old people don't spend money. They bribe the grandkids, and they go on cruises where they just stuff themselves with food and booze.

Do you know how to tell if you're buying a car from an older person? It's going to be ten years old and have only 40,000 miles on it. They drive 4,000 miles a year. They just go down the street to get a Starbucks coffee and a newspaper. Then they go back home. How do you know you're buying a car from a soccer mom? It's driven 20,000 miles a year, carting the kids around all day to school, soccer practice, whatever. This is the power of demographics.

So let me tell you what causes inflation. It's young people. Young people cause inflation. They cost everything and produce nothing. That's inflation in people terms.

Why did we have high inflation in the '70s? Because Baby Boomers were in school, drinking, spending their parents' money. While this was going on, we experienced the lowest-productivity decade in the last century.

Do you remember the 1970s? We had worsening recessions as the old Bob Hope generation began to save more while the Baby Boomers entered the economy en masse at great expense. It costs a lot of money to incorporate young people, raise them, and put them into the workforce.

Then suddenly, in the early '80s, like some political genius did something brilliant, the economy started growing like crazy, and inflation fell. You know what that was? That was the largest generation in history transitioning en masse from being expensive, rebellious, young people to highly productive yuppies with young new families. It was the move from cocaine to Rogaine.

The correlation between labor force growth and inflation is crystal clear.

When lots of young people come into the labor force, it's inflationary. When lots of old people move out of the labor force and into retirement, it's deflationary. Right now, where is the highest inflation in the world? It's in emerging countries. Do they have more old people or young people? They have more young people.

We saw it in the 1970s, we see it in emerging markets, and we'll see it ahead as the Baby Boomers head off into the sunset. First, there was inflation. Ahead is deflation. No doubt about it.

Harry Dent, the editor of Boom & Bust, has put together a free report for John Mauldin's readers, called: Survive and Prosper in This Winter Season: Take These Steps Now... Before Dow 3,300 Arrives.