The Fed's Deflation Problem?

by: Leo Kolivakis            
             

Summary
  • U.S. employment rose at a solid clip in July and wages rebounded after a surprise stall in the prior month, increasing the likelihood the Fed will raise rates in September. 
  •        
  • While traditionally the Fed has solely focused on the domestic economy to set interest rate policy, the specter of global deflation will weigh heavily in its decision. 
  •        
  • If the Fed ignores global weakness, it will all but ensure a prolonged period of global weakness and risk importing a serious deflation problem. How should you position your portfolio?

Lucia Mutikani of Reuters reports, Improving U.S. jobs market bolsters case for Fed rate hike:
U.S. employment rose at a solid clip in July and wages rebounded after a surprise stall in the prior month, signs of an improving economy that could open the door wider to a Federal Reserve interest rate hike in September. 
Nonfarm payrolls increased 215,000 last month as a pickup in construction and manufacturing jobs offset further declines in the mining sector, the Labor Department said on Friday. The unemployment rate held at a seven-year low of 5.3 percent. 
Payrolls data for May and June were revised to show 14,000 more jobs created than previously reported. In addition, the average workweek increased to 34.6 hours, the highest since February, from 34.5 hours in June.  
"If you thought that the Fed was going to go in September, this report would suit that thematic nicely. I don't think anything has changed in that regard. I think it's another step toward the eventual lift-off," said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York. 
U.S. stock index futures and prices for shorter-dated U.S. Treasuries were trading lower after the data. The dollar rose to a two-month high against the yen and firmed versus the euro. The swaps market was pricing in a 52 percent chance of a September rate hike, up from 47 percent before the jobs data.
Though hiring has slowed from last year's robust pace, it remains at double the rate needed to keep up with population growth. The Fed last month upgraded its assessment of the labor market, describing it as continuing to "improve, with solid job gains and declining unemployment." 
Average hourly earnings increased five cents, or 0.2 percent, last month after being flat in June. That put them 2.1 percent above the year-ago level, but well shy of the 3.5 percent growth rate economists associate with full employment.

Still, the gain supports views that a sharp slowdown in compensation growth in the second quarter and consumer spending in June were temporary. Economists had forecast nonfarm payrolls increasing 223,000 last month and the unemployment rate holding steady at 5.3 percent. 
Wage growth has been disappointingly slow. But tightening labor market conditions and decisions by several state and local governments to raise their minimum wage have fueled expectations of a pickup. 
In addition, a number of retailers, including Walmart, the nation's largest private employer, Target and TJX Cos have increased pay for hourly workers. 
NEARING FULL EMPLOYMENT 
The jobless rate is near the 5.0 percent to 5.2 percent range most Fed officials think is consistent with a steady but low level of inflation.  
A broad measure of joblessness that includes people who want to work but have given up searching and those working part-time because they cannot find full-time employment fell to 10.4 percent last month, the lowest since June 2008, from 10.5 percent in June. 
But the labor force participation rate, or the share of working-age Americans who are employed or at least looking for a job, held at a more than 37-1/2-year low of 62.6 percent.
The fairly healthy employment report added to robust July automobile sales and service industries data in suggesting the economy continues to gather momentum after growing at a 2.3 percent annual rate in the second quarter. 
Employment gains in July were concentrated in service industries. At the same time, construction payrolls rose 6,000 thanks to a strengthening housing market, after being unchanged in June. Factory payrolls increased 15,000 as some automakers have decided to forgo a usual summer plant shutdown for retooling, after rising 2,000 in June. 
More layoffs in the energy sector, which is grappling with last year's sharp decline in crude oil prices, were a drag on mining payrolls, which shed 4,000 jobs in July. The mining sector has lost 78,000 jobs since December. 
Oilfield giants Schlumberger and Halliburton and many others in the oil and gas industry have announced thousands of job cuts in the past few months.
The U.S. jobs numbers came in as expected, bolstering the case for the talking heads on Wall Street that the Fed is ready to go in September. At this writing, stocks are selling off as everyone is worried about another Fed taper tantrum.

I will discuss stocks a little lower. First, let me discuss Janet Yellen's global deflation problem. It is a widely held view on Wall Street that while the Fed pays attention to global developments, it ultimately sets interest rate policy based solely on what is going on in the U.S. economy. This has been the tradition and it looks like it will continue. However, I agree with those who keep warning of the Fed making a monumental mistake if indeed it raises rates too early.

Importantly, the return (more like continuation) of deflation presents a unique and very worrisome problem for the Fed. If it raises rates too early, it will exacerbate global deflation and usher in a prolonged period of sub-par growth and the possibility of a debt deflation spiral in the United States.

Before you dismiss this scenario as "impossible," take a good look at U.S. bonds (NYSEARCA:TLT). The yield on the 10-year Treasury fell on Friday following the jobs report and now stands at 2.18%. The bond market is definitely more worried about deflation than inflation. Even Bill Gross is warning that the global economy is dangerously close to deflation.

Emerging markets (NYSEARCA:EEM) have plunged 16% since their late-April highs and are now back to the level seen in June 2013, when then Fed chairman Ben Bernanke raised the prospect of a rate hike. The bursting of the China bubble and the subsequent rout in commodities is behind that selloff.

But it's not just emerging markets. Andrea Wong of Bloomberg notes that Canada is becoming a big problem for Yellen:
Federal Reserve Chair Janet Yellen said less than a month ago that she expected the dollar's drag on the American economy to dissipate. She may not have foreseen that the greenback would surge to an 11-year high against the currency of the U.S.'s biggest trading partner.
 
As the greenback's advance against the euro and the yen subsided, its 5 percent rally against the Canadian dollar this quarter may prove to be more detrimental to the world's biggest economy. The U.S.'s northern neighbor buys about 17 percent of America's products, more than any other nation, data compiled by Bloomberg show. And shipments already have declined after reaching a record last year (click on image below).

(click to enlarge)

A firm dollar makes American goods relatively more expensive abroad, presenting a hurdle for Fed officials as they prepare to raise interest rates for the first time since 2006. 
The central bank's trade-weighted dollar index is approaching the March high that prompted Yellen at the time to warn the currency is weighing on exports and inflation. The index, which includes only major currencies, gives an almost 13 percent weighting to Canada, trailing only the euro area's influence. 
``Since late June, the speed in the dollar rally is probably equivalent to what we had earlier,'' said Charles St-Arnaud, senior economist at Nomura Holdings Inc. in London. ``I can hear some investors saying, `Oh yeah we're back to where we were in March when the Fed started to be worried about the dollar.'''
You already know my thoughts on Canada, stick a fork in her, she's done. I've been short Canada since December 2013 and judging from the latest employment figures, the Canadian economy is going nowhere fast. In fact, Martin Roberge of Canaccord Genuity told me and Fred Lecoq he wouldn't be surprised if the Bank of Canada engages in QE next year and that in this scenario, provincial bonds will rally hard.

Martin also warned us of the US Dollar Index (DXY) and its effect on the global economy. I've been long the mighty greenback for some time and keep ignoring those who are shorting it. But I'm starting to think the consensus is too comfortable with the long U.S. dollar trade and the unwinding of the Mother of all carry trades may spook markets this fall.

It's important to understand that the strong U.S. dollar has already done a lot of the heavy lifting for the Fed. It has kept import prices low, capping inflation expectations. If it rises a lot more, it will continue to pummel commodities and bring about another crisis in emerging markets, which in turn will reinforce deflationary pressures around the world.

Interestingly, Bloomberg reports that hedge fund losses from commodities is sparking an investor exodus but not everyone is feeling the pain of rout in commodities:
Andurand Capital Management, run by Pierre Andurand, gained 3.5 percent in July, bringing his 2015 gains to 4.8 percent, according to a person familiar with the matter. The fund, which manages about $500 million, delivered a 38 percent return in 2014. The company declined to comment.
You will recall Pierre Andurand provided his outlook on oil for my blog readers at the end of December, 2014. He was much more bullish on oil and global growth than I was but if you read his views in that comment of mine, he pretty much nailed it which is why his fund is up in 2015 when most other commodity funds are suffering huge losses (a true testament to Pierre Andurand's exceptional talent in trading commodities).

That brings me to my outlook on stocks. All this negativity about a September rate hike is presenting interesting opportunities. The bears are all growling, warning us that stocks are a disaster waiting to happen, but I would ignore them.

Why? There is still plenty of liquidity to drive stocks and other risk assets much, much higher. Sure, we are experiencing summer doldrums, people are increasingly nervous about what will happen this fall, but I still maintain you should be buying the dips on stocks and ignore the fear.

Having said this, pick your spots very carefully and keep focusing on the leaders. Fears of Fed tightening may boost financials (NYSEARCA:XLF) as banks and insurance companies will make money on the spread. Conversely, fears of global deflation are propping up utilities (NYSEARCA:XLU) and REITs (NYSEARCA:VNQ) as investors are betting the Fed will hold off on raising rates for a lot longer.

I'm avoiding these sectors and keep focusing my attention on tech (NASDAQ:QQQ) and especially biotech (IBB and XBI) where I use big dips to load up on companies I like going forward. Admittedly, it's been a god awful week for media and biotechs, especially many of the smaller biotechs I trade and invest in, but that is all part of the game (they are insanely volatile; click on the list below to view a few I track and trade).



Also, something else to think about. What if the Fed doesn't move in September? What if the U.S. dollar starts reversing course? What if the reflationistas are right and global growth finally picks up this fall?

Don't be surprised if you then see a snap-back rally in energy (NYSEARCA:XLE) and mining and metal shares (NYSEARCA:XME). I am paying particular attention to oil service (NYSEARCA:OIH) and drilling shares as these will move first and have been decimated in 2015 (click on image):



For now, I continue to steer clear of energy and commodity sectors but I'm keenly aware there will be violent countertrend rallies along the way and some might last for weeks (bag holders should use these rallies to shed their positions).

Still, my strategy hasn't changed despite the Septaper tantrum. I continue to buy the dips on biotech and sell the rips on energy and mining shares, believing the leaders will surge higher and the laggards will continue hitting new lows.

Below, Jim Paulsen, Wells Capital Management, provides his thoughts on the impact of Friday's jobs number on the Fed's decision to raise interest rates and its likely impact on the markets.

Also, it's been a great year for short sellers in the S&P. Which popular short could drop even more? Rich Ross of Evercore ISI and Gina Sanchez of Chantico Global discuss with CNBC's Brian Sullivan. Apart from energy and mining, I think the short of the year and week was Keurig Green Mountain (NASDAQ:GMCR).

Lastly, everyone's favorite bull during the tech bubble, Abby Joseph Cohen, president of Goldman Sachs Group Inc.'s Global Markets Institute, talks about the outlook for U.S. equities and the economy, and Goldman's investment research and strategy. Take the time to watch this Bloomberg interview here.


What Greece Needs to Prosper

Edmund S. Phelps

AUG 6, 2015

Greek flag held by teenage boy

NEW YORK – Some economists overlook the modern idea that a country’s prosperity depends on innovation and entrepreneurship. They take the mechanistic view that prosperity is a matter of employment, and that employment is determined by “demand” – government spending, household consumption, and investment demand.
 
Looking at Greece, these economists argue that a shift in fiscal policy to “austerity” – a smaller public sector – has brought an acute deficiency of demand and thus a depression. But this claim misreads history and exaggerates the power of government spending.
 
Much of the decline in employment in Greece occurred prior to the sharp cuts in spending between 2012 and 2014 – owing, no doubt, to sinking confidence in the government. Greek government spending per quarter climbed to a plateau of around €13.5 billion ($14.8 billion) in 2009-2012, before falling to roughly €9.6 billion in 2014-2015. Yet the number of job holders reached its high of 4.5 million in 2006-2009, and had fallen to 3.6 million by 2012. By the time Greece began to cut its budget, the rate of unemployment – 9.6% of the labor force in 2009 – had already risen almost to its recent level of 25.5%.
 
These findings weigh heavily against the hypothesis that “austerity” has brought Greece to its present plight. They indicate that Greece’s turn away from the high spending of 2008-2013 is not to blame for today’s mass unemployment.
 
Another finding casts doubt on whether austerity actually was imposed on Greece. Government spending has certainly fallen – but only to where it used to be: €9.6 billion in the first quarter of this year is, in fact, higher than it was as recently as 2003. So the premise of austerity appears to be wrong. Greece has not departed from past fiscal norms; it has returned to them. Rather than describing current government spending as “austere,” it would be more correct to view it as an end to years of fiscal profligacy, culminating in 2013, when the government’s budget deficit reached 12.3% of GDP and public debt climbed to 175% of GDP.
 
The “demand school” might respond that, regardless of whether there is fiscal austerity now, increased government spending (financed, of course, by debt) would impart a permanent boost to employment. But Greece’s recent experience suggests otherwise. The huge rise in government spending from 2006 to the 2009-2013 period did produce employment gains, but they were not sustained.
 
The real sticking point is that the government would have to issue bonds to finance its extra spending.
 
Assuming a limit to foreign investors’ willingness to buy these bonds, Greeks would have to buy them. In an economy unequipped for growth, household wealth relative to wages would soar, and the labor supply would shrink, causing employment to contract.
 
So spending more is not the remedy for Greece’s plight, just as spending less was not the cause.

What is the remedy, then? No amount of debt restructuring, even debt forgiveness, will suffice to achieve prosperity (in the form of low unemployment and high job satisfaction). Such measures would only help Greece to revive government spending. Then the economy’s stultifying corporatism – clientelism and cronyism in the public sector and vested interests and entrenched elites in the private sector – would gain a new lease on life. The European left may advocate that, but it would hardly be in Europe’s interest.
 
The remedy must lie in adopting the right structural reforms. Whether or not the reforms sought by the eurozone members raise the chances that their loans will be repaid, these creditors have a political and economic interest in the monetary union’s survival and development. They should also be ready to help Greece with the costs of making the necessary changes.
 
But it is Greece itself that must take charge of its reforms. And there are encouraging signs that Prime Minister Alexis Tsipras is willing to take up that cause. But he will need a sense of the required reforms. Greece must dismantle corporatist arrangements and practices that obstruct whatever innovation and entrepreneurship might emerge. Nurturing an abundance of imaginative innovators and vibrant entrepreneurs requires embracing a vision of venturesome lives of creativity and discovery.
 


Why The Downturn In Gold Does Not Reflect Long-Term Reality

by: Atlas Grinned 
          



Summary
  • Gold is down on perceived economic strength in the US, but the coming rate hike is coming on the back of very low GDP and inflation statistics.
  • This indicates any rate hike will not be sustained and possibly quickly reversed, and when the market figures this out, gold will likely climb.
  • Gold miners continue to lose money, and at this rate most of the industry will go bankrupt, squeezing supply.
Over the past 30 days, the price of spot gold has fallen 7%. As is to be expected, the majority of gold ETFs have mirrored this decline. The SPDR Gold Trust ETF (NYSEARCA:GLD) traded for $105.37 at last close, having opened the month at a little over $111. The iShares Gold Trust ETF (NYSEARCA:IAU) currently trades at $10.62, again down from the $11.30 where we opened the month. The sharp decline comes as a culmination of a number of factors, including expectations of a Fed interest rate hike on the back of a perceived strong US economy, and a downturn in China, which has the potential to weaken global demand for most metals on the back of reduced manufacturing activity.

With all this activity, the big question is how hard is gold likely to fall, and is now the time to reallocate towards higher return assets. Judging by popular news media, the answer looks to be yes.

However, for a number of reasons, things may not be quite so simple. From a global economic perspective, we are in something of an unprecedented situation, and the traditional capital flow between risk-on and risk-off assets in response to economic expansion/contraction might need a second look.

According to popular perception, the US economy has expanded over the last five years. The NASDAQ is up more than 130% since this time in 2010 while the Dow Jones Industrial Average up more than 70%, and the S&P 500 hit fresh highs on July 17 to chalk up gains of more than 92% across a five-year period. Further, unemployment is down at a little over 5% - its lowest level since Mid-2008. This activity has fueled expectations of a near-term interest rate hike. The US dollar has gained strength over the last few months relative to other currencies, and this strength has played a big part in gold's recent fall.

However, take a closer look at the US economy, and there are questions over whether a) it is ready for an interest rate hike and b) if such a hike could spark an economic downturn. Interest rates are normally used by a country's central bank to control inflation - when the target is hit, it will generally raise interest rates, with the reverse being true for a below target inflation levels at times of economic downturn.

The last CPI read, which measures inflation, came in at 0.1%.


This is the highest level of inflation we have seen this year. Back in April, inflation came in at -0.2%.

Deflation is not generally associated with a booming economy and an interest rate hike.

Similarly, quarterly GDP growth for March came in at -0.2%. The US economy actually contracted on a quarter-over-quarter basis. Again, an economic contraction generally does not precede an interest rate hike, and it is definitely not a sign of a stable and thriving economy.

What is happening in equities markets does not seem to reflect the fundamental economic situation in the US.

Before we draw any speculative conclusions, let's move quickly on to China. Chinese growth keeps coming in at 7% - bang on target with the Chinese government's GDP expectations.

Numerous questions exist as to the validity of the data we see out of China, but these questions aside, it looks as though the Chinese economy is slowing. China being a big gold buyer, it is this weakening that has contributed to the gold's recent decline. However, when we think bigger picture, a reduction in industrial metal demand may well translate to a medium-term reduction in the price of metals such as copper, iron and to some extent silver, but a reduction in the price of gold can only be a short-term perspective.

Why? Because if the Chinese economy is indeed weakening to the extent that its demand for industrial metals has a marked impact on the price of these metals, then there will likely be fallout on a global scale. The majority of Asian nations, as well as Australia and New Zealand are very closely tied to the Chinese economic prosperity, and could suffer as a result of a Chinese slowdown. The US is also not immune. A global economic impact would likely quickly alter sentiment, and initiate an allocation of capital back towards risk-off assets, translating to yellow metal strength. This is something akin to what happened in 2008, when gold initially sold off short term, but then flew to new highs for the next 3 years led by miners.

And what about Greece? Well, Greek banks reopened this week, and it now looks as though Greece will remain part of the Eurozone for the foreseeable future. Strict austerity measures are reported to be the answer to the nation's current fiscal crisis, and it is now just a case of hammering out a deal that suits both sides. But is it really this simple? With the Greek banks reopened, it is not unreasonable to suggest that cash reserves will quickly deplete. In fact, Greek bank stocks have been crashing limit down every day since the Athens exchange has reopened. If banks in your domestic economy closed for three weeks, how much longer would you leave your deposits sitting with them once they reopened?

The bank run that was only avoided through the closing of these banks could still take place over the next few weeks regardless of any political agreement between Greece and the wider Eurozone. What collateral effects might this have on banking systems across Europe? Further, austerity measures have repeatedly been shown as not being a realistic option for Greece. The country is in a position where it needs its debt written off entirely, and in the current negotiations, this is very unlikely to happen. The takeaway? That it is only a matter of time (likely short term rather than longer term) that we are again in a very similar situation.

So to bring this all together, we have the potential interest rate hike in the US, six years into a nationwide economic recovery, but imposed upon fundamental data that includes economic contraction and quarterly deflation. Further, we have a gold and industrial metal sell-off because shortsighted speculators see Chinese manufacturing weakening, without taking the global economic implications of a Chinese downturn into consideration. Finally, markets have seemingly reversed their bearish outlook on Greece and the Eurozone, based upon negotiations that fix only a very short-term problem in the single currency region, and fuel further and more serious problems down the line.

Moreover, this is looking at things from a macroeconomic perspective only. At current prices, gold mining companies cannot afford to keep processing ounces. The further the gold falls, the higher the loss each company shoulders per ounce, and the lower newly mined supply will become. Weak prices make it very difficult for junior gold explorers to attract investment, meaning not only do we have a reduction in the processing of current supply, but also a reduction in the exploration and identification of fresh unprocessed supply.

Gold may be down, but longer term, both macro and micro economic forces dictate that we must see a turnaround or we will simply run out of gold as bottom pickers buy existing supply and store it away. If suddenly, after 5,000 years of financial history, nobody else but the gold bugs care about gold anymore, then it won't matter. But if there is to be a supply of any kind, gold prices must rise, and soon.

Catching the proverbial falling knife is dangerous though, and the more conservative play is to wait for a breakthrough of around $1,170 an ounce.


Wednesday, August 5, 2015

Cash Will Be Abolished. Here's Why ...

by Larry Edelson


Governments have largely always despised cash. It's almost impossible to trace, and therefore, tax. And it sustains an underground economy for drug dealers and terrorists.

Never mind that there are plenty of good people in the underground economy. The government doesn't care. They see a rat in the barn, and governments, as they are, are all too ready to burn down the barn to catch the few rats.

For years now, that's largely how governments around the world have waged a war on cash. They've implemented restrictions on how much you can carry with you. How much cash you have on you that you have to report when you go through customs. How much you can withdraw from the bank at any one point in time. And more.

The thing is, government wars on cash are now on steroids. The reason: The looming sovereign-debt collapse that will soon cascade from Europe, then to Japan, and finally, to the US of A.

As I have said all along, when governments' backs are up against the wall, they act like caged animals, lashing out at anything and anyone that restricts their ability to stay alive.

Governments around the world have waged a war on cash, restricting how much you can carry with you.

One of the chief proponents of eliminating cash from the system is Ken Rogoff of Harvard University. But along with him are other economists who agree, and who also have major clout with governments and central banks around the world. Larry Summers and Citigroup Chief Economist Willem Buiter, for instance.

Their thinking is this: Cash is, yes, difficult to track and tax, but it also makes it difficult, if not impossible, for negative interest rates to stimulate the economy.

That's critical now because deflation is surrounding the globe. In Europe, for instance, the European Central Bank (ECB) has had negative interest rates in effect since June of last year. Currently at -0.2%, if you're a bank in the eurozone, your "reserves" at the ECB gradually lose value if you don't lend them out.

The Danish and Swiss national banks have steeper negative interest rates of -0.75%. After a year, 1 million Danish krone or Swiss francs would be worth only DKK/CHF992,500, respectively.

Sounds logical from an economic management point of view, right? After all, if banks aren't lending, then the right thing to do is to force them to lend by charging them if they don't.

Problem is, it doesn't work that way. Instead, the banks are largely turning around and charging their customers who deposit funds with them the same or steeper negative rates. That way, whatever the bank loses at the central bank, it gets it back from you, its depositing customer.

So now we have negative deposit rates for customers in much of Europe. And what is the customers' reaction to negative interest rates?

Simple — they pull their money out of the banks, in cash, and hoard it, or send it offshore to better lands and opportunities.

Along comes Ken Rogoff and gang. Their answer: Eliminate cash and ...

A. Less cash will be withdrawn from banks.

B. Banks will therefore lend more readily. And …

C. Bank runs, if they occur, can be ended immediately — by simply shutting down the system with an "internet-type kill switch."

Mark my words: Elimination of cash is where the governments of developed economies are headed. Toward fully electronic currencies instead.

If you don't believe me, then consider the steps that have already been taken that are leading in that very same direction:

In France, cash transactions over 1,000 euros are now illegal. It's also a crime to send any amount of cash by mail.

In Spain, the limit is 2,500 euros. Break that law and the government will confiscate 25% of your cash.

Italy has banned all cash transactions over 999.99 euros. To pay 1,000 euros or more, you must use a debit card, credit card, a "non-transferrable check," or pay by bank transfer. Violate the law, and the government will confiscate 40% of the amount paid.

Similar restrictions on cash are in place in Belgium, Bulgaria, Greece, Mexico, Russia, Uruguay and a number of other countries.

Here in the U.S. we don't (yet) have any restrictions onspending cash. But there are strict reporting rules. If you deposit or withdraw more than $10,000 from a bank or other financial institution (either by cash or electronically), the bank must file a "currency transaction report" with the U.S. Treasury.

In some parts of the country, there are "geographic targeting orders" in place — a fancy term for locations where the government feels there are drug or terrorist activities going on. Instead of the $10,000 limit, it's a $3,000 limit.

And then there are the "civil forfeiture" laws in place across the country, which gives the police the ability to confiscate any amounts of cash you may have in your pocket or in your car if they suspect you're a dealer or a terrorist. Problem is, scores of innocent citizens are being stopped and have their cash confiscated.

It's all going to get a heck of a lot worse for us in the months and years ahead. Bankrupt destitute governments are the cause. They will hunt you and your wealth down like never before.
And the problem is, they are simply too dumb to realize that in the end, they will still collapse, taking you — if you don't prepare — right along with them.

Stay safe and stay tuned ...