Monetary Fiasco

Doug Nolan

All great monetary fiascos are forged upon a foundation of misperceptions and flawed premises. There’s always an underlying disturbance in money and Credit masked by supposed new understandings, technologies, capabilities and superior financial apparatus.

During the nineties “New Paradigm” period, exciting new technologies and “globalization” were seen unleashing a productivity miracle. The Greenspan Fed believed this afforded the economy an accelerated speed limit. With inflation and federal deficits believed conquered, there was little risk associated with low interest rates and an “asymmetrical” policy approach to supporting the booming economy and financial markets. The Fed significantly loosened the reins on finance precisely when they needed to be tightened.

The nineties were phenomenal from a financial perspective. Total system Debt about doubled to $25.4 TN. Remarkably, Financial Sector borrowings surged more than 200% to $8.2 TN. 

Outstanding Agency (GSE) securities ballooned from $1.267 TN to end the decade at $3.916 TN, for growth of 209%. Securities Broker/Dealers (liabilities) jumped 212% to $1.73 TN. “Fed Fund and Repo” expanded 112% to $1.655 TN. Wall Street “Funding Corps” rose 387% to $1.064 TN. Securities Credit surged 414% to $611 billion.

And the most incredible aspect of the nineties boom in “Wall Street Finance”? Pertinent to today’s backdrop, the 1990’s Bubble unfolded over years with barely a notice. Everyone was mesmerized by the Internet, exciting new technologies and the white-hot IPO market. I was fixated by what I was convinced was evolving into epic financial innovation and a historic Credit Bubble. Yet attempts to explain this backdrop to other financial professionals, academics, economists, journalists and even Fed officials went absolutely nowhere. Repeatedly I heard frustrating variations of “Doug, you don’t understand.” “Only banks create Credit.”


“The Federal Reserve controls the money supply.” “Fannie and Freddie are only financial intermediaries – they don’t impact system Credit.” “Financial system borrowings don’t matter. Doug, you’re double-counting debt.”

Even back in the nineties, it was largely ideological. Everyone had adopted a doctrine of how finance worked and it was very rare that someone would take a deep dive into developments and the analysis and then challenge orthodoxy. As I’ve noted in the past, it was not until Paul McCulley coined “shadow banking” in 2007 that analysts and policymakers belatedly began to take notice.

Somehow history’s greatest period of financial innovation and Credit excess transpired without drawing the attention of conventional thinkers or even policymakers. Especially by 2006 and 2007, it was the “naysayers” that had been completely discredited. The conventional view held that financial innovation and policy enlightenment had fostered extraordinary financial and economic system stability. Analysis that the GSEs, MBS, ABS, speculative leveraging, securities finance and the derivatives marketplace had nurtured acute systemic fragilities was completely pilloried. The notion back in 2006 and 2007 that the world was at the brink of a major crisis was considered absolute wackoism. Incredibly – and well worth contemplating these days - virtually no one saw the deep structural impairment associated with the protracted Bubble in “Wall Street Finance.”

An even more momentous monetary fiasco has been perpetrated since the 2008 crisis, constructed upon a foundation of even more outlandish misperceptions and flawed premises. It was dumbfounding that virtually everyone disregarded the financial, economic and social ramifications associated with a doubling of mortgage Credit in just over six years. Throughout the boom, the issue of a systemic mispricing of mortgage Credit concerned virtually no one – not the marketplace and certainly not financial regulators. These days, analysis of a deeply systemic mispricing of financial assets on a global basis garners a yawn. Ramifications for an unprecedented inflation in central bank Credit and associated market manipulation go largely unappreciated. Somehow, it is accepted as obvious fact that the expansion of central bank Credit entails overwhelming benefits with minimal risk.

The financial world has come a long way since 2012. ECB president Mario Draghi Friday stated, “We will do what we must to raise inflation as quickly as possible” and use “all the instruments available.” This historic pronouncement is a historically notable upgrade from 2012’s “whatever it takes,” especially with it coming amid European economic recovery and securities market boom (i.e. bond yields near record lows).

Meanwhile, sentiment in the U.S. was captured with a simple CNBC headline: “Expect a ‘One-and-Done” Fed Rate Hike.” After delaying a little 25 bps bump in rates for seemingly forever, the Fed now sees it necessary to communicate the most dovish (potential) rate hike in the history of central bankers. And with the People’s Bank of China apparently in the midst of protracted monetary loosening, global markets are back in a holiday mood.

In not too many weeks it will be 2016. The financial crisis hit in 2008. A fundamental CBB maxim over the years is that once commenced monetary inflation becomes virtually impossible to suspend. While the Fed has paused QE, from a global Bubble perspective the BOJ and ECB still combine for about $125 billion monthly QE, with Draghi hankering to upsize. The Fed hasn’t raised rates in about a decade, with Fed funds stuck near zero now for almost seven years. The ECB, BOJ and “developed” central banks around the world are stuck at near zero short-term rates.

There are a number of myths and misperceptions underpinning the great “global government finance Bubble.” For starters, there’s the “so long as inflation (CPI and PPI) remains low and contained, unlimited central bank Credit expansion can be called upon to stabilize markets and economies.”

There is no bigger misperception than the belief that with Fed liabilities largely contained within the U.S. banking system (as a banking system asset) this Credit has minimal impact on the markets and real economy. Many early CBBs attempted to tackle the complex issue of how GSE Credit was distorting the financial system and economy (as well as international financial flows).

Most directly, the expansion of GSE liabilities created purchasing power that spurred a self-reinforcing inflation in mortgage Credit, home prices and sales transactions. Through myriad channels, this Bubble was boosting purchasing power throughout the economy. Less obvious – and certainly unrecognized at the time – mortgage Credit growth was inflating corporate profits and boosting incomes. And through various channels expanding mortgage Credit was instrumental in expanding the amount of finance flowing into the markets. Importantly, the booming liquidity backdrop incentivized a self-reinforcing Bubble in asset prices, risk-taking and speculative leveraging.

When reading academic papers on “Monetary Finance” (thanks R.C.), it’s clear that the economics community misses key dynamics of central bank monetary inflation. Simplistically, conventional thinking holds that if the federal government issues debt that is then purchased by the central bank, all is good so long as it’s not done in egregious excess. So long as there’s slack (insufficient demand) in the economy, risk remains minimal. This is consistent with the conventional view that’s taken hold in global markets that enlightened central bankers have mastered the science of non-inflationary stimulus of aggregate demand.

It’s interesting that contemporary academic theories and models supportive of Central bank “monetary financing” focus chiefly on traditional concepts of “aggregate nominal demand” and “inflation.” So long as demand is insufficient and inflation low, “monetary financing” is seen as both highly desirable and low-risk. Supposedly there is essentially no limit to the size of the central bank’s holdings of government debt so long as aggregate demand is below potential and inflation is contained. The academics avoid the critical issue of monetary inflation’s highly complex (I would argue unpredictable) impact on security and asset market dynamics, including leveraged speculation and Bubbles.

At the heart of today’s misperceptions is the view that the Federal Reserve is able to purchase Treasury debt without creating inflationary effects so long as Fed Credit is held inertly on the banking system’s balance sheet. Apparently, the federal government can deficit spend and the Fed can monetize this debt with minimal risk because of economic slack and tame inflation. 


There are today effectively no restraints on the Treasury’s debt load, as there is no reason for the Fed to liquidating its Treasury holdings. As thinking goes, the current backdrop affords central bankers an essentially unlimited capacity to monetize debt, in the process stimulating aggregate demand back to potential. And at some point the Fed (and global central banks) will extinguish their sovereign debt holdings and erase federal government debt obligations altogether

Between 2008 and 2014, the Federal Reserve’s balance sheet swelled $3.604 TN, from $951 billion to $4.555 TN. Over this same period, banking system total assets expanded $3.753 TN (to $16.898 TN). Loans, the banking system’s largest, expanded only $789 billion (to $9.087 TN). 


The fastest growing asset, Reserves at the Fed, surged from $21 billion to $2.357 TN.

There’s a misperception that banking system holdings of “Reserves at the Fed” signifies that this liquidity has not departed the banking system. In reality, the banking system came to hold Reserves at the Fed as banks created new deposits for customers in exchange for Fed liquidity. 


Since 2008, Bank Deposits (checkable, small & savings and large time) have expanded $3.982 TN, or 46% (to $12.470 TN to end 2014).

The surge in bank deposits (reflected in M2) is evidence of a historic post-2008 monetary inflation. Why this inflation in purchasing power has not translated into rising CPI is a complex issue (massive global investment/overcapacity, unlimited supply of technologies and digitalized output, a services-based economy, inequitable wealth distribution, “financial engineering”, etc.). Clearly, with the Fed manipulating interest rates and backstopping securities markets through massive QE purchases, “money” has been incentivized to flow into the securities and asset markets (over real economy investment). Furthermore, the Fed targeting higher securities market prices has incentivized leveraged speculation and “financial engineering,” both working to draw finance into the “Financial Sphere” as opposed to the “Real Economy Sphere.”

This gets to the heart of the most dangerous myth and misperception: that central banks control inflation. I would contend that the Fed some time ago lost control of inflationary dynamics. The move to unfettered global market-based finance was transformative. Runaway financial Bubbles provided virtually unlimited finance for unprecedented growth in manufacturing capacity (i.e. China, Asia, EM, technology, healthcare and all things energy/commodities). At the same time, these Bubbles became magnets for finance, again with major ramifications for inflation dynamics. Moreover, the financial Bubble backdrop ensured major wealth disparities, one more profound factor in today’s highly unusual inflationary backdrop.

For the past two decades, global central bankers have nurtured and accommodated securities market-based finance. The resulting Bubble stimulated historic growth and perceived wealth creation like never before. Unprecedented post-2008 measures ensured Bubble Dynamics turned increasingly unwieldy. 


Concerted open-ended QE in 2012 was the final straw: market Bubbles are out of control. 

Draghi will not raise consumer price inflation with QE, although he very well could further stoke securities markets inflationary Bubbles. A weaker euro may somewhat raise consumer inflation, yet such “beggar thy neighbor” policies are a zero sum game. Chinese manufactures saw their currency gain another 1% versus the euro this week.


The Bubble Right In Front Of Our Faces
             

 

Following the steep but relatively contained market plunge in August, the major indices rebounded toward their May highs, but neither the broad market nor high-yield credit participated meaningfully. Only 34% of individual stocks remain above their respective 200-day averages, widening credit spreads suggest growing concerns about low-quality debt defaults, and sectoral divergences (e.g. relative weakness in shipping vs. production) confirm what we observe in leading economic data — a buildup of inventories and a shortfall in new orders and order backlogs. Employment figures lag the economy more than any other series.

When investors are risk-seeking, they tend to be indiscriminate about it. If market internals were uniformly favorable, suggesting that investors remained inclined toward yield-seeking speculation, we could at least expect that continued speculation might defer immediate market losses, or possibly drive valuations to even more offensive levels. Fed easing (or the decision not to raise rates) might be bullish in that environment. But as investors should recall from Fed easing in late-2007 and early 2001, just as market collapses were beginning, Fed easing is among the most bearish possible events when it occurs in an environment of rich valuations and unfavorable market internals, as such easing is typically provoked by concern about economic deterioration.

In the absence of favorable internals, we conclude not only that risk premiums in equities are razor thin, but that the continued shift toward risk-aversion among investors leaves the market vulnerable to abrupt spikes in risk premiums. This is an environment that has historically left the market open to vertical air-pockets, panics, and crashes.

The bubble right in front of our faces


Investors don’t like to acknowledge bubbles. And because they’ve been so prone to deny them, bubbles (and their consequences) have become a recurring part of the financial landscape over the past two decades. During the late-1990’s technology/dot-com bubble, debt-financed malinvestment was mainly directed toward internet-related companies. The end result was a collapse in the Nasdaq 100 of -83%, while the S&P 500 lost half its value. By the 2002 low, the entire total return of the S&P 500 — in excess of Treasury bills — had been wiped out, all the way to back May 1996.

It has taken yet another full-fledged multi-year speculative bubble to get the Nasdaq back to even (most likely only temporarily), and to bring the total return of the S&P 500 since 2000 to even 4% (again, most likely only temporarily). By the completion of the current market cycle, we fully expect that the total return of the S&P 500 since the 2000 peak will fall to zero or negative levels for what will then be a roughly 17-year span, and that the S&P 500 will have underperformed Treasury bills all the way back to roughly 1998; what will then be a nearly 20-year span.

As a reminder of how unwilling investors are to acknowledge bubbles, one must remember that in 2000, even before the S&P 500 even reached its final bull market high on a total-return basis, a broad range of dot-com stocks had already collapsed by about 80% from their own 52-week highs.

Investors were finally willing to acknowledge that bubble only after it collapsed, but somehow continued to believe that the bubble was contained only to dot-com companies, and continued to push the S&P 500 higher. Consider this gem from the Wall Street Journal, which appeared in July 2000 with the title “What were we THINKING?”
“For a while it seemed that risk was dead. Now we know better... Why didn’t they see it coming? Arrogance, greed and optimism plus fear of being left out blinded people to the risks. After all, the dot-commers embraced risk. They prided themselves on their willingness to gamble and used it to justify their lucrative stock-option plans. Unfortunately, at the extreme far end of the risk curve, people lose perspective.”
All of that apparent learning, stated in the past tense, might have been well and good were it not for the fact that the S&P 500 was still at record highs, at the most extreme valuation in history, and the broader collapse had not even started. The tech-heavy Nasdaq 100 was down -14% from its March 2000 high, but would go on to lose another -80% by its October 2002 low.

Many of those companies were, and remain, outstanding businesses. But just as a parabolic stock price advance is no assurance that the underlying business is sound, having a sound underlying business does little to prevent an overvalued stock from collapsing once investors lose their taste for speculation. Investors have a habit of pointing to past bubbles as if they have actually learned something, even when they are in the midst of another one.

By 2007, the S&P 500 had again reached record highs, though the market’s total return from the 2000 peak was still only about 2% annually. The preferred object of speculation during the housing bubble was mortgage debt. With the Federal Reserve suppressing yields to just 1% in 2003, yield-seeking investors found higher returns in mortgage securities, Wall Street jumped to create new “product,” credit standards were lowered, debt was “financially engineered” to bundle it in ways that could get a rubber stamp from ratings agencies, and unsound debt filled the portfolios of insurance companies, banks, and hedge funds. By the March 2009 low, the entire total return of the S&P 500 — in excess of Treasury bill returns — had been wiped out all the way back to June 1995. Investors, analysts, and economists look back on that bubble, and the global collapse that followed, as if they have actually learned something.

So here we are, in what in hindsight will likely be called the “QE Bubble” — a moment in history where the most reckless and intentional encouragement of speculation by central bankers actually came to be viewed as not only acceptable but welcome. This is tolerated despite the fact that activist departures of monetary policy from simple rules (such as the Taylor Rule) have absolutely no correlation with subsequent economic activity. This is tolerated despite the clear evidence that yield-seeking speculation was the primary driver of malinvestment that created the housing bubble and economic collapse. We’ve still evidently learned nothing.

The preferred object of debt-financed speculation this time around is the equity market. As for direct debt-finance of equity speculation, margin debt soared to more than $500 billion in April, 2.8% of GDP, eclipsing the 2000 and 2007 record highs. One should not compare margin debt to equity market capitalization, but rather to a fundamental; otherwise, the existence of a bubble in prices can make even alarming levels of margin debt appear reasonable. The recent level of stock margin debt is equivalent to 25% of all commercial and industrial loans in the U.S. banking system. Meanwhile, hundreds of billions more in low-quality covenant-lite debt have been issued in recent years. As a ratio of corporate gross value added, both corporate debt and the market value of corporate equities have climbed to the highest levels in history. Our friend Albert Edwards shares another interesting observation: the surge in corporate debt maps closely to the volume of net corporate equity buybacks.

(click to enlarge)

The preferred objects of speculation, and the greatest casualties of the 2000 bubble, were technology and dot-com companies. The preferred objects of speculation, and the greatest casualties of the mortgage bubble, were housing and the financial companies that held those mortgages. Recognize that because QE provoked such indiscriminate speculation, the recent extremes in the median price/earnings and price/revenue ratios, across all stocks, actually surpassed their 2000 peaks. Make no mistake: the preferred objects of speculation during the QE bubble have been low-grade debt and the entire stock market, indiscriminate of industry, sector, quality, or capitalization. We are now beginning to observe internal divergences that signal increasing risk aversion among investors. The greatest casualty of the QE bubble will also likely be low-grade debt and the entire stock market, probably just as indiscriminately.

Investors don’t like to acknowledge bubbles. Yet somehow we have little doubt that a few years from now, they will look back at the present moment and ask that tragically perennial question: “What were we THINKING?”

Choose your weapon

As a brief valuation review, the chart below shows a variety of the most historically reliable valuation measures we identify, charted as percentage deviations from their historical norms.

Note that raw price/forward earnings and the Fed Model are not among them, because their correlations with actual subsequent market returns are rather weak (though we’ve seen charts that make them look compelling as long as one ignores enough history). I wrote my August 20, 2007 market comment Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios, to counter what I viewed as misguided claims of “reasonable valuation” at a time when, as now, historically reliable measures were quite extreme. That said, one can obtain a fairly useful valuation measure by adjusting the forward P/E to reduce the impact of cyclical fluctuations in profit margins. To obtain historical data before 1980, one has to impute based on other observable information (as explained in that 2007 article). That’s because forward operating earnings are an object created by Wall Street, not by Generally Accepted Accounting Principles.

As I noted in Valuations Not Only Mean-Revert; They Mean-Invert, reliable valuation measures typically fully mean-revert within a 12-year horizon, meaning that there is no relationship between initial overvaluation (or undervaluation) and the level of overvaluation (or undervaluation) 12 years later. It follows that the most reliable horizon to relate valuations with subsequent equity market returns is also about 12 years. It’s also worth noting that since 1950, there has been no material relationship between interest rates and their level 12 years later.

The following are the correlations, since 1950, between each valuation measure and actual subsequent S&P 500 nominal total returns over the following 12-year period. The correlations are negative because higher valuations are associated with lower returns:

Shiller P/E: -84.7% correlation with actual subsequent 12-year S&P 500 total returns

Tobin’s Q: -84.6% correlation

Nonfinancial market capitalization/GDP: -87.6%

Margin-adjusted forward operating P/E (see my 8/20/10 weekly comment): -90.7%

Margin-adjusted CAPE (see my 5/05/14 weekly comment): -90.7%

Nonfinancial market capitalization/GVA (see my 5/18/15 weekly comment): -91.9%

(click to enlarge)


Choose your weapon. We view all of these measures as reasonably reliable (in comparison with a broad range of popular but largely worthless alternatives), but even here there are differences. Tobin’s Q and the Shiller P/E are currently the least extreme relative to their pre-bubble historical norms (75.5% and 99.6% overvalued, respectively), but they are also not as reliable as the other measures. Interestingly, market capitalization to GDP (which Warren Buffett once cited in a 2001 Fortune interview as “probably the best single measure of where valuations stand at any given moment”) is the most extreme among these, at more than 145% above its pre-bubble norm, implying a -59% market drop simply to restore that norm — not even to move to historical undervaluation. While Buffett hasn’t said boo about this indicator in recent years, it’s certainly not because it has lost its correlation with subsequent market outcomes in recent market cycles. Indeed, the correlation of Market Cap/GDP with subsequent 12-year S&P 500 returns since 1980 (capturing multiple recent market cycles) is even stronger at -93.0%. The same is true among all of these measures. Still, even MarketCap/GDP isn’t the most reliable measure presented here.

Not surprisingly, if one had to choose a single weapon on the valuation front, my preference would be one of my own: nonfinancial market capitalization to corporate gross value added, inclusive of estimated foreign revenues (see my 5/18/15 comment introducing this measure). At present, MarketCap/GVA is about 128% above its pre-bubble norm, and implies negative 10-year S&P 500 nominal total returns, with expected 12-year S&P 500 nominal total returns averaging only about 1% annually.

In the chart below, the blue line shows MarketCap/GVA on an inverted log scale (left). The red line shows the actual subsequent 12-year annual nominal total return of the S&P 500 in percent (right scale).

(click to enlarge)

If it seems preposterous to expect such dismal market returns over a 10-12 year period, recall that the S&P 500 did worse than that after the 2000 market peak. In my view, the most likely path to dismal market returns is the one that has been most typical historically: a major bear market loss, followed by a long period of reasonably positive average returns that recover the loss over time. For example, either of the following possible outcomes would result in a 12-year total return just over 1% annually: a) a -47% market loss over 2 years, followed by a 10-year period in which the S&P 500 achieves a positive total return of 8% annually, or b) a -55% market loss over 2 years, followed by a 10-year period over which the S&P 500 achieves a positive total return of 10% annually. The reason I used those particular figures is that they correspond to the 2000-2002 and 2007-2009 collapses.

Interestingly, if this sort of scenario actually emerges, the red line in the preceding chart will fit over the blue line like a glove. I expect we’re in for quite a loss in the S&P 500 over the completion of the present market cycle.

What about interest rates?

Investors may wish to believe that low interest rates somehow, by their very nature, are sufficient to prevent such losses. They may do well to recall that Japanese stocks plunged by -62% in 2000-2003 and -61% in 2007-2009 despite interest rates that never exceeded half of one percent. There are certainly structural differences between Japan and the U.S., but those differences do not extend to eliminating the iron laws of investing; that every security is a claim on some stream of expected future cash flows, and the higher the price one pays for those cash flows, the weaker the long-term rate of return. Recall also that the historical correlation between interest rates and equity valuations has actually been zero outside of the disinflationary 1980-1998 period. Suppressed interest rates can certainly encourage yield-seeking speculation, helping to drive equities and other securities to extreme valuations that offer similarly dismal prospects for future returns. But when investors turn risk-averse, as they did in 2000-2002 and 2007-2009, those dismal prospects are realized, and even persistent and aggressive Fed easing has not prevented U.S. equities from collapsing.

Similarly, it’s tempting to assume that interest rates will remain so low in the future that investors will maintain stocks at extremely high valuation levels, with no tendency toward mean-reversion at all. The fact is that the correlation is very weak between interest rates at one date and interest rates 10-12 years later. More importantly, however, there is a 90% correlation between interest rates at any given date (e.g. the 10-year Treasury bond yield) and nominal economic growth over the preceding decade. So if you’re assuming that interest rates will be low a decade from now, you’re also effectively assuming that nominal economic growth will be dismal.

The question of whether interest rates should directly enter a valuation model depends on what one is doing with it. If one wishes to estimate the long-term expected rate of return on a security, all that’s required is the expected stream of future cash flows and current price. In contrast, one might wish to reverse that question, and calculate the price that would be consistent with some required rate of return. In this case, interest rates come into the model only as a way of deciding what return one wishes to obtain. Given expected future cash flows and that required rate of return, it is then just arithmetic to calculate the corresponding price.

As I noted in our 2015 Annual Report:
“It is important to recognize that while depressed interest rates may encourage investors to drive risky securities to extreme valuations, the relationship between reliable valuation measures and subsequent investment returns is largely independent of interest rates. To understand this, suppose that an expected payment of $100 a decade from today can be purchased at a current price of $82. 
One can quickly calculate that the expected return on that investment is 2% annually. If the current price is given, no knowledge of prevailing interest rates is required to calculate that expected return. Rather, interest rates are important only to address the question of whether that 2% expected return is sufficient. If interest rates are zero, and an investor believes that a zero return on other investments is also appropriate, the investor is free to pay $100 today in return for the expected payment of $100 a decade from today. The investor may believe that such a trade reflects ‘fair value,’ but this does not change the fact that the investor should now expect zero return on the investment as a result of the high price that has been paid.  
Once extreme valuations are set, poor subsequent returns are baked in the cake.”
As a side note, many of our methods of projecting 10-year S&P 500 total returns embed the assumption of 6% nominal growth in earnings, revenues and the broad economy; a rate that has been fairly consistent when one looks peak-to-peak across historical economic cycles, despite substantial shorter-term variation (see Ockham’s Razor and the Market Cycle).

Assuming that interest rates will be strikingly low in the future is essentially equivalent to assuming nominal growth will be strikingly low. Because those two effects tend to offset each other, the relationship between valuations and subsequent 10-12 year returns has typically been unaffected.

The long-term outcomes are inevitable; the shorter-run outcomes hinge on market internals
When investors are inclined to speculate, they tend to be indiscriminate about it, so strongly speculative markets demonstrate a clear uniformity across a broad range of individual stocks, industries, sectors, and risk-sensitive securities, including debt of varying creditworthiness. In contrast, as risk-aversion sets in, the first evidence appears as divergence in these market internals.

Put simply, overvaluation reflects compressed risk premiums and is reliably associated with poor long-term returns. Over shorter horizons, investor risk-preferences determine whether speculation will continue or collapse, and the condition of market internals acts as the hinge that distinguishes those two outcomes.

Valuations have been obscene for some time. Historically, the thing that has differentiated an overvalued market that remains elevated or continues higher, and an overvalued market that plunges, is the preference of investors toward risk — which is best inferred from the uniformity or divergence of market internals. Those measures have been unfavorable since the third quarter of 2014, which has opened the door to more frequent air-pockets and vertical losses. As with the 2000 and 2007 top formations, market peaks are often a process, and while recoveries on weak internals tend to be followed by fresh losses, the process can extend for months.

Overvalued, overbought, overbullish conditions have also been a rather persistent feature of the market in recent years. In prior cycles across history, similar extremes were typically accompanied or quickly followed by deterioration in market internals, and the overextended extremes were resolved by market losses. In the half-cycle advance since 2009, the Federal Reserve aggressively and intentionally encouraged yield-seeking speculation, and disrupted that overlap. One had to wait for market internals to deteriorate explicitly before adopting a strongly negative market outlook. That, in a nutshell, was our fundamental problem in this half-cycle; I responded directly to overvalued, overbought, overbullish conditions by immediately taking a negative market outlook; just as prior market cycles across history had encouraged.

I’ve regularly admitted that error, but it’s equally important to understand why the market advanced despite wickedly overextended conditions. The reason is not that Fed easing can be blindly relied upon to support speculation (it certainly didn’t in 2000-2002 and 2007-2009), but rather because extreme valuation risk is typically only realized once investors become risk averse, as evidenced by deterioration in market internals. We addressed this in mid-2014 by imposing restrictions against adopting a hard-negative market outlook until our measures of market internals have also explicitly deteriorated. We don’t get to re-live the recent half-cycle, but we do have the opportunity to move forward with methods that are historically informed by a century of market cycles, and that resolve the primary issue that made the half-cycle since 2009 legitimately “different” as a result of extraordinary monetary policy.

As I’ve noted before (see The Two Pillars of Full Cycle Investing and Air-Pockets, Free-Falls and Crashes), a more demanding emphasis on market internals is the primary factor that, in hindsight, would also have deferred our constructive response after the 40% market plunge in late-2008, holding off that shift until early-2009. Measures of what I’ve often called “early improvement in market action” that were effective in post-war data were too fragile and prone to whipsaw to endure the extremes of the Great Depression and the late-2008 to early-2009 period. More robust factors (particularly relating to risk-sensitive internals such as credit spreads) were necessary, and that was one of the key outcomes of our 2009 stress-testing efforts.

In short, market internals are the hinge that not only distinguishes overvalued markets that continue higher from overvalued markets that collapse; they are also the hinge that distinguishes undervalued markets prone to further losses from undervalued markets that give rise to new bull advances.

The same sort of hinge operates with regard to economic prospects. As Bill Hester nicely illustrated a few weeks ago, given economic activity similar to the present, the likelihood of a recession has been remarkably higher when the equity market has been fairly weak; for example, below its 12-month average, or its level 6 months earlier. Notably, the S&P 500 is below both levels at present.

The same is also true with regard to Fed easing and Fed tightening. In the presence of rich valuations, and the absence of favorable market internals, a Fed easing is actually the most bearish event that can occur (see When An Easy Fed Doesn’t Help Stocks and When It Does), mainly because Fed easing in risk-off conditions is typically a response to continuing economic deterioration.

The overall economic and financial landscape, then, is one where obscene valuations imply zero or negative S&P 500 total returns for more than a decade — an outcome that is largely baked-in-the-cake regardless of shorter term economic or speculative factors. Presently, market internals remain unfavorable as well. Coming off of recent overvalued, overbought, overbullish extremes, this has historically opened a clear vulnerability of the market to air-pockets, free-falls and crashes.

From an economic standpoint, the most leading measures of economic activity are new orders and order backlogs, followed by sales and production, followed by income, and followed much later by employment measures. From that standpoint, the most leading measures of economic activity are clearly deteriorating, even while many observers look to the lagging employment measures as if they are predictive. In the context of poor market action, similar economic data has been associated with a high risk of recession (though we don’t currently have sufficient evidence to anticipate a recession with confidence).

As for Fed policy, in my view, there is — and has been for some time — an immediate case to be made for the Fed to stop reinvesting the proceeds of balance sheet assets as they mature. The Fed could reduce its balance sheet by $1.4 trillion without driving market interest rates higher.

The only way to drive market rates higher here is for the Fed to explicitly pay banks interest on excess reserves. Given that there is no empirical evidence that activist departures of Fed policy from a fixed rule (such as the Taylor Rule) have any meaningful effect on the real economy, we’re fairly indifferent to whether the Fed raises rates or not in December. Our primary focus is on market internals here — not because an improvement would change the dismal long-term market outlook a bit, but rather because an improvement would suggest fresh risk-seeking that could defer a collapse in the nearer-term.

In the absence of improved market internals, my impression is that the economy is increasingly likely to roll into a recession at the same time the equity market rolls into a rather severe bear market decline. If the Fed raises rates in that environment, the FOMC will likely be blamed for losses that are actually already inevitable as a result of the Fed’s much earlier recklessness. If the Fed fails to raise rates in that environment, after having conditioned investors to expect a rate hike, it will likely be taken as a vote of no-confidence in the economy, and the FOMC will likely be blamed for losses that are actually already inevitable as a result of its much earlier recklessness. A uniform improvement in market internals would suggest fresh speculative pressures that could defer these outcomes, but ultimately, the only way to avoid near-term losses is to make the prospect of longer-term losses that much worse.


Emerging markets: Deeper into the red

 
Companies from Brazil to China are finding it harder to repay loans and raise fresh cash, hampering growth
 
EM central bankers have been concerned that inflows of cash will inflate their currencies
 
 
When China Shanshui Cement embarked on a borrowing spree in 2011, its managers could not have known that they had set in motion a chain of events that would lead to the company’s default last week on Rmb2bn ($315m) of short-term bonds, in all likelihood setting off a cross-default affecting debts totalling $3bn.

With hindsight it seems inevitable. Shanshui’s borrowing had been encouraged by a massive stimulus that Beijing unleashed after the global financial crisis of 2008-09. But borrowing in China and around the emerging world was also turbocharged by funds that were born in the US Federal Reserve’s quantitative easing programme.

Those funds, designed to stimulate a recovery in the US, were also leveraged into many multiples of their original value and invested in businesses producing goods the world would soon have too much of: cement factories in China, steel mills in China, Russia or Brazil or iron ore mines in Australia.

Now the Fed has called an end to ultra-loose money, pushing companies such as Shanshui into a credit crunch and forcing them to postpone or cancel investments. The result is a world economy dicing with deflation and recession.
 
By some estimates, $7tn of QE dollars have flowed into emerging markets since the Fed began buying bonds in 2008. Now, a year after the Fed brought QE to an end, companies in emerging markets from Brazil to China are finding it increasingly hard to repay their debts.

The excess capacity these companies created became apparent just as China’s slowing economy triggered a collapse in global commodity prices, hurting companies across the emerging world and sending Brazil’s economy into deep recession. Some experts say QE policies by the Fed and other central banks have left a legacy of oversupply from which it will take years to recover.

They also warn that the leveraging of QE money has resulted in piles of debt around the emerging world that are very hard to measure or even detect. As Carmen Reinhart, a Harvard University economist, said recently, it is often only after things go wrong that the size and destructive power of hidden debts become apparent.

Creating oversupply

How did this happen? For an answer, we must look at the mechanisms that turned the ambitious project of QE into a driver of global oversupply.

It begins with the creation of money under QE, the post-crisis stimulus programme led by the Fed and joined by the Bank of England, the European Central Bank, the Bank of Japan and others. The Fed has run four QE programmes, printing money under the last one at a rate of $85bn a month. Western central banks have created about $8tn since 2008.

There are two main routes by which QE money reached emerging markets. One involved the Fed buying US Treasury bonds from savers such as pension funds, which hold them as long-term, super-safe investments with unexciting but reliable yields. By doing so, the Fed drove bond prices up and yields down, sending savers in search of higher yields — such as in mutual funds buying corporate and emerging market debt.

“This is the route most people think of,” says Andrew Hunt of consultancy Andrew Hunt Economics. “I suspect it is the smaller channel.”

Another route involved the Fed buying Treasuries from commercial banks, which — again, to replace the yield they lost by swapping Treasuries for cash — loaned the proceeds to hedge funds and other investors. Hedge funds and so-called leveraged funds often used these loans to buy money-market instruments in the Singapore dollar, Philippine peso or Brazilian real, for example, earning a higher yield.

On this route, which Mr Hunt believes is more widely used, some QE money would be multiplied before leaving the donor country: a leveraged fund might take $10 in cash, borrow another $30 and invest $40 in an emerging currency. Some of it would not be leveraged, but all the money on this route is taking part in the “carry trade”: borrowing in currencies where interest rates are low and investing the proceeds where they are high. This works while exchange rates are favourable — but can go wrong when they change.

Between 2009 and 2014, when the Fed generated some $4tn in QE, credit provided overseas in US dollars through bank loans and bonds hit $9tn, according to the Bank for International Settlements. Mr Hunt estimates that the $4tn or so created by the Fed became $7tn by the time it reached emerging markets. And once it arrived, the money was leveraged yet again.

Enter the shadow banks

When floods of cash wash ashore in Brazil, Malaysia or Singapore, local central bankers start to worry. If they leave the inflows unchecked, their currency will appreciate strongly. This makes their economies less competitive than those of their trade rivals. So central bankers intervene, buying the incoming dollars, sterling or euros.

In taking these foreign assets on to their balance sheets, they must also create liabilities. So they print money, which makes its way into the local banking system. Flush with new cash, local banks can lend more. In fact, with their cash deposits parked at the central bank, they can lend multiples of those amounts — about four times in Brazil, eight times in Malaysia and 10 times in Chile, for example.

Banks are not the only lenders. The role of “shadow banking” has grown strongly since the crisis, as new regulations have reined in banks. Some shadow banking is provided by hedge funds and other financial institutions that are lightly regulated. Some is provided by companies lending to other companies, such as within a supply chain, and may be impossible to detect.

Central-banks-chart-1

A recent study by the BIS found evidence that big EM companies were issuing foreign currency bonds expressly to take part in the carry trade. Big issuers of bonds tended to be cash-rich, and they were most likely to issue when the difference between interest rates in their own country and the country where they issued was at its greatest.

Foreign direct investment is another likely route. Total FDI to Brazil in 2014, for example, was $97bn, according to its central bank, of which $39bn was intracompany loans. In China, FDI last year was $289bn, of which $105bn was “other capital flows”, including intra-company loans and payments. Some of this would be used to fund productive activities, but it is likely that some of it ended up in the carry trade or shadow banking.

It is impossible to say how much. “We have no way of knowing just what the resulting leverage ratio for a dollar that left the US in 2010 was by the time it became the basis for a loan made in Singapore, Hong Kong, Brazil or elsewhere, but we suspect that the answer would be well into double figures,” Mr Hunt says.

What is clear is that debt has risen to alarming levels. As a percentage of gross domestic product, private sector debt (households and companies) is now greater in emerging markets than it was in developed markets on the eve of the financial crisis.

Central-banks-chart-2

Taking on more debt for productive investment may well be a good idea, but it is not what has happened. Philip Turner and colleagues at the BIS looked at leverage and profitability at 280 big EM corporate bond issuers. They found that while leverage at those companies was up, profitability was sharply down.

And while foreign currency bond issuance at EM corporates has risen enormously since the crisis, it represents only a small part of the build-up in EM corporate debt. The vast majority — about 90 per cent by most estimates — is in plain old lending by local banks. This may be cause for some reassurance — after all, local bank lending is unaffected by the currency mismatches that can upend the carry trade. Or is it?

As Mr Turner at the BIS points out, some of the money borrowed by big EM companies was deposited at local banks, encouraging them to lend. And as big companies have turned to foreign capital markets to raise debt, local banks have had to find new companies to lend to. Were big companies to find it harder to refinance their foreign currency bonds as they fall due — because their earnings are down, or exchange rates have moved against them, or both — a withdrawal of liquidity would spread through local banking systems.

Lending conditions worsen

Trouble can also spread through mismatches in liquidity. Savers and other lenders in developed markets often believe the assets they are buying — a fund or a bond — can easily be sold if times change. But the final borrowers, who have used the funds to build a factory or provide a mortgage, cannot take their money back so quickly. As investors in developed markets withdraw their money, indebted EM companies are forced to pare activities and costs to the bone. The capital outflows weaken the local currency, pushing up foreign borrowing costs and tightening local lending conditions.

Central-banks-chart-3


This is already happening. Last week, the Institute of International Finance said bank lending conditions in emerging markets — a broad measure that includes credit demand, availability and non-performing loans — had deteriorated sharply, with some measures at their worst levels since the IIF began monitoring conditions in 2009.

Hung Tran, the IIF’s managing director, says EM companies are finding it harder to repay their debts and raise new money for investment, putting further downward pressure on growth.

And he does not buy the argument that currency mismatches — especially in the overseas debts of EM governments — no longer present the danger they did in the crises of the 1990s.

“People say, this time there is no currency mismatch,” he says. “They are not wrong. But the problem now is much deeper and much more general than a currency mismatch. This is a pure and simple problem of over-indebtedness and of slowing economic growth.”

EM companies are suffering from the same problems as Shanshui: too much borrowing invested in too much capacity, coming to market as demand is falling. This misallocation of capital is blowing the ill winds of deflation to the developed world. The process is not over yet: as the Fed pulls back, the ECB and BoJ are in full QE mode.


Mr Hunt believes emerging markets, especially China, have already driven global growth below 3 per cent a year. He says the developed world is heading for a recession similar to the one that followed the turn of the century; if no action is taken, he expects the impact to be worse than the Asian financial crisis of the late 1990s.

“QE has made this possible,” says Luis Oganes, head of EM research at JPMorgan. “Our concern is not of a full-blown EM crisis but of the heavily indebted companies and the banks exposed to them, as they fall into a vicious circle of low profitability, higher non-performing loans and tighter credit conditions. We should not expect an investment-led recovery anytime soon.”

Chinese companies may have more immediate help. Beijing has reined in credit over the past two years to curtail overcapacity, mainly through restrictions on shadow banking. But this year, official lending has again been on the rise.

For Shanshui and thousands of others, though, the party is over.


Taking Terror Abroad

The Islamic State's New Strategy

By Jörg Diehl and Christoph Sydow

 A still from a propaganda video featuring Islamic State fighters: "We have to prepare for a new situation."
REUTERS/ A still from a propaganda video featuring Islamic State fighters: "We have to prepare for a new situation."

The attacks in Paris mark a shift in the Islamic State's strategy. For the first time, the Syrian jihadists have organized attacks abroad, making the terrorist organization look more like al-Qaida.

First the bombing of a Russian passenger jet over Egypt's Sinai Peninsula, and then the attacks in Paris. Within the scope of two weeks, the terrorist organization Islamic State (IS) has conducted devastating attacks on targets abroad. Around 350 people perished in the strikes.

IS has directed its attacks against civilians from Russia and France, two countries currently conducting air strikes against Islamic State positions in Iraq and Syria.

Foreign intelligence officials say the attacks have been orchestrated by high-level Islamic State operatives in Syria. In the case of the downed Russian Metrojet aircraft en route from Sharm el-Sheikh to St. Petersburg on Oct. 31, intercepted conversations between jihadists in the unofficial IS capital of Raqqa and the organization's offshoot in Egypt suggest a hand in the bombing. Meanwhile, Belgian Islamist Abdelhamid Abaaoud, who is currently in Syria, is believed to have been the mastermind behind the Paris attacks. It appears he trained at least some of the suicide attackers in Syria and then sent them back to Europe in order to conduct the attacks.

Growing Similarities Between IS and Al-Qaida

The centrally steered attacks mark a shift in strategy for the Islamic State. For the first time, the jihadists have planned and carried out attacks against countries currently waging war against IS. The attacks in Paris, in particular, carried out as commando actions, took European intelligence services by surprise.

As recently as late summer, German security authorities believed that IS viewed the "consolidation of existing spheres of influence" to be its main priority. That, they believed, required focusing its resources on Syria and Iraq, thus reducing its "operational capacity" for "coordinating international attacks in Western countries," an internal review by the German Interior Ministry states.

The interpretation by German intelligence services and police authorities was that the terrorist militia had been focusing on expanding its Islamist caliphate. IS leader Abu Bakr al-Baghdadi had declared the battle against the Syrian regime his organization's chief goal, after breaking ties with al-Qaida and Osama bin Laden successor Ayman al-Zawahiri in April 2013.

IS leaders never officially excluded attacks against Western countries. And although the Islamic State praised the killing of editorial staff at Charlie Hebdo in January, it at best inspired the actions of the radicalized perpetrators, rather than organize or order such attacks itself, a journalist with Germany's Süddeutsche Zeitung wrote on Monday.

But that appears to have changed now. "We have to prepare for a new situation," a high-ranking security official in Berlin said.

Increasingly, IS' actions are starting to resemble those of al-Qaida at the start of the new millennium.

At the time, al-Qaida terrorist cells carried out attacks in New York, Washington, Madrid and London in the name of the organization. After this weekend's Paris attacks, IS has already announced the US capital to be a future target. The head of the CIA has said he assumes there will be further IS attacks against targets in the West.

There's another disturbing novelty here as well: Paris marks the first time the terrorist militia has deployed suicide bombers in Europe. Even though dozens of volunteers from the West have already died in Syria and Iraq as suicide bombers, their home countries had been spared until Friday of this perfidious form of attack.

Suicide Attacks Almost Impossible to Prevent

The Islamic State in Syria and Iraq relies heavily on foreigners because "these men are highly ideological, they aren't rooted locally and are prepared to do anything," Peter Neumann, a terrorism researcher at the International Center for the Study of Radicalization and Political Violence in London, recently told SPIEGEL ONLINE. "Suicide attacks make sense from a military perspective.

With relatively little effort, they can inflict major damage while at the same time spreading extreme fear."

German security agencies have also been taken by surprise. "This has a new and special quality," says one intelligence source. "For one thing, it requires one to be incredibly radical and determined. For another, these types of attacks can no longer be stopped once the perpetrators are out on the street."


Don’t Fear a Rising Dollar

Anatole Kaletsky
 US dollar. 


LONDON – The US Federal Reserve is almost certain to start raising interest rates when the policy-setting Federal Open Markets Committee next meets, on December 16. How worried should businesses, investors, and policymakers around the world be about the end of near-zero interest rates and the start of the first monetary-tightening cycle since 2004-2008?
 
Janet Yellen, the Fed chair, has repeatedly said that the impending sequence of rate hikes will be much slower than previous monetary cycles, and predicts that it will end at a lower peak level. While central bankers cannot always be trusted when they make such promises, since their jobs often require them deliberately to mislead investors, there are good reasons to believe that the Fed’s commitment to “lower for longer” interest rates is sincere.
 
The Fed’s overriding objective is to lift inflation and ensure that it remains above 2%. To do this, Yellen will have to keep interest rates very low, even after inflation starts rising, just as her predecessor Paul Volcker had to keep interest rates in the 1980s very high, even after inflation started falling. This policy reversal follows logically from the inversion of central banks’ objectives, both in America and around the world, since the 2008 crisis.
 
In the 1980s, Volcker’s historic responsibility was to reduce inflation and prevent it from ever rising again to dangerously high levels. Today, Yellen’s historic responsibility is to increase inflation and prevent it from ever falling again to dangerously low levels.
 
Under these conditions, the direct economic effects of the Fed’s move should be minimal. It is hard to imagine many businesses, consumers, or homeowners changing their behavior because of a quarter-point change in short-term interest rates, especially if long-term rates hardly move. And even assuming that interest rates reach 1-1.5% by the end of 2016, they will still be very low by historic standards, both in absolute terms and relative to inflation.
 
The media and official publications from the International Monetary Fund and other institutions have raised dire warnings about the impact of the Fed’s first move on financial markets and other economies. Many Asian and Latin America countries, in particular, are considered vulnerable to a reversal of the capital inflows from which they benefited when US interest rates were at rock-bottom levels. But, as an empirical matter, these fears are hard to understand.
 
The imminent US rate hike is perhaps the most predictable, and predicted, event in economic history. Nobody will be caught unawares if the Fed acts next month, as many investors were in February 1994 and June 2004, the only previous occasions remotely comparable to the current one. And even in those cases, stock markets barely reacted to the Fed tightening, while bond-market volatility proved short-lived.
 
But what about currencies? The dollar is almost universally expected to appreciate when US interest rates start rising, especially because the EU and Japan will continue easing monetary conditions for many months, even years. This fear of a stronger dollar is the real reason for concern, bordering on panic, in many emerging economies and at the IMF. A significant strengthening of the dollar would indeed cause serious problems for emerging economies where businesses and governments have taken on large dollar-denominated debts and currency devaluation threatens to spin out of control.
 
Fortunately, the market consensus concerning the dollar’s inevitable rise as US interest rates increase is almost certainly wrong, for three reasons.
 
First, the divergence of monetary policies between the US and other major economies is already universally understood and expected. Thus, the interest-rate differential, like the US rate hike itself, should already be priced into currency values.
 
Moreover, monetary policy is not the only determinant of exchange rates. Trade deficits and surpluses also matter, as do stock-market and property valuations, the cyclical outlook for corporate profits, and positive or negative surprises for economic growth and inflation. On most of these grounds, the dollar has been the world’s most attractive currency since 2009; but as economic recovery spreads from the US to Japan and Europe, the tables are starting to turn.
 
Finally, the widely assumed correlation between monetary policy and currency values does not stand up to empirical examination. In some cases, currencies move in the same direction as monetary policy – for example, when the yen dropped in response to the Bank of Japan’s 2013 quantitative easing. But in other cases the opposite happens, for example when the euro and the pound both strengthened after their central banks began quantitative easing.
 
For the US, the evidence has been very mixed. Looking at the monetary tightening that began in February 1994 and June 2004, the dollar strengthened substantially in both cases before the first rate hike, but then weakened by around 8% (as gauged by the Fed’s dollar index) in the subsequent six months. Over the next 2-3 years, the dollar index remained consistently below its level on the day of the first rate hike. For currency traders, therefore, the last two cycles of Fed tightening turned out to be classic examples of “buy on the rumor; sell on the news.”
 
Of course, past performance is no guarantee of future results, and two cases do not constitute a statistically significant sample. Just because the dollar weakened twice during the last two periods of Fed tightening does not prove that the same thing will happen again.
 
But it does mean that a rise in the dollar is not automatic or inevitable if the Fed raises interest rates next month. The globally disruptive effects of US monetary tightening – a rapidly rising dollar, capital outflows from emerging markets, financial distress for international dollar borrowers, and chaotic currency devaluations in Asia and Latin America – may loom less large in next year’s economic outlook than in a rear-view glimpse of 2015.
 


How the Great Depression 2.0 Will Soon Unfold

By: Michael Pento


Those who place their faith in a sustainable economic recovery emanating through government fiat will soon be shocked. Colossal central bank counterfeiting and gargantuan government deficit spending has caused the major averages to climb back towards unchanged on the year.

Zero interest rate and negative interest rate policies, along with unprecedented interest rate manipulations, have levitated global stock markets. But still, sustainable and robust GDP growth has been remarkably absent for the past 8 years.

Equity prices have now become massively disconnected from underlying economic activity, and the recession in corporate revenue and earnings growth is exacerbating this overvalued condition. Throw in the fact that earnings have been manipulated higher by Wall Street's recent prowess in the art of financial engineering, and you get an extremely combustible cocktail.

I have been on record saying this will end in chaos and here is how I think it will unfold:

Global central banks have universally adopted inflation targets, yet claim those goals have yet to be met. This is because of the inaccurate way governments measure consumer price inflation.

Nevertheless, most of the new money created has been pushed directly into real estate, equities and bonds by financial institutions; thus primarily inflating the asset prices of the rich and increasing the wealth gap. And since these economic leaders equate growth with inflation, the inability to achieve inflation targets is viewed also as the primary reason why growth has remained so elusive.

To bring inflation sustainably above the stated goals of 2% the private banking system would have to be able to push credit directly onto debt disabled consumers, which is impossible unless real income growth, after decades of falling, suddenly begins to surge; and/or consumer debt levels were dramatically pared down.

Therefore, central banks would need to inject credit directly into consumer's bank accounts while pushing deposit rates sharply into negative territory. In order for that to be truly effective they would also have to ban physical currency. To date no central bank has dared to use these drastic measures to meet their inflation targets...although if they did, intractable inflation would be guaranteed.

Governments have failed to reach their stated inflation and growth targets through the current "conventional" strategies of currency depreciation and manipulating the yield curve to record lows.

The salient issue being that chronically low nominal GDP growth rates are resulting in an insufficient tax base to handle the sharply mounting global deficits and debt. Japan is a perfect example of the flawed strategy of producing growth through inflation: the nation is suffering through its third recession since 2012, despite Prime Minister Abe's monumental efforts to lower the value of the yen and ramp up government deficits.

Enormous increases in government debt have historically caused sovereign debt yields to spike, causing debt service payments to become unmanageable. The recent European debt crisis is a perfect example of this:

Back in 2012, creditors grew wary of the countries referred to as PIIGs (Portugal, Ireland, Italy and Greece); and their ability to pay back the massive amount of outstanding debt they had accumulated.

Consequently, creditors drove interest rates dramatically higher to reflect the added risk of potential defaults. For example, in Portugal the Ten-year Note went from 5% to 18%, as government debt to GDP soared from 70%, before the crisis, to where it sits today at 130%. 

But thanks to their European Central Bank's (ECB) policy of buying ever-increasing amounts of Portuguese debt, that yield today stands at just 2.7%

The ECB, the Bank of Japan (BOJ) and the Peoples Bank of China (PBOC) have already promised the markets to artificially hold borrowing costs at record lows as they try to inflate their way out of a debt crisis. This is why ECB head Mario Draghi felt compelled to "do whatever it takes" to keep bond yields quiescent. This commitment of government to usurp control over the entire sovereign debt market is spreading across the globe.

The Federal Reserve is about to join these other central banks once the insipient U.S. recession manifests, even to the eyes of an economically-blind member of the FOMC. This dilating epiphany will occur as annual deficits vault once again over one trillion dollars and pile onto the $18.6 trillion dollar debt. It will be at that point all major global central banks will be in a position of permanently monetizing most, if not all, of the massive sovereign debt issuances.

The mandatory strategy of allowing deflation to rebalance debt levels and return asset prices to a sustainable equilibrium has become anathema to global leaders because the temporary depression that would result is politically untenable. Instead, Gov't Leaders are 100% committed to the flawed and baneful strategy of trying to create viable GDP growth through prodigious currency depreciation, interest rate domination and inflation.

In order to facilitate this inflation scheme, Central banks, in full cooperation with governments, are swiftly moving to the strategy of circumventing the banking system and directly monetize sovereign debt. The bottom line is intractable inflation has been the inevitable and tragic fate of all insolvent governments.

But this scenario of central bank over reach is not just the ramblings of some Cassandra. The new Economic Counselor for the International Monetary Fund (IMF), Maurice Obstfeld, called for unconventional intervention in an interview ahead of the annual IMF research conference.

This economic leader of the new world order said, "I worry about deflation globally...It may be time to start thinking outside the box...at the zero lower bound, our options are much more limited...In order to bring inflation expectations firmly back to 2% in the advanced countries, where we'd like to see it, it's probably going to be necessary to have some overshooting of the 2% level..."

And if that wasn't telling enough here is a striking excerpt from a paper prepared by Adair Turner who is a member of The Bank of England's Financial Policy Committee, which supports my contention that central banks are exploring the option to directly finance government spending. From the Wall Street Journal:

"One option is for central bankers to overtly finance increased budget stimulus with permanent increases in the money supply. Japan will be forced to use such 'monetary financing' within the next five years and the policy should become a normal central bank tool for all economies facing stagnation."

We now have the all conditions in place for an unprecedented breakout of worldwide stagflation; secular economic stagnation, insolvent governments and central banks that are willing to enable a humongous increase in deficit spending by permanently monetizing that debt. Sadly, the fiscal and monetary conditions for global economic chaos have now been set in stone. It's only a matter of time.

And unfortunately, that time is short.


Gambling the World Economy on Climate

The emission-cut pledges will cost $1 trillion a year and avert warming of less than one degree by 2100.

By Bjorn Lomborg


   Photo: Getty Images/Ikon Images
 
The United Nations climate conference in Paris starting Nov. 30 will get under way when most minds in the French capital will still understandably be on the recent terror attacks. But for many of the 40,000 attendees, the goal is to ensure that climate change stays on the global economic agenda for the next 15 years.

The Paris conference is the culmination of many such gatherings and is expected to produce agreements on combating climate change. President Obama and the dozens of other world leaders planning to be in Paris should think carefully about the economic impact—in particular the staggering costs—of the measures they are contemplating.

The U.N.’s climate chief, Christiana Figueres, says openly that the aim of the talks is “to change the economic development model that has been reigning for at least 150 years, since the industrial revolution.” That outlook will be welcome among attendees like the delegation from Bolivia. That country’s official material submitted for the talks proposes a “lasting solution” for climate change: “We must destroy capitalism.”

Perhaps capitalism as “a system of death” is a minority view, but the agreements coming out of Paris are likely to see countries that have flourished with capitalism willingly compromising their future prosperity in the name of climate change. But before ditching that economic model, it’s worth considering how much progress it has brought.

For one, life expectancy in the past 150 years has more than doubled, to 71 years in 2013 from fewer than 30 years in 1870. Meanwhile, billions of people have risen out of poverty. One and a half centuries ago, more than 75% of the world’s population lived in extreme poverty, consuming less than $1 a day, in 1985 money. This year the World Bank expects extreme poverty to fall below 10% for the first time in history.

It is telling that U.N. officials provide no estimated costs for an economic transformation. But one can make an unofficial tally by adding up the costs of Paris promises for 2016-30 submitted by the U.S., European Union, Mexico and China, which together account for about 80% of the globe’s pledged emissions reductions.

There is no official cost estimate for Mr. Obama’s promise to cut U.S. greenhouse gas emissions 26%-28% below 2005 levels by 2025. However, the peer-reviewed Stanford Energy Modeling Forum has run more than a hundred scenarios for greenhouse-gas reductions and the costs to gross domestic product. Taking this data and performing a regression analysis across the reductions shows that hitting the 26%-28% target would reduce GDP between $154 billion and $172 billion annually.

The EU says it will cut emissions 40% below 1990 levels by 2030. Again, there is no official estimate of the cost given, which is extraordinary. The data from the Stanford Energy Modeling Forum suggests hitting that target would reduce the EU’s GDP by 1.6% in 2030, or €287 billion in 2010 money.

Mexico has put into place the strongest climate legislation of any developing country, conditionally promising to cut greenhouse-gas and black-carbon emissions by 40% below the current trend line by 2030. The Mexican government estimates that cutting emissions in half by 2050 will cost between $6 billion and $33 billion in 2005 money, but that is many times too low.

Peer-reviewed literature, supported by the U.S. Environmental Protection Agency and the EU, suggests that by 2030 the cost would already reach 4.5% of GDP, or $80 billion in 2005 money.

China has promised by 2030 to reduce its carbon-dioxide emissions, per unit of GDP, to at least 60% below 2005. Using the data from the Asia Modeling Exercise we find that hitting this target will cost at least $200 billion a year.

So in total, the Paris promises of the EU, Mexico, U.S. and China will diminish the economy at least $730 billion a year by 2030—and that is in an ideal world, where politicians consistently reduce emissions in the most effective ways.

Experience tells us that won’t happen. For instance, policy makers could have chipped away at emissions efficiently with modest taxes on carbon, or by switching electrical generation to natural gas. Instead many countries, including the U.S. and those in the EU, have poured money into phenomenally inefficient subsidies for solar and biofuels, which politicians go for like catnip. The EU’s 20/20 climate policy—the goal, embarked upon in 2010, to cut emissions 20% from 1990 levels by 2020—is the clearest example of such gross inefficiency.

A 2009 study of the targets, published in Energy Economics, estimated that “inefficiencies in policy lead to a cost that is 100-125% too high.” It’s likely that in the future even more money will be wasted propping up green energy that is both unaffordable and inefficient.

Another 127 nations have made promises for Paris that increase the total emissions cuts by one-fourth. The cuts on the table in Paris, then, will leave the global economy, in rough terms, $1 trillion short every year for the rest of the century—and that’s if the politicians do everything right. If not, the real cost could double.

All of these high-flown promises will fail to accomplish anything substantial to rein in climate change. At best, the emissions cuts pledged in Paris will prevent a total temperature rise by 2100 of only 0.306 degrees Fahrenheit, according to a peer-reviewed study I recently published in Global Policy.

If nations formalize their planned carbon cuts in Paris and then stick to them, Ms. Figueres’s economic transformation will indeed happen: But it won’t be a transformation to be proud of.


Mr. Lomborg, president of the Copenhagen Consensus Center, is the author of “The Skeptical Environmentalist” (Cambridge Press, 2001) and “Cool It” (Knopf, 2007).


It's a Matter of Solvency

By: Captain Hook



When it comes to enduring enterprise and buoyant economies, in the end, future fortunes depend on solvency. This brings us to the problem with enterprise in our debt saturated western economies, because the pillars are largely insolvent, meaning corporations, and governments will never repay the debt they owe because its too much. Greece has been the visible exemplar of the larger problem in western media because authorities were able to impose increasingly draconian terms of repayment on a weak and weary periphery state, kicking the insolvency can down the road once again. It's important to realize that the kind of tactics used by the Troika to arrive at a solution to their larger solvency problem will not work when developed economy borrowing costs begin to rise in earnest, calling into question core economy solvency, extending all the way back to the United States.

Because it's the debt ladies and gentlemen - it's the Empire of Debt (thank you Max Keiser) - on which the America Empire has built its fortunes. Individuals, corporations, and government alike have gorged themselves on cheap debt since the 'financial crisis' in 2008, and now America, and much of the world (especially the West), are at a point where just the slightest increase in interest rates would topple the debt colossus, which has not only been pyramided to a point of critical diminishing returns, but also has reached the Rubicon of spiraling collapse and default. 

Therein, it should be understood that just the interest on $18 trillion plus of national debt in the US (now closer to $20 trillion) is in excess of $500 billion, and growing. (i.e. in unlimited fashion now.) What's more, if left unchecked, and at current trajectories, by 2025 the interest on the national debt will consume most of the federal budget, which is something you won't hear much about on the up coming Presidential debates.

And you also won't hear much about how over-indebted zombie consumers lead to a larger non-performing zombie economy, which will eventually lead to non-payment(s) on a macro-level, which will in turn expose the solvency issues that bring down this deception we have allowed our wicked rulers to construct. By educated accounts, the bond bubble is set to burst next year, likely as a result of increasing sovereign disarray (think led by the collapse of the European Union), which will unleash an uncontrolled global monetary emulation that will make the debasement race obvious to all because nobody, not even those who think they exist in Elysium, will be able to insulate themselves from its force. It's beginning now in the more mature socialistic states like Sweden, and will move quickly through Europe as the migration crisis intensifies, causing the need for corresponding competitive devaluations across the rest of the globe (West, East, et al) as process unfolds. (i.e. the decentralization process et al.)

Next year, the inflation will be so bad the government will no longer be able to hide it. Some degree of hyperinflation is on the way. Money supply growth has gone parabolic since the financial crisis of 2008, but prices have not reflected that inflation because the US exported it to the rest of the world by lending out dollars($). (i.e. the $ carry trade.) All that is going to change next year. Boat loads of those exported (borrowed) $'s (America's chief export) will be coming back to the US to pay the debts off as a result of a return to deleveraging globally (the synthetic short on the $), with the net effect being an import of the same inflation that was exported for years compressed into a very short time frame. This means increasing $'s will be chasing fewer goods locally, as not only are inventories high, but credit facility and supply chain problems will put a strangle hold of just about everybody, dampening (crashing?) the economy. Then you will see who is solvent and who is not.

How can I be so sure of this? What about all the cranks that have been predicting this for years and have been wrong? Again, how can you be so sure about this - won't central planners just keep expanding money supplies faster if need be? Answer: Yes, they will likely keep printing increasing amounts of new currency faster until the economy(s) completely shut down and people literally stop eating. And when the middle class stops eating - that's when the reality of what the cranks at the Fed (et al) have done will hit the masses. That's when they will want some real answers / solutions. And that's coming beginning next year, as signaled by the profound Fibonacci resonance signature in the Dow / Philadelphia Gold & Silver Index (XAU) Ratio (see Figure 1) marking a secular turn back into an inflation cycle. (i.e. money supply, price gains, etc.) This is how I can be so sure next year will mark a very important turn in macro / market trends. (See Figure 1)

Figure 1


 
As you can see above however, the Dow / XAU Ratio is at trend-line resistance of a good sized corrective flag (as defined by the channel) as of the end of last week (right now), meaning a pullback to gain energy to punch through this resistance may be necessary over the next week or two. Once this occurs however, which I have every confidence will be the case since precious metals have put in some degree of a top (it could last months), it will likely be off to new highs for both the ratio, and likely the Dow, along with some of the other cap weighted indexes.

Further supporting this view, we also have the Dow / Gold Ratio (DGR) pictured below (weekly plot) showing the possibility (likelihood?) of a surge to new highs for the move as well, yet another Fibonacci signatured target at 17.5 that will act as a magnet as the collective psychology of the market (manipulated as it is) is exercised. (See Figure 2)

Figure 2


Now some may be thinking, that's all fine and dandy if that happens - if gold and gold stocks make a bottom in coming weeks (months?) and then scream to new highs, but that doesn't necessarily mean general prices have to follow in this predominantly deflationary world. Well, I am sorry to burst your bubble if you are under this impression because as you can see in Figure 2 attached here, the commodity complex, as represented by the CRB is set to make an equally important turn against the Dow in tandem with the gold complex, so don't kid yourself.

Therein, once stocks top out in coming days, which again could take until early next year with corporate buybacks and year-end window dressing in the equity markets to deal with, the sucking sound in the economy will be increasingly difficult to hide, which will in turn force the Fed to not only drop its bullshit story (US economy strong), but reverse tack and start not just talking dovish, but acting, with more and expanded QE. (i.e. a check in every mail box.)

That's right - central authorities will start sending everybody checks in the mail to buy their loyalty and keep the mob placated. The problem is because America has exported its fiat currency economy template to the world, everybody else will be doing the same, which will unleash a liquidity tsunami on the world that will be so profound it will be impossible for the status quo boys to hide. And again, it will be worse in the US proper because of all those already printed $'s returning home. This will make the Fed's already impossible position even more unmanageable, which will in turn cause a loss of confidence in 'the system'. This is when prices will really take off - when all confidence in the Fed and central planning is lost - forcing even more money printing as the parasites in the machine attempt to save 'the system'. Unfortunately for most, they will be wiped out financially overnight at some point, as 'system resets' become necessary.

First they will start with negative interest rates (NIRP), and then when stocks come under pressure in spite of all their efforts, they may resort to bail-ins. And if things keep getting worse, which is certain through time, who knows what 'the authorities' will do, say if (when) bank / brokerage holidays become necessary. You will be glad to own precious metals when that day comes, as when the holiday(s) is lifted, your bank account and other savings people keep with the crooks could be ravaged severely. New currencies and currency rollbacks could become a regular feature in 'the system'. You go into the holiday with $500,000 in the bank, and come out the other side with a fraction of that, and general price levels keep rising. It's impossible to know what measures will be implemented at this time, but it's safe to say whatever they are it will involve the parasites attempting to preserve their own wealth and positions at the public's expense.

This is when the United States of America will officially turn into one of those 'banana republics' they have been exploiting for so many years over night - over night.

That's really all I want to say this week - because it's enough. Try to really wrap your head around what I am saying above because it could save you financially - at a minimum. Risky banana republics where solvency concerns abound can't issue new debt at 1% or less. So this means it must be issued at higher rates, but this would eat up the entire federal budget if rates were to go up a measly 1%. The Authorities may be able to juggle the situation for a while longer, but some point they are going to get caught in their deceptions. Confidence men always do - it's just a question of how long it takes.

Next year, we have the Presidential election, which as discussed previously, have a tendency to be dangerous for stock market gamblers, and in turn naïve long term chumps.

Don't be a chump. Protect yourself. Make sure your boat is well anchored to precious metals in proper form. A buying opportunity is approaching when the Dow / XAU Ratio hits the Fibonacci target outlined above. Patient accumulation between now and this point is the strategy financial survivors of the holocaust that is approaching are undertaking. So again, be smart, not a status quo chump.

Last weeks COT reports for gold and silver show idiot hedge funds going even longer, which will not end well for them, or gold and silver, once selling is forced on them. This is why you want to be patient. Let the market come to you. These are the knuckleheads that will take the Dow / XAU and DGR to the respective Fibonacci targets delineated above.

Good investing in precious metals is almost here.