Interest Rates Around the World Are Coming Down. What Investors Need to Know.

By Avi Salzman and Nicholas Jasinski

                                                                                                              llustration by Chris Mihal

Central banks have performed a pirouette so graceful that it’s hard to remember: Just six months ago, it looked as if a decade of ultra-accommodative global monetary policies was ending.

Now, interest rates are coming down en masse. Investors who adjusted their portfolios for a high-rate environment must readjust. That means leaning into growth stocks again, scouring Asia for opportunities, and earning income from investments that won’t succumb to the low-rate trend and will also hold up in a shaky economy.

There are significant risks, too. Juicing growth during a recovery can lead to asset bubbles, and easing now leaves little policy room to respond when an economic crisis demands it.

Global bankers have eased rates in tandem before. What makes this different from periods in past cycles—say, right after the financial crisis—is that there is not much left to cut. This time even negative rates aren’t stopping bankers from considering loosening monetary policy further.

“Additional stimulus will be required” in Europe, Mario Draghi, the president of the European Central Bank, said on Tuesday, making it clear that the bank’s negative 0.4% benchmark interest rate hasn’t done the trick. Australia’s central bank thinks it is “more likely than not that a further easing in monetary policy would be appropriate in the period ahead,” minutes released in the past week showed. Japan’s central bank already offers negative 0.1% rates, but J.P. Morgan says they could fall to minus 0.3% before the end of the year.

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U.S. rates look comparatively steep, given that they are still solidly in positive territory, at 2.25% to 2.5%. But the Federal Reserve declared on Wednesday that it “will act as appropriate to sustain the expansion.” Most traders now see interest rates coming down, starting next month, and market yields are falling fast. The yield on the benchmark Treasury 10-year note slid below 2% on Thursday for the first time since November 2016.

In a slow-growing, but still healthy, economy, low rates are caffeine to investors willing to take on risk. The last time the Fed cut rates with a similar economic backdrop—in 1998—the S&P 500 rose 3.5% in the next month, and 20.9% over the following year, according to Yardeni Research. Growth sectors like tech and consumer discretionary advanced the most then. Today, strategists say they are advising clients to buy growth stocks over value names.

As for bonds, “I’d be moving up in credit quality, because if we do get this global slowdown, you don’t want to be buying credit at what are relatively expensive levels today,” says Brian Rehling, co-head of global fixed-income strategy for the Wells Fargo Investment Institute.

Rehling also thinks longer-term bonds might be worth buying. “Even though rates are very low, they could quite frankly go lower,” he says.

For the risk-averse, investing in this environment is much trickier.

Low rates tend to hurt retirees. “I remember my father back in the 1970s happily talking about his 15% bank CDs, saying he’s going to double his money every seven or eight years,” says financial advisor Ric Edelman. “Now, people come to us saying, ‘I’m trying to generate a certain amount of investment income and I don’t know how.’”

Edelman, whose average client has $600,000, puts their assets in diversified portfolios of stocks and bonds, but he also advises other moves—like refinancing homes and credit card debt.

None of this seemed likely last fall as policy makers around the world appeared poised to tighten rates to control inflation and “normalize” policy to have more room to cut in case an economic downturn forced them to stimulate again. In an interview in Washington on Oct. 3, Fed Chairman Jerome Powell said that interest rates were “a long way from neutral,” implying that there were several rate increases ahead.

Markets shuddered. The MSCI World Indexshed 18% before Christmas, and didn’t recover until after the new year, when Powell said that the U.S. central bank would be “patient” about raising rates again. The word-parsers initially liked the word “patient.”

Over the next few months—as U.S.-China trade talks fell apart and global economies sputtered—traders grew impatient. When the Fed removed the word “patient” from its statement on Wednesday, it was to complete a 180-degree turnaround.

Forget rate increases. It’s cutting time.

The recent developments are a “remarkable U-turn” for central banks, ING’s European economists wrote afterward. “Only time will tell if this unprecedented activism was genuinely ahead of the curve or just sheer panic.”

In the U.S., the economic data make the rate cuts look more like panic. Unemployment is at 3.6%, seemingly fulfilling the Fed’s mandate to promote employment, and consumer spending rose at its highest rate in a decade in March.

But other forces—political and economic—point the other way. Business confidence has declined as the U.S.-China trade war has intensified, and inflation has slowed, raising the specter of deflation ahead.

Some strategists think the Fed is being led by markets, as opposed to the other way around. “Apparently, Trump is not the only policy maker who views the stock market as the most important poll of the success or failure of their policies,” says Ed Yardeni, president and chief investment strategist at Yardeni Research.

That should give investors confidence that the Fed will be there should a global shock cause the market to falter. “As long as [central banks] continue to provide ultra-easy monetary policy, a lot of it will spill over into asset markets,” Yardeni says.

“So stay long,” he advises. “And if they change their mind, let’s all have a hissy fit and a tantrum, as we did at the end of last year and get them back on the right course.”

Others echoed Yardeni’s sentiments.

Jim Paulsen, chief investment strategist at the Leuthold Group, notes that fiscal policy is equally supportive. The U.S. federal budget deficit rose to 4.7% of gross domestic product in May, one percentage point higher than the level a year ago. Late in previous postwar economic expansions, that measure has steadily declined as the economy recovered. Yet governments from the eurozone to Japan continue to run fiscal deficits, adding fuel to the fire.

Paulsen also notes that the decline in the yield on the 10-year Treasury, to 2% from almost 3.3% last fall, has lowered borrowing costs across the U.S. economy. “We’ve got every major policy gun going off at the same time, and you generally only see that when you’ve been in a recession and you’re trying to get out, not when you’ve been in a recovery,” Paulsen says. “And yet that’s what we’ve got, we’ve got a three-gun gooser right now.”

The triumvirate of stimulative ammo has been in place only 14% of the time over the past half-century, according to his data. In those periods, the S&P 500 was higher six months later 80.5% of the time, climbing at an average annualized clip of 17.5%.

On a sector level, Paulsen recommends taking advantage of recent strength to sell such defensive stocks as utilities and move the proceeds to areas that thrive on low rates, like technology and communication services. He also advises a tilt toward emerging markets, which could experience more of an upswing if monetary and fiscal easing is successful at reaccelerating global economic growth.

“The one area where there is more room for inflationary policy is Asia,” says Robert Horrocks, chief investment officer for Matthews Asia. “You look at Singapore, you look at Thailand, these countries are incredibly tight, both in monetary and fiscal policy.” He suggests that investors buy bank stocks in countries like Thailand, Singapore, and India, where monetary policy may loosen.

Central bankers may be projecting pessimism, but the outlook for investors willing to take on some risk isn’t as gloomy.

“I think the biggest thing is to fight the urge to get too bearish,” Paulsen says. “In order to be successful last year, you had to be appropriately cautious in the face of nothing but good news. This year, I think it’s the opposite. You really have to stay appropriately bullish in the face of nothing but bad news.”

Trade war sparks fears of China weaponising US Treasuries

Recent $20bn sale of US debt could not be explained by typical ebb and flow of Beijing’s holdings

Joe Rennison and Colby Smith in New York

Beijing’s sale of US Treasuries last week amounted to China’s largest retreat from the market in more than two years

It was an unnerving piece of data for investors last week, buried halfway down an esoteric spreadsheet released by the US government that tracks how many Treasuries foreign investors buy and sell.

China, the largest foreign creditor to the US government with total Treasury holdings in excess of $1.2tn, sold $20bn of securities with a maturity exceeding one year in March, according to US government data. The sales amounted to China’s largest retreat from the market in more than two years.

The move came shortly before tensions over trade between Beijing and Washington heated up again, with the US slapping additional tariffs on the country’s imports and Chinese officials retaliating with measures of their own. What is more, the sales could not be explained away by the typical ebb and flow of China’s Treasury holdings that result from managing its large reserves to keep the currency stable.

The data reignited fears that Beijing may weaponise its holdings as part of the trade war, wreaking havoc with the biggest bond market in the world, pushing interest rates higher and increasing the US government’s cost of borrowing.

“If China starts dumping its Treasuries, it would cause huge financial instability,” said Mark Sobel, a former Treasury department official who spent nearly four decades at the agency, adding that he considered this an unlikely scenario.

China’s holdings of Treasuries are inextricably linked to the country’s trade with the US. China receives dollars in payment for its exports to America, and then needs to invest that money somewhere. The Treasury market has long been China’s destination of choice because the market is not only big enough to host its enormous reserves, but it also offers a better return than other super-safe investments. Moreover, China avoids currency fluctuations that could come from selling those dollars to buy other assets.

As a result, China’s Treasury holdings typically dip if its reserves fall. It has also sold Treasuries over the past year to support its beaten-down currency, as tariff talk has intensified. On this occasion, though, neither of those forces appears to have been a factor. To some analysts, it seems as though China simply decided to sell.

“One should take notice of a month of sales during a period when reserves appear to be stable by most indicators,” said Brad Setser, senior fellow at the Council on Foreign Relations and a former Treasury department official. “It is certainly something that warrants attention.”

While concerns are mounting, investors and analysts are wary of jumping to conclusions. Mr Setser cautioned that the March data are a snapshot and not yet a trend.

Moreover, few see any alternative for China, other than remaining invested in Treasuries. The benchmark 10-year Treasury yield is currently 2.42 per cent, well above the negative yields on equivalent German and Japanese sovereign bonds and still markedly higher than the 1.03 per cent offered on 10-year gilts in the UK.

Other markets are also much smaller than the US Treasury market, meaning they would struggle to digest any inflows from China’s massive holdings.

“Even it this were to be a threat, it’s a very non-credible one,” said Sonal Desai, chief investment officer for fixed income at Franklin Templeton in California. “What else [is China] going to buy?”

Meanwhile, there are few signs that recent bouts of selling by China have pushed US interest rates higher. In the second half of 2011 China ramped up its sales of Treasuries but interest rates dropped too. The 10-year Treasury yield tumbled from a peak of 3.74 per cent earlier in the year to 1.88 per cent by the year-end, amid a general bout of risk aversion caused by Europe’s sovereign debt crisis.

In 2016, China sought to prop up its currency and sold a net $160bn of long-term Treasuries, with its holdings hitting the lowest since 2010 in November that year. Ten-year interest rates did rise in the US — from 2.30 per cent to 2.44 per cent over the course of the year — but that seemed spurred primarily by the election of President Donald Trump, which brought renewed hopes of growth for the economy.

In March this year, during the latest round of selling, the 10-year Treasury yield slipped 30 basis points over the month to 2.41 per cent.

Still, few disagree that if China wanted to cause an upset in US interest rates by heavy selling of Treasuries, it probably could. The catch is that it would lead to a revaluation of the country’s own US bonds as it sold.

“China selling its Treasury holdings is a nuclear option, because it will hurt their own portfolio,” said Shawn Matthews, a former Cantor Fitzgerald trading head who launched his own hedge fund, Hondius Capital Management, last year.

“It depends on what the goal is,” said Torsten Slok, chief economist at Deutsche Bank Securities in New York. “If the goal is to disturb the US Treasury market, then they may not care about inflicting self-harm.”

In Mexico, a New Approach to Crime Produces the Same Old Results

Mexico’s president has promised to improve security, but progress has been slow.

By Allison Fedirka


Six months after Andres Manuel Lopez Obrador took office promising to restore security in Mexico, violence remains a huge problem in the country. According to Mexican authorities, there were 11,221 homicides between Jan. 1 and April 30, a 7 percent increase from the same period in 2018, a year in which homicides reached a record high. Lopez Obrador has said the problem can’t be solved overnight, and he’s right, but the lack of tangible results thus far has sparked concerns over his new approach to an old problem.


At a press conference earlier this month, Lopez Obrador said he would combat crime and violence through a series of measures that fall into six broader components: address the root causes of crime by investing in development and welfare programs; protect public security, mainly by developing a new National Guard; invest in youth education and employment; ask the U.S. to boost efforts to reduce youth drug consumption within the United States; address drug consumption within Mexico, possibly by legalizing certain substances; and develop a national peace agreement that would include multiple segments of Mexican society, even potentially members of organized crime groups. Details on each of these initiatives, especially the last two, are still murky, but it’s worth examining the progress, or lack thereof, so far – and what’s impeding it.
Progress and Setbacks
The first step in Lopez Obrador’s plan to improve security in Mexico is to reorient efforts away from traditional security institutions (and violence associated with them) and focus on social and economic development. Under the president’s strategy, security authorities would play a supporting role rather than serve as the driver. The strategy is still in the early stages, but projects to address youth addiction have recently been launched and more complex programs related to youth education and employment are being discussed. Still, the programs that have been initiated have limited reach, and funding is a major barrier to implementing a nationwide strategy.

More progress has been made on establishing the new National Guard, a civilian-controlled national security force made up of federal police and soldiers. The government has already passed the legal framework for the body, though supporting legislation is still under consideration; only time will tell how long it will take before the National Guard is up and running. The government estimated that it would take three years in total, but addressing public concerns over its composition and appropriate use of force might require more time.

The fourth component in Lopez Obrador’s strategy requires cooperation from the United States to reduce drug consumption in the U.S. However, the United States’ historical approach to fighting organized crime has focused on targeting drug production and transport and financing of criminal groups. In other words, the U.S. prefers to target activities taking place in other countries rather than its own contributions to the drug trade, including high levels of consumption and arms supplies.

In addition, Washington has been preoccupied with border security rather than regional development in the countries in which drugs are being produced and through which they’re transited. Lopez Obrador wants the U.S. to focus on development projects instead of providing funding and logistical support to fight organized crime for two reasons. First, Mexico’s current administration genuinely believes that economic and social development will, over time, help improve security in Mexico and Central America’s Northern Triangle countries (Guatemala, Honduras, and El Salvador). The U.N. recently backed some Mexican-driven development projects involving Mexico and the Northern Triangle, but these projects are too limited to bring about a real transformation in the region. Such a transformation will require the support of a wealthy partner like the United States. Mexican officials have estimated that an investment of $20 billion to $30 billion is necessary, and the U.S. is one of the few countries in the world that could singularly make this level of investment.

The second reason the president wants the U.S. to focus on development is that Mexico has had a complicated security relationship with the U.S. in the past. One of the main frameworks for cooperation on organized crime and law enforcement between the two countries is the Merida Initiative, which supports security efforts in Mexico using U.S. funds. It’s much weaker and smaller than Plan Colombia, the U.S. program to help combat the FARC, and for a reason. Mexico is willing to accept only certain types of assistance from the U.S. because it doesn’t want any U.S. incursions into Mexican territory. In 1848, Mexico lost large swaths of territory to the U.S. after the Mexican-American War. And just over 100 years ago, U.S. troops marched into northern Mexico and occupied the Mexican port of Veracruz for six months during the Mexican Revolution. Such an incursion today would be entirely untenable for Mexico. Lopez Obrador has thus said he wants to end the Merida Initiative and divert U.S. funds to development projects. The U.S., however, has no intention of suspending the program. U.S. Embassy officials even told Mexico’s Foreign Relations Commission that Washington will support the implementation of the National Guard though the Merida Initiative.

The most controversial parts of Lopez Obrador’s security plan are his proposals to legalize consumption of certain substances and introduce a national peace agreement. It’s still unclear, however, whether these proposals will come to fruition. The government hasn’t said what substances would be legalized, though marijuana has been the most discussed option. The national peace agreement would offer amnesty to members of organized crime groups, but the government doesn’t have a lot of leverage over criminal groups to force them to the negotiating table, and there are no indications that talks behind the scenes have even begun.

Indeed, Lopez Obrador still talks of the two measures as possibilities rather than realities. And despite significant public backlash, he seems insistent on going ahead with them. Last August, Lopez Obrador started holding town halls across the country to discuss his security strategy, and since then citizens have been voicing their concerns. Last August, participants reportedly criticized the then-government-elect’s lack of organization, respect and protocol. Attendees in cities like Ciudad Juarez objected to the possibility of granting amnesty to criminals. Subsequent meetings were either restricted or canceled due to concerns over clashes involving civil society, and possibly criminal, groups. The town halls ended two weeks early and skipped some of the country’s most violent states like Veracruz, Sinaloa, Tabasco, Morelos and Tamaulipas. Since then, the backlash against Lopez Obrador has grown and protests have erupted, the largest of which took place on May 5, when demonstrators called for the president’s resignation.



The Corruption Problem
One issue that’s noticeably absent from Lopez Obrador’s strategy is corruption, a problem he promised to tackle during his campaign. Succeeding in this area will be instrumental to his broader security agenda; development projects may be the cornerstone of Lopez Obrador’s plan, but they require lots of government funding, which has been misused in the past. Lopez Obrador has himself said that the barrier to executing development plans isn’t a lack of funds but rather corruption. This rings particularly true when it comes to law enforcement and state security officials. Organized crime groups have deep pockets that can persuade police, judges and other government officials to turn a blind eye to illicit activities. Improved vetting and monitoring of officials as well as increases in salaries can help, but such measures are costly and the government has limited financial resources at its disposal.

Progress on this front, therefore, has been minimal. The most notable achievement thus far is the creation of the “Institute to Return to the People What Has Been Stolen From Them,” a project funded by auctioned luxury items confiscated from organized crime groups. The problem, however, is that it’s impossible to know how much money these auctions will raise. Lopez Obrador said they will also help fund the National Strategy to Prevent Addictions, so both programs will be competing for funds from the same source. It’s likely, then, that the government will also need to pitch in, and its ability to do so is questionable at this point.

Lopez Obrador’s anti-corruption efforts have been limited and focused on two main targets. The first is international companies and investment. Lopez Obrador has postponed auctions for major projects like oil and gas development due to corruption concerns. However, whether corruption is being rooted out is still in question given that, in the first quarter of 2019, more than 70 percent of contracts were awarded without a competitive bidding process, according to the nonprofit Mexicans Against Corruption and Impunity. Many in Mexico see this as evidence that the government isn’t serious about tackling corruption. Lopez Obrador has also targeted past presidents for their alleged involvement in corruption. He has proposed a public consultation on whether to investigate past presidents over corruption allegations, an idea that has been fiercely debated by both politicians and civil society groups. It has been put on hold, purportedly because supporting legislation must be implemented first.

Lopez Obrador said he would follow a new and novel approach to fighting crime in Mexico. Past administrations had made little progress, and he promised to be different. But while his approach is certainly different, its results have been more of the same. Constraints, including lack of funding, corruption and insufficient support from other parties, make the viability of his strategy even more questionable. It could also strain U.S.-Mexico relations, as U.S. cooperation will be critical to addressing Mexico’s security problem.

Iran Calls Trump’s Bluff

The President is caught between hawkish goals and dovish means.

By The Editorial Board

Photo: jim lo scalzo/Shutterstock

President Trump called off a military strike against Iran in mid-mission Thursday, and his supporters and even some of his critics are hailing it as an act of restraint and courage. The question for American interests is whether Iran and other adversaries will see it instead as a sign of weakness and indecision.

“We were cocked & loaded to retaliate last night on 3 different sights when I asked, how many will die. 150 people, sir, was the answer from a General. 10 minutes before the strike I stopped it, not proportionate to shooting down an unmanned drone,” Mr. Trump tweeted Friday morning.

It’s important to understand how extraordinary this is. The Commander in Chief ordered ships and planes into battle but recalled them because he hadn’t asked in advance what the damage and casualties might be? While the planes were in the air, he asked, oh, by the way? This is hard to take at face value.

More likely, he changed his mind because he had second thoughts about the military and political consequences of engaging in a conflict he promised as a candidate to avoid. Mr. Trump may have saved Iranian lives now, but his indecision and professed fear of casualties may be risking more American lives later.

Squeezed by the U.S. “maximum pressure” campaign, Iran’s rulers are trying to pressure Mr. Trump in return. In recent weeks they have attacked oil pipelines, mined oil tankers, and this week brazenly shot down a $130 million U.S. drone monitoring shipping lanes over international waters. Iran’s bet is that Mr. Trump is so averse to military confrontation that he will ease U.S. sanctions. On the evidence of the aborted mission, they may be right.

The damage from Mr. Trump’s stand-down depends in part on how Iran’s leaders respond. If they agree to talks to revise the 2015 nuclear agreement, the restraint might pay off. Yet Iran’s leaders have shown no interest in talking as long as U.S. sanctions are in place. If Mr. Trump eases sanctions to get Iran to the bargaining table, he is back to the Obama nuclear deal.

On the other hand if the Iranians escalate again, Mr. Trump’s restraint will look misguided and weak. If Americans are now killed by Iranian proxies, his failure to use force to deter attacks will deserve some of the blame.

Laying out these potential stakes isn’t “war mongering,” as the new isolationists on the right claim. This is the reality of geopolitics in which credibility is crucial to deterrence. The more that adversaries think Mr. Trump’s threats of force aren’t credible, the more they will seek to exploit that knowledge.

After Barack Obama failed to enforce his “red line” in Syria in 2013, adversaries soon took advantage. Vladimir Putin snatched Crimea from Ukraine and moved into Syria, China pushed further into the South China Sea, and Iran expanded its proxy wars in the Middle East. Will they draw similar license now from Mr. Trump’s stand-down?

The great weakness of Donald Trump’s foreign policy is its volatility. He is unpredictable to a fault. He has doubted his own Venezuela policy from the first week he signed off on it. He called Kim Jong Un crazy but now says he’s a swell guy. He signed a trade deal with Mexico then threatened it with new tariffs.

On Iran he has adopted a policy goal favored by hawkish Sen. Lindsey Graham but wants to use only the means of isolationist Sen. Rand Paul to achieve it. He warned that “if Iran wants to fight, that will be the official end of Iran,” but he lets Iran shoot down a drone and interfere with international shipping.

If Mr. Trump’s real policy is Mr. Paul’s, then he should be honest with Americans and return to the Obama nuclear deal. In the meantime, Iran appears to be calling Mr. Trump’s bluff.

Gold Decisively Breaches Major 2013 Overhead Resistance Wall

by: Gordon Long
- The $1,360/oz price level has acted as an invisible "Maginot Line" since 2013. The wall was decisively breached this week.

- The blow to the wall was decisive and a retreat by the Bullion Banks to a new higher resistance zone of $1,470/oz looks likely.

- Both the fundamentals and technicals suggest that there is just too much force to be held back for the $1,470 and $1,650 levels not to be tested in 2019.

The $1,360/oz price level has acted as an invisible "Maginot Line" since 2013. The wall was decisively breached this week as both Chairman Powell and ECB President Draghi signaled monetary easing was ahead. This was sufficient confirmation to the gold market that currency debasement was again soon to be ignited.
The gold market delivered a crushing blow to once impenetrable wall. However, those that trade gold know only too well that gold is a manipulated market and will be looking for another "fat finger": billions of dollars of notional value of gold; in the middle of the night; offshore; executed in seconds; and sell order - thereby crushing price (once quadruple-witch is in the rear view mirror)! Where is the SEC?
However, the blow to the wall was decisive and a retreat to a new resistance zone is likely. $1,470/oz looks likely...
...but momentum may force the troops to select $1,650.
Both the fundamentals and technicals suggest that there is just too much force to be held back for these levels not to be tested.
FUNDAMENTALS: De-Dollarization is a core driver (See June 15th Seeking Alpha post: Gold Likely To Soon Be Lifted By Rising De-Dollarization Surge)
TECHNICALS: We have gold technicals which haven't looked stronger in a long time:
  • A Bullish "Ascending Triangle"

  • A Completed "Cup & Handle"

  • An "Inverse Head & Shoulders"

The International Man, Nick Giambruno, lays out eight reasons in a multi-article analysis why a huge Gold-Mania is about to begin:
  • No. 1: Basel III Moves Gold Closer to Officially Being Money Again

  • No. 2: Central Banks Are Buying Record Amounts of Gold

  • No. 3: Oil for Gold - China's Golden Alternative

  • No. 4: The Fed's Dramatic Capitulation

  • No. 5: Takeover Frenzy in the Gold Mining Industry

  • No. 6: President Trump Is Pro-Gold

  • No. 7: Socialism Is on the Rise

  • No. 8: Gold-Backed Cryptos - A Monetary Revolution
We may have a perfect storm which the Bullion banks are ill prepared to combat!

How Inflation Could Return

After years of low inflation, investors and policymakers have settled into a cyclical mindset that assumes advanced economies are simply suffering from insufficient aggregate demand. But they are ignoring structural factors at their peril.

Mohamed A. El-Erian


NEW YORK – Debates about inflation in advanced economies have changed remarkably over the past decades. Setting aside (mis)measurement issues, concerns about debilitatingly high inflation and the excessive power of bond markets are long gone, and the worry now is that excessively low inflation may hamper growth.

Moreover, while persistently subdued – and, on nearly $11 trillion of global bonds, negative – interest rates may be causing resource misallocations and undercutting long-term financial security for households, elevated asset prices have heightened the risk of future financial instability. Also, investors have become highly (and happily) dependent on central banks, when they should be prudently more fearful of them.

In search of new ways to produce higher inflation, the major central banks have tended to favor a cyclical mindset, making frequent references to insufficient aggregate demand. But what if that is the wrong lens through which to view current conditions, and we are actually in the middle of a multi-stage process in which strong disinflationary supply-side forces eventually give way to the return of higher inflation? In that case, monetary policymakers and market participants would need to consider quite a different opportunity-risk paradigm than the one currently being pursued.

To be sure, after coming close to central banks’ 2% target in 2018, core inflation rates in Europe and the United States have since been declining. The conventional measure of market expectations for inflation – the break-even rate on five-year US Treasuries – remains stubbornly below target, even though the six-month moving average pace of job creation is almost 50% above the historical level needed to absorb new labor-market entrants so deep in the economic cycle. Though the US unemployment rate (3.6%) is at its lowest level in around five decades, the labor-force participation rate (62.8%) also remains relatively low.

Owing to the persistence of low inflation, monetary policies have remained ultra-loose for an unusually long time, raising concerns that the US or Europe may succumb to “Japanification” as consumers postpone purchases and companies reduce investment outlays. So far, that risk has led to protractedly low or negative (in the case of the European Central Bank) policy rates and bloated central-bank balance sheets, despite the potentially deleterious effects of such policies on the integrity of the financial system.

In fact, some economic observers favor the ECB not just maintaining negative interest rates, but also restarting asset purchases under its quantitative-easing (QE) program. Likewise, there are those who want the US Federal Reserve to implement an “insurance cut,” despite indicators suggesting that this will be another year of solid economic growth and job creation. Meanwhile, central banks have begun to look beyond their existing toolkits (traditional and unconventional) for new ways to spur economy-wide price increases, such as by raising the inflation target, either directly or by pursuing an average and allowing for deviations over time.

But today’s surprisingly low inflation also appears to be linked to larger structural forces, which means that it’s not rooted only in insufficient aggregate demand. Technological innovations – particularly those related to artificial intelligence, big data, and mobility – have ushered in a more generalized breakdown of traditional economic relationships and an erosion of pricing power.

Taken together, I call these structural forces the Amazon/Google/Uber effect. While the Amazon model pushes down prices by allowing consumers to bypass more expensive intermediaries, Google undercuts companies’ pricing power by reducing search costs, and Uber brings existing assets into the marketplace, further eroding established firms’ pricing power.

The Amazon/Google/Uber effect has turbocharged a disinflationary process that began with the acceleration of globalization, bringing far more low-cost production online and reducing the power of organized labor in advanced economies (as has the gig economy more recently). But while these trends will most continue for now, they are likely to confront countervailing inflationary influences that have yet to reach critical mass: the slack in the labor market is diminishing every month, and increased industrial concentration is giving some companies, especially in the technology sector, far greater pricing power.

Now, consider those trends in the context of today’s changing political landscape. Fueled by understandable anger over inequality (of income, wealth, and opportunity), more politicians are embracing populism, with promises of more active fiscal management and measures to curb the power of capital in favor of labor. At the same time, there is growing political pressure on central banks to bypass the asset channel (that is, QE bond purchases) and inject liquidity directly into the economy.

Economic anxieties are also driving anti-globalization politics. The weaponization of economic-policy tools such as tariffs and other trade measures is risking a fragmentation of global economic and financial relationships, favoring higher prices, and compelling a greater degree of more costly self-insurance by companies and consumers. At the same time, as expectations of continued low inflation become more entrenched, an upward price shock could expose vulnerabilities and increase the risk of policy mistakes and market accidents.

Considering how these competing forces are likely to play out over time, policymakers and investors should not rule out a return of inflation over time. Looking ahead, we will likely continue experiencing an initial stage in which the Amazon/Google/Uber effect remains dominant. But that may well be followed by a second stage in which tight labor markets, populist nationalism, and industry concentration begin to offset the one-time structural effects of new technologies being widely adopted. And in a third stage, the possible onset of higher inflation may catch policymakers and investors by surprise, producing excessive reactions that make a bad situation worse.

As with most paradigm shifts, there can be little certainty regarding the timing of this scenario. But, either way, policymakers in advanced economies must recognize that their inflation outlook is subject to a wider range of dynamic possibilities than they have considered so far. Focusing too much on the cyclical, rather than the structural, could pose serious risks to future economic wellbeing and financial stability. The longer we wait to broaden the prevailing mindset, the more likely we are to advance to the next stages of an inflationary process in which the impact of an exciting one-and-done technological event gives way to some old and more familiar tendencies.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

Can the Belt and Road Become a Trap for China?

Through its Belt and Road Initiative, China is building ties to some of the world’s most authoritarian, financially opaque, and economically backward countries. Rather than exposing itself to massive political, economic, and default risks, Chinese policymakers should instead seek to repair relations with the West.

Yasheng Huang


CAMBRIDGE – Critics often claim that China is using its massive “Belt and Road Initiative” as a form of coercive “debt-trap diplomacy” to exert control over the countries that join its transnational infrastructure investment scheme. This risk, as Deborah Brautigam of John Hopkins University recently noted, is often exaggerated by the media. In fact, the BRI may hold a different kind of risk – for China itself.

At the recent BRI summit in Beijing, Chinese President Xi Jinping seemed to acknowledge the “debt-trap” criticism. In his address, Xi said that “building high-quality, sustainable, risk-resistant, reasonably priced, and inclusive infrastructure will help countries to utilize fully their resource endowments.”

This is an encouraging signal, as it shows that China has become more aware of the debt implications of BRI. A study by the Center for Global Development concluded that eight of the 63 countries participating in the BRI are at risk of “debt distress.”

But as John Maynard Keynes memorably put it, “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.” In the context of the BRI, China may turn out to be the banker who is owed a million pounds.

In particular, China may fall victim to the “obsolescing bargain model,” which states that a foreign investor loses bargaining power as it invests more in a host country. Infrastructure projects like those under the BRI are a classic example, because they are bulky, bolted to the ground, and have zero economic value if left incomplete.

Unsurprisingly, some BRI partner countries are now demanding to renegotiate terms, and typically after the projects have started. China may be forced to offer ever more favorable concessions in order to keep the projects on track. In mid-April, for example, Malaysia announced that a major BRI rail project, put on hold by the government after last year’s election, would now go ahead “after renegotiation.” According to media reports, the costs of construction were reduced by as much as one-third. Other BRI countries will probably also ask for debt forgiveness and write-offs, the costs of which will ultimately be borne by Chinese savers.

The BRI may well have additional hidden costs for China down the road. For starters, it is extraordinarily difficult to make money on infrastructure projects. There is a widespread belief that infrastructure investment powers economic growth, but the evidence for this is weak. In fact, China itself built much of its current infrastructure after its growth had taken off. In the 1980s and 1990s, for example, China grew much faster than India despite having a shorter railway network. According to the World Bank, in 1996 China had 56,678 kilometers (35,218 miles) of rail lines, and India had 62,915 kilometers. Chinese growth was not jump-started by infrastructure, but by reforms and human capital investments. If growth fails to materialize in BRI countries, Chinese companies may end up bearing the costs.

Furthermore, many of China’s BRI partner countries are risky – including Pakistan, a major recipient of investments under the scheme. In addition to its high political, economic, and default risks, the country also scores poorly on education indicators. According to one report, Pakistan ranked 180th among 221 countries in literacy. This is a potential red flag for Chinese investments in Pakistan, because research suggests that investments in physical infrastructure promote growth only in countries with high levels of human capital. China itself benefited from its infrastructural investments because it had also invested heavily in education.

Nor should the BRI be compared to the Marshall Plan, the US aid program to help rebuild Western Europe after World War II, as an example of how large-scale investment projects can boost growth. The Marshall Plan was so successful – and at a fraction of the BRI’s cost – because it helped generally well-governed countries that had been temporarily disrupted by war. Aid acted as a stimulus that triggered growth. Several of the BRI countries, by contrast, are plagued by economic and governance problems and lack basic requirements for growth. Simply building up their infrastructure will not be enough.

Finally, the BRI will probably further strengthen China’s state sector, thereby increasing one of the long-term threats to its economy. According to a study by the American Enterprise Institute, private firms accounted for only 28% of BRI investments in the first half of 2018 (the latest data available), down by 12 percentage points from the same period of 2017.

The BRI’s massive scale, coupled with the lack of profitability of China’s state sector, means that projects under the scheme may need substantial support from Chinese banks. BRI investments would then inevitably compete for funds – and increasingly precious foreign-exchange resources – with China’s domestic private sector, which is already facing a high tax burden and the strains of the trade war with the US.

Moreover, Western firms, an important component of China’s private sector, are retreating from the country. Several US companies, including Amazon, Oracle, Seagate, and Uber – as well as South Korea’s Samsung and SK Hynix, and Toshiba, Mitsubishi, and Sony from Japan – have either scaled down their China operations or decided to leave altogether. Partly as a result, US foreign direct investment in China in 2017 was $2.6 billion, compared to $5.4 billion in 2002.

This is a worrisome development. Through the BRI, China is building ties to some of the world’s most authoritarian, financially opaque, and economically backward countries. At the same time, a trade war, an ever-stronger state sector, and protectionism are distancing China from the West.

China has grown and developed the capacity to undertake BRI projects precisely because it opened its economy to globalization, and to Western technology and knowhow. Compared to its engagements with the West, the BRI may entail risks and uncertainties that could become problematic for the Chinese economy. As the Chinese economy slows down, and its export prospects are increasingly clouded by geopolitical factors, it is worth rethinking the pace, scope, and scale of the BRI.

Yasheng Huang is International Program Professor in Chinese Economy and Business and Professor of Global Economics and Management at the MIT Sloan School of Management.

Is Gold About To Get Whacked?

Gold has spent the past couple of weeks steamrolling technical barriers and reviving the spirits of long-suffering gold bugs.
But markets don’t move in a straight line. Bull runs (if that’s what this is) have stomach-churning corrections along the way – usually just as everyone concludes that the good times will roll on forever.
321gold’s Bob Moriarty, a consistent voice of reason in the precious metals space, explained this to his readers yesterday:
Gold bulls are coming out of hibernation with even billionaires talking about how much they like gold. That tends to happen just before a correction. The gold bulls get frothy around the mouth; speculators pour money into gold contracts just in time to get whacked once more so they can whine about how gold and silver are manipulated and no one saw it coming. 
I’ve written a number of times about the importance of understanding bullish sentiment.  
I find the DSI of Jake Bernstein the single most valuable indicator I use. On both Thursday and Friday last, the DSI for gold hit 94. That doesn’t suggest a major high marking a top for the next 200 years but it does say caution would be merited.  
Too many people turned bullish all of a sudden. 
The COTs agree. Gold sentiment is excessive.

Speaking of the COTs (which show the structure of the gold futures market), they are indeed excessive. The past few weeks have seen an epic buildup of speculator longs and commercial shorts:

Gold COT gold whacked

Here’s the same data in graphical form, with the speculators in gray and the commercials in red:

Gold COT chart gold whacked

Since the speculators are usually wrong at big turning points and the commercials are usually right, the paper market set-up is extremely bearish. As Moriarty says, this doesn’t mean an end to the bull market, but it might mean a several-week-long pause.

As for how to play this kind of squiggle, that’s easy. Keep doing what you should have been doing all along, which is dollar-cost-averaging into gold and silver bullion and well-chosen mining stocks. The fundamentals that will eventually drive precious metals and other real assets higher will continue their long march towards an era-ending financial crisis. And gold will track this evolution — with the occasional correction.

Ray Dalio Is Kinda, Sorta, Really Wrong, Part 3

By John Mauldin

Two weeks ago I started a mini-series in the form of an open letter responding to a series of essays by Ray Dalio, the founder of Bridgewater Associates. I wrote here and here that he was kinda, sorta wrong in Why and How Capitalism Needs to Be Reformed, Parts 1 and 2 but really, really wrong in It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and ‘Modern Monetary Theory,’ in which he basically endorsed MMT. Today I continue my response.

If reader feedback is any indication, you are also passionate about this conversation. Last week’s letter generated many long, thoughtful reader comments. Clearly, it is not just Ray and I who are worried about the country’s future direction. I find that encouraging. A national conversation is precisely what we need in these serious times.

As noted, Ray has done us all a service by pointing out some rarely mentioned elephants in the room (some tinged with pink). We discuss various parts but seldom the entire creature. By that, I mean the rapidly growing potential for “progressive” control of both Congress and the White House. This stems from differences between haves and have-nots, between the protected and unprotected, combined with a desire to have government solve our society’s perceived ills.

So let’s pick up where we left off last week.

Dear Ray

In Part 1 of this letter I mostly agreed with you about the significant wealth and income disparities in the US today. And then in looking for your hope of a bipartisan commission that can deal with the problems, I simply pointed out that such commissions have rarely worked in the past and would be even more unworkable given today’s partisan, ideological divide.

Now I want to review two of your suggested solutions. Since this is an open letter and others will be reading it, let me quote directly from that section:

1. Leadership from the top. I have a principle that you will not effect change unless you affect the people who have their hands on the levers of power so that they move them to change things the way you want them to change. So there need to be powerful forces from the top of the country that proclaim the income/wealth/opportunity gap to be a national emergency and take on the responsibility for reengineering the system so that it works better.

4. Redistribution of resources that will improve both the well-beings and the productivities of the vast majority of people. As an economic engineer, naturally I think about how money might be obtained from taxes, borrowing, businesses, and philanthropy, and how it would flow to affect prices and economies. For example, I think about how a change in personal tax rates might occur and how changes in them relative to corporate tax rates would affect how money would flow, and how changes in tax rates in one location relative to another location would drive flows and outcomes in them. I also think a lot about how the money raised will be spent—e.g., how much will be spent on programs that will improve both social and economic outcomes, and how much will be redistributive. Such decisions would of course be up to the people on the bipartisan commission and the leadership to decide and are way too complicated an engineering exercise for me to opine on here. I can, however, give my big picture inclinations. Above all else, I’d want to achieve good double bottom line results. To do that I’d:

b. Raise money in ways that both improve conditions and improve the economy’s productivity by taking into consideration the all-in costs for the society (e.g., I’d tax pollution and various causes of bad health that have sizable economic costs for the society).

c. Raise more from the top via taxes that would be engineered to not have disruptive effects on productivity and that would be earmarked to help those in the middle and the bottom primarily in ways that also improve the economy’s overall level of productivity, so that the spending on these programs is largely paid for by the cost savings and income improvements that they create. Having said that, I also believe that the society has to establish minimum standards of healthcare and education that are provided to those who are unable to take care of themselves.

A National Emergency?

Let me highlight in particular one sentence from the above with my own bolded emphasis.

So there need to be powerful forces from the top of the country that proclaim the income/wealth/opportunity gap to be a national emergency and take on the responsibility for reengineering the system so that it works better.

First, let’s ignore the fact that many would not agree that the income and wealth gaps rise to the level of “national emergency.” Let’s for the moment assume the levers of power you mention would pass to a majority who would in fact see it that way and want to do something about it.

Using suppositions and hypotheticals, this is not all that far-fetched. It is entirely possible next year’s elections will deliver a Democratic Congress and White House that would consider these gaps a national emergency. A recession in early 2020 would raise those odds. And if not in 2020 then by 2024 it might even be more plausible.

That said, let’s look at what your proposals to raise taxes and redistribute income might actually look like.

First, the on-budget national deficit for this year will be in the $1 trillion range and when you add in the off-budget deficits total debt could easily rise by $1.3 trillion or more. That’s just in 2019 and it won’t get much better in 2020.

Total US government debt is now $22.4 trillion. We could easily see the national debt at $25 trillion before the next inauguration. That doesn’t include the $3 trillion+ state and local governments owe, nor some $100 trillion of unfunded federal liabilities or $6.7 trillion of unfunded state and local government pensions (data from The US Debt Clock.)

Even a garden-variety recession will blow those deficit numbers out of the water. If revenue falls and expenses rise as they did in the last two recessions, a $2-trillion deficit is more than likely. The national debt would almost certainly reach $30 trillion within a few years.

Interest on the national debt is budgeted at $389 billion for fiscal 2019. Assuming similar interest rates in the future, that cost will rise to almost $550 billion on a $30-trillion national debt—almost as much as the defense budget.

Essentially, we would need to raise taxes by $1 trillion along with some considerable budget cutting just to balance the budget before we get into any redistribution of income. But let’s set aside that for the moment and talk about raising taxes enough to fund the income redistribution programs you would like to see.

In your words, you want to increase taxes “from the top” and earmark those increases to help those in the bottom and middle, somehow “engineering” those taxes to have no effect on productivity. Let’s look at some real-world numbers of what the top income earners pay in taxes, courtesy of the Tax Foundation.

Some 68% of all income tax revenue comes from the top 10% of income earners.
That’s fair enough, I suppose. Interestingly, the top 1/10 of 1% of income tax payers pay more than the bottom 50% combined.  

Source: Bloomberg

Here’s a chart from that same Bloomberg article that breaks it down by the different percentiles and the percentage of total income taxes they paid. The top 1% paid a greater share of individual income taxes (37.3%) than the bottom 90% combined (30.5%).

Source: Bloomberg

Now, let’s go back to the Tax Foundation data. This is part of a larger and more detailed analysis at the website.

Note the top 10% of income tax payers paid approximately $1 trillion in income taxes. When you say that you want to “raise more from the top via taxes” let’s see what that means. Giving $3,000 to each of the 70 million tax filers in the bottom half would require $210 billion. You would also need the government to have the systems and people to do this which would require at least another $20 billion or so, and that may be giving a lot of credit to government efficiency.

So, getting an additional $230 billion from the top 10% of income earners would mean giving that group a roughly 23% across-the-board tax increase. That’s before we do anything about the national deficit.

Note also, to do this you wouldn’t be taxing only millionaires and the rich. To get in the top 10% of income payers you merely need to be making ~$140,000 a year. The cut-off for the top 5% is approximately $200,000.

So, let’s say we ask only the top 5% of income earners to fund this new spending. To get that same $230 billion you would need to raise their taxes by approximately 30%, give or take.

Want to do it just from the top 1%? You would need to raise their tax rates by 50%. Again, that is before we even begin to reduce the deficit.

And when you say that you want to engineer these taxes not to affect productivity, I am scratching my head trying to figure out precisely how to do that. The marginal tax rate for incomes over $500,000 is 37%. So if you wanted to get that $230 billion from the wealthiest taxpayers, their top marginal tax rate would rise to approximately 56%. Add state income tax and the rates could easily get to 60% or more in some states.

And do we really want to raise taxes either during or just after recession? Seriously? Not exactly a prescription to boost the economy and productivity.

Adding a little more complexity, there is a difference between the top 10% of earners and the top 10% of taxpayers. To be a top-10% earner, you merely have to make $118,000. In October of 2018, the Economic Policy Institute published a study showing that the top 1% reached the highest wages ever in 2017. But when you read all those stories about the 1%—or even the top 5% or 10%—how much money do you need to pull in to be in one of those groups?

Source: Investopedia

We already have a system where somewhere between 40–47% of taxpayers literally pay no income tax. (They do, of course, pay Social Security and Medicare taxes on their wage incomes.) How much more progressivity do we need in order to be “fair,” whatever that is?

It is one thing to simply state that you want to engineer taxes in order to redistribute income to the lower half and doing that while not hurting productivity. But it is another thing entirely to lay out exactly how much money is needed to be able to make the system more equitable.

Is $3,000 per family enough? Do you need twice that much? Where does the money come from and how much would taxes have to be raised? It is one thing to say that we should tax pollution (if it would help bring down pollution, I might even find myself in favor of that—pollution has a social cost) but it is another thing to say what constitutes pollution and how much. Automobile emissions? Do you raise taxes on the bottom 50% for their cars? It gets complicated real quick.

Louisiana Sen. Russell Long (Senate finance committee chair from 1966 to 1981) is credited with saying, “Most people have the same philosophy about taxes. Don’t tax you, don’t tax me, tax that fellow behind the tree.” If the top 10% are the “fellow behind the tree” then you must raise their taxes substantially in order to collect any meaningful amount of money. Or else move down the scale and raise taxes on many more people.

The real emergency? Trillion-dollar deficits that will grow to $2-trillion deficits during the next recession. You could literally double taxes for the top 10% and barely balance the budget today, before any recession. That is how far out of balance our system has gotten.

And all this is before we have paid for climate change or free college or any of the progressive left’s other proposals, along with income redistribution. And to be fair, Republicans are no longer concerned about multi-trillion-dollar deficits, either. They just have different spending priorities.

You want bipartisanship, Ray? It seems to me that deficit spending pretty much gets everyone’s support. Not exactly the kind of bipartisan cooperation that I find helpful.
A Little Coordination, Please

Finally, you call for coordinated monetary and fiscal policies. Quoting:

5. Coordination of monetary and fiscal policies. Because money is clogged at the top and because the capacity of central banks to ease enough to reverse the next economic downturn is limited, fiscal policy will have to be more coordinated with monetary policy, which can happen while maintaining the Federal Reserve’s independence. If done well, this will both stimulate economic growth and reduce the effects that quantitative easing has on increasing the wealth gap by shifting money and credit into the hands of those who have a higher propensity to spend from those who have a higher propensity to save and from those who need it less to those who need it more.

Here and elsewhere, you acknowledge that quantitative easing did in fact make the income and wealth gap worse. So you call for fiscal policy to do the income redistribution that you feel necessary.

When I read Parts 1 and 2, I came to this section and left a little bit mystified. If you didn’t want to use quantitative easing, and the realities of our national debt and growing deficits being what they are, how much would taxes have to be raised?

And then you answered that question when you wrote It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and ‘Modern Monetary Theory’. And it is at this point that you went from being kinda, sorta wrong to being really, really, really wrong.
[To be continued…]

Next week we will look at various scenarios for the future (going out about 10 years), what their various outcomes and costs might be, and how we can deal with the massive debt and deficits, not to mention new spending programs. I am actually going to propose my own solution that I think will put us back on track.

Unfortunately, paraphrasing Winston Churchill, the US will likely try everything else before we finally do the right thing.

Boston, New York, and Puerto Rico

I am enjoying the beautiful weather here in Puerto Rico. Later this month I’ll be visiting Boston and New York, then on July 4 I fly back to Puerto Rico working on what will likely be Part 5 of this series. It may or may not be the final part. I’ll just see how far I get.

Shane has developed an interesting new hobby. One of our guest bedrooms has an open outdoor alcove. There was really nothing in it but weeds when we moved in. She has cleared it out and made a nice little garden. The interesting thing is that she planted something that to me looks like a weed but monarch butterfly caterpillars evidently consider those weeds to be ambrosia. So now Shane is growing cocoons and raising monarch butterflies. It is really pretty cool to watch them emerge from the cocoon. And theoretically, they’ll migrate back next year, since they supposedly return where they were born to start the process all over again. We’ll see how that theory works next year. But right now, it’s just a lot of fun.

And with that I will hit the send button. I feel like there’s more to be said on taxes. I know that Elizabeth Warren is talking about a wealth tax. I’m not quite certain how that would work on illiquid assets. It would certainly raise a lot of money but imagine the chaos.

On that cheerful thought, let me wish you a great week!

Your thinking about taxes in the future analyst,

John Mauldin
Chairman, Mauldin Economics