Unintended Consequences, Part 1: Bigger Deficits = Higher Interest Rates =…Many Bad Things 

Mainstream economics uses a fairly simple equation when it comes to public policy: More government spending equals more growth, which is just about always a good thing.

The problem is with the “just about always” part. At the bottom of recessions, tax cuts and higher government spending can indeed stop the shrinkage and get things going again. And fiscal stimulus might be relatively harmless when an economy has minimal debt and can therefore handle a bit of deficit spending without negative side effects.

But this is not one of those times. Eight years into a recovery, with unemployment and interest rates at near-record lows and global debt at record highs (by a wide margin), borrowing a ton of new money virtually guarantees rising inflation and shortages of everything from trained workers to copper and zinc. To which the Fed is pretty much required to react:
Spending Bill Raises Expectations for More Fed Rate Increases 
(Wall Street Journal) – A bipartisan spending deal reached by U.S. lawmakers earlier this month has prompted many Wall Street economists to raise their projections of how much the Federal Reserve will raise interest rates this year and next.
More forecasters say they now expect four Fed rate increases this year, up from three, because of the deal to increase federal government spending by $300 billion over the next two years. 
The funding bill is more generous than many economists anticipated, and they predict it could boost U.S. economic growth in 2018 and ’19 by around 0.3 percentage points each year—roughly the same size increase expected from the $1.5 trillion tax cut signed into law by President Donald Trump in December. 
Economists at UBS Group AG , Nomura Securities and Oxford Economics in the past week raised their projections for rate increases, joining other prominent forecasting shops that had already projected four quarter-percentage-point increases in the Fed’s benchmark short-term interest rate this year. 
Nomura sees the Fed raising rates four times this year and twice next year, adding one more additional rate rise to its forecast in both years. UBS also added one rate increase to its forecast each year, now expecting the Fed to raise rates four times this year and three next year. 
Economists at Goldman Sachs Group Inc. and JPMorgan Chase & Co., which were among those already projecting four rate rises this year, have said the government spending package makes them more confident in those calls.

What’s wrong with deficit-led growth pushing up interest rates a bit? History, for one thing.

Note how a rising Fed Funds rate preceded every recession in living memory. AND that the point at which higher short-term rates kicked the economy into reverse has been lower in each post-1980 cycle. So it’s reasonable to assume that in the current hyper-leveraged system it won’t take much higher rates to produce instability.

The question then becomes “what is the magic – or tragic – number that sets off the next conflagration?” That’s unknowable, but given the pattern of the past few decades it appears to be south of 5%. Another four quarter-point hikes gives Fed Funds a 3-handle, which may or may not do it but is definitely getting close.
Meanwhile, long-term rates are reacting aggressively to the prospect of wage and raw material inflation. The 10-year Treasury yield took off when the Trump tax cuts became feasible and hasn’t looked back:

Now it’s getting harder for the US to convince people to buy its paper at current rates:
Treasury Seven-Year Sale Caps $258 Billion Week of Higher Yields

(Bloomberg) – The U.S. Treasury’s $29 billion auction of seven-year notes drew the highest yield for securities at that tenor since 2011, capping a $258 billion flood of debt sales over three days. 
As with the week’s other note offerings, there was a dip in the amount of bids relative to the amount sold, signaling weaker demand. With the Treasury ramping up borrowing as part of its plan to finance widening budget deficits, the auction was $1 billion larger than it was last month and the bid-to-cover ratio slid to 2.49 from 2.73 at the prior sale. 
Indirect bidders, a class of investors that includes pensions and mutual funds, purchased 62.2 percent, down from 78.1 percent last month. Direct bidders, on the other hand, bought 15.6 percent, the largest share since September. The securities were priced to yield 2.839 percent, the highest since March 2011. 
All told, the auctions show that there’s demand out there for Treasuries, even as supply ramps up, but investors may require higher yields to step in and buy.

Rising tide of debt to hit rich countries’ budgets, warns OECD

Members’ total sovereign debt has increased from $25tn in 2008 to more than $45tn

Kate Allen and Chris Giles in London

The total stock of OECD countries’ sovereign debt has increased from $25tn in 2008 to more than $45bn this year © FT montage; Dreamstime

Developed nations face a rising tide of government debt that poses “a significant challenge” to budgets as interest rates increase around the world, the OECD has warned.

Low interest rates have helped sustain high levels of government debt and persistent budget deficits since the financial crisis, according to the OECD, but the “relatively favourable” sovereign funding environment “may not be a permanent feature of financial markets”.

Fatos Koc, senior policy analyst at the OECD, cautioned that most members of the organisation — sometimes dubbed the rich nations’ club — confront an “increasing refinancing burden from maturing debt, combined with continued budget deficits”.

The warning on the longer-term consequences of high public borrowing marks a shift in stance by the OECD, which as recently as November was praising countries for easing fiscal policy to help global growth.

In an Economic Outlook, published at that time, the Paris-based organisation said that “even a lasting increase in 10-year government bond yields of 1 percentage point . . . might worsen budget balances on average by only between 0.1 per cent and 0.3 per cent of GDP annually in the following three years”.

But Ms Koc now argues that the wisdom of using fiscal measures as economic stimulus depends on an individual country’s budget position, and that it is “important to create strong fiscal roots in an economy while times are good”.

The total stock of OECD countries’ sovereign debt has increased from $25tn in 2008 to more than $45tn this year. Debt to GDP ratios across the OECD averaged 73 per cent last year, and its members are set to borrow £10.5tn from the markets this year.

Because much of the debt raised in the aftermath of the financial crisis is set to mature in the coming years, developed nations will have to refinance 40 per cent of their total debt stock in the next three years, the OECD said. 

Many countries’ credit ratings have fallen as their debt levels have risen over the past decade, diminishing the attractiveness of some sovereign debt for investors looking for high-quality credit.

Fitch, the credit rating agency, warned last month that rising interest rates would pose a fiscal challenge for governments, which are set to increase borrowing from private investors this year for the first time in four years, a recent analysis by JPMorgan Chase found.

The global economy is experiencing a co-ordinated upswing in growth and policymakers are gradually unwinding the unprecedented monetary policy measures they implemented after the financial crisis. As central banks’ holdings of government debt reduce and interest rates begin to rise, bond yields have started to shift upwards.

The US is issuing significantly more debt to finance recent tax reforms, with the additional supply of Treasuries prompting some investors to forecast further rises in bond yields.

A sustained rise in yields would mean that governments would face higher costs to refinance existing debt and issue new bonds

“In the past decade [governments’ debt] refinancing was generally done at the same or only marginally different terms,” said Douglas Rediker, a former US representative on the IMF board now at the Brookings Institution think-tank. “Now, the reality is that the refinancing costs are likely to be a greater burden on the issuing country and so the question is about the impact of those debt servicing costs on the underlying economy.”

OECD countries are implementing some precautionary measures to cope with such concerns, the research noted, including increasing the amount of long-dated debt they issue so as to reduce their refinancing requirements in any one year.

This story has been amended to correct the figure for current OECD members’ outstanding debt, which is more than $45tn

domingo, marzo 04, 2018


Chung Kuo

by Doug Casey

This article is entitled Chung Kuo, which means Middle Kingdom.

The Chinese have long seen themselves as superior to every other race (like almost every race does) and the center of the world. It’s because they were so confident of this that they never ventured out as Europeans did, with a brief exception in the 15th century when a gigantic

Chinese fleet, composed of ships vastly superior to those of Europe, ventured as far as Africa.

Since dropping the ball on world conquest back then, or at least exporting their culture wholesale, they’ve been in stasis, and on the receiving end of what Europe had to dish out.

The Chinese resent the “gweilo,” or “laowai” (loosely translated in Cantonese and Mandarin respectively as “foreign devil”) for appropriating places like Hong Kong, Macau, Shanghai, and numerous other enclaves. They resent episodes like the Opium Wars, which resolved whether they were to be used as a market for narcotics. They never learned to appreciate lots of foreign soldiers running around their countryside, even though Westerners felt it was a birthright.

Rent 55 Days at Peking for the conventional European view of imperialism during the Boxer Rebellion. Better yet, buy or rent The Sand Pebbles, in my opinion one of the best movies out there—and the book is even more entertaining and educational.

The Chinese absolutely resent the U.S. government parading its aircraft carriers off the China coast as if it owned the place. The U.S. government is not showing strength, it’s displaying arrogance and stupidity by antagonizing a sleeping dragon. And the thought of American politicians—which is to say an assortment of insular lawyers, eggheaded wannabe social engineers, and refugees from Arkansas trailer parks—negotiating with people who’ve been through what the Chinese have, is just scary.

The U.S. government may feel like it can call the shots now because it has a dozen aircraft carriers and a couple thousand fighter planes. But it’s making a serious enemy while it’s going to bankrupt America in a counterproductive projection of force to the other side of the planet. And that’s not all. Because the day will go to the people with the most wealth, not the ones that have the most expensive military hardware.

The Future in China

I can give you a dozen credible scenarios describing what might happen in China over the next couple of decades. But the trend that seems certain to continue is the rapid rate of wealth increase there. I don’t credit official figures with any great accuracy, but if we take them as being approximately right, then the U.S. economy is growing at 2%, and China’s at about 7%—but with a base of about four times the population. What this means is that the largest economy on the planet will soon no longer be America’s—but China’s.

It’s already been something of a psychological smack upside the back of the head for Americans to realize that they’re far less powerful than they were in the ’50s and early ’60s, when America was wealthier than the rest of the whole world put together. What will it mean when it’s only a fraction as wealthy as China alone?

Of course, the average American will still be living far more comfortably than the average Chinese; he’ll still have a bigger house, more gadgets, cars, and consumer goods. But he may actually have considerably less investment capital and savings. And there will be vastly more wealthy Chinese, and they’ll have vastly more wealth than wealthy Americans.

There are a number of reasons for this. One is that Chinese culture is ingrained with the Confucian work ethic, which is quite similar to the Protestant work ethic that helped the West get where it now is. The difference is that the West has become a group of flaccid welfare states, morally weakened by its own prosperity, pretty much as Joseph Schumpeter predicted. While I’m philosophically averse to believing that success must necessarily lead to dissipation, that certainly seems to be the historical record. And it also seems pretty clear that a society, a government, a corporation, or an organization of any type is pretty much like a human body in at least one way: As it gets older, it gets weaker and more corrupt, approaching its inevitable death.

Another element of Chinese ascendance is just the sheer number of people that share a common culture and language. Upwardly mobile Chinese all learn English, the world’s language, as well as Mandarin. So they can access everything from the West, but very few people in the West will ever learn Chinese, making it hard to reverse the flow.

Further, just as every other people from a given culture tend to prefer associating and doing business with themselves—Jews, blacks, Arabs, Irish, Italians, you-name-it—the same is true of the Chinese. But they’re an order of magnitude larger than most any other cultural grouping. From a financial point of view, it’s just arithmetic.

Take an American and a Chinese, each with a dollar. Say both are equally smart and hardworking, and each is able to double his dollar every year—2, 4, 8, 16… The only difference is that the American pays 35% in taxes and the Chinese pays nothing. Actually the American is paying close to 50% and the Chinese is paying something, but the difference is about the same. With only that differential, by the time the American has one million dollars, how much does the Chinese have? The answer is that by the time the American has a million dollars in 28 years, the Chinese has 268 million.

Actually the situation is even grimmer. The Chinese will probably work harder. He’s in an environment where, if only because of minimal regulation, he’ll make his capital grow faster. If Herrnstein and Murray are right in their book The Bell Curve, the Chinese guy is smarter (105 v. 100 average IQ for Europeans). And then, when the American dies, the government will take half of his piddling million dollars for estate taxes, so his kids start with no meaningful financial capital. And probably minimal intellectual capital, if the obvious dumbing down of American schools has anything to do with it. Meanwhile, the scions of the Chinese will have an untaxed $268 million, and probably a much better education and stronger work ethic to help them deploy it.

The situation was best summed up by my friend The Great Winfield, the famous commodity speculator, who, when I asked him how he was going to deal with the eventuality, commented “After I kick the bucket, I’m going to come back as a young, good-looking girl. That way, maybe I’ll get a rich Chinese boyfriend, and at least I’ll eat regularly.”

And I’m not overdoing the tax angle, either. The average American has been so brainwashed that he thinks he has a moral obligation to give the government whatever it asks for; he thinks he’s being dishonest and cheating if he puts his own and his family’s welfare above the demands of the State. At the same time, he thinks the State has a moral obligation to provide for his health, education, welfare, and retirement.

The average Chinese, however, recognizes the government as his adversary and feels no moral obligation at all towards it, only to his family. He knows the guy calling himself “the government” is just a successful warlord, and a successful warlord is just a major league criminal. He considers it his duty to deny resources to the State because he knows he can’t feed the beast and his family with the same grain of rice. And he has no concept of the State taking care of him; that’s something his family does.

Where will it all end up? In the short run, more of the world will surely resemble British Columbia, with its majority Oriental population. In the long run, the world portrayed in David Wingrove’s Chung Kuo novels, in which the Chinese dominate the world as thoroughly in the 22nd century as the Europeans did in the 19th, isn’t at all out of the question.

China’s Most Powerful Weapon in the Coming Trade War

by Nick Giambruno

“When any market is down 90%, you’re obligated to go and investigate.”

That’s what Doug Casey often says. And it’s part of the reason I put my boots on the ground in China a few months ago.

As I told you yesterday, the country has a monopoly on a little-known resource market. For years, stocks in this sector only went down. The industry was left for dead… until recently.

The last time this happened, the price of this resource skyrocketed over 10 times almost overnight.

And, as I’ll show in a moment, I think there’s a strong chance a similar mania will start son…

China’s Monopoly

Most people have never heard of the material China controls. But it’s essential to modern life.

It’s used to make crucial components for advanced electronics like iPhones, electric cars, flat-screen TVs, computers, and sophisticated military equipment—like guidance systems, drones, anti-missile systems, radars, and fighter jets.

The United States’ top-line fighter jet, the F-35, contains nearly 450 kilograms of this material.

There’s no substitute for this resource in these advanced electronics. The US military and US consumer depend on it.

The problem is that finding this material isn’t cheap. And once you find it, mining it is expensive and messy. It takes about 40 tonnes of rock (40,000 kilograms) to get only about 250 kilograms of this valuable material.

The costs are even higher if you separate the material from the ore in an environmentally friendly way.

But China is willing to do the dirty work.

Beijing helps by subsidizing the industry. Meanwhile, many companies in other countries—operating without hefty state subsidies—go bankrupt.

Plus, China doesn’t fret about the environmental fallout as much as other countries. This lets it produce the material at a much lower cost than its competitors.

Until recently, one company in the US still produced a small amount of this material. Then, after a spat with a neighboring country, China flooded the market with supply. This oversupply drove the last US company out of business.

According to a US Congressional report:

[China] flooded the market by more than tripling the previous world supply of the materials. During this time, [Chinese firms] were largely unprofitable but were allowed to survive through direct and indirect support by the Chinese government.

This backing enabled [China’s industry] to continue to mine and export these materials at prices far below the actual costs of production…

Mines in the United States and elsewhere, unable to remain profitable against cheap Chinese exports, went out of business.

This is how China undercut everyone else and came to dominate the industry. Today, China produces around 90% of global supplies of this material.

In short, no one poses a serious threat to China’s monopoly. China can simply hold prices lower for longer than any competitor can stay solvent.

This unchallenged monopoly could quickly become a huge problem for the US. But the US government won’t just sit on its hands…

The US-China Trade War Is Heating Up

Regular readers know I think a full-blown trade war between the US and China is imminent.

And we’ve already heard the opening shot.

Let me explain…

Early on in his presidency, Donald Trump indicated that he wouldn’t handle China like the previous US presidents.

In January 2017, he became the first president in 40 years to speak with the leader of Taiwan, an island off the coast of China that Beijing considers a renegade province.

Even during the campaign, Trump famously threatened a 45% tariff on Chinese goods entering the US.

He also said China was sucking “the blood out of the United States” and “we can’t continue to allow China to rape our country, and that’s what they’re doing.”

Getting tough with China on trade is a campaign promise Trump can actually keep. He doesn’t need anyone’s cooperation. Legally, he can implement the necessary policies on his own.

And last summer, Trump fired the first shot in the trade war.

His administration launched an investigation against China using Section 301 of the Trade Act of 1974.

This rarely used provision allows Trump to “take all appropriate action... to obtain removal of any [trade] practice that is unjustified, unreasonable, or discriminatory, and that burdens or restricts U.S. commerce.”

The Chinese considered this a provocative move. Since the World Trade Organization (WTO) was founded in 1995, member countries—including China and the US—have traditionally settled trade disputes through it.

But Trump, using the Section 301 investigation, is taking a one-sided approach.

China’s Not-So-Secret Weapon

As I mentioned yesterday, China has a big card to play now. It could easily restrict supplies of the special material again.

That would bring any country—including the US—to its knees.

This isn’t some wild speculation. Remember, China didn’t hesitate to restrict supplies in the past.

Plus, if it restricts supplies again, I think the WTO will give its blessing. That’s because China’s move would probably be in response to one-sided US trade penalties—something Trump has already shown he’s willing to implement.

There’s no way around it. The Chinese are ready to use their monopoly in this market. It’s their ultimate weapon in the trade war with the US.

The good news for investors is that we can use this crisis to make huge profits.

Prices of this special resource are still near their lows for this cycle. So before tensions between Washington and Beijing escalate further, we can buy a dollar’s worth of assets for a dime or less.

This way, we’ll be positioned to profit before the war heats up and the next mania kicks in.