The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, sometimes some people think it’s justified to lie. I’m not just talking about our kids. We had a pretty fierce punishment for lying as our kids were growing up and they still remember that, but I’m thinking about finance ministers in Europe saying sometimes it’s appropriate.
David: Yes, and the topic today is a familiar one. You have the European finance minister, some time ago, Jean-Claude Juncker, who said, “When it becomes serious, you have to lie.” That is, in fact, what we suspect from the Fed. That is what we think is happening today with the Fed as they attempt to manage, or frankly, manipulate, market expectations. We have information flows from the Fed and their designs to influence market behavior and not necessarily express, really, the heart and mind of the Fed’s governing board. We assume that what they release is what they are actually thinking, and it should be, correct?
Kevin: Right.
David: Except that you have to go back to that issue of extraordinary circumstances, redefining what is ethically acceptable. We are talking about the difference between a European finance minister and a U.S. finance minister. Perhaps it is not fair to assume that the Fed would consider lying to be a real alternative, but we do know that we are looking at extraordinary measures. We are looking at interest rates which have been held low for 5 years. We are looking at the kind of stimulus, not only here in the United States, but around the world, that is unparalleled in modern times, in terms of modern finance.
To see these radical actions having been taken, and to forget that these are not only extraordinary measures, but represent very dire circumstances which necessitated them, we would be wrong to assume that the Fed doesn’t have some flexibility, some play, if you will, in how they interpret truthfulness, or lack thereof, what is appropriate in terms of truth-speaking.
Kevin: You have to put yourself in their shoes, and then put yourself back in your own shoes. If you are in their shoes and you think, “If I told the truth right now, and I told everyone that we were shrinking, not growing, as an economy, without the 85 billion, and that interest rates were artificially being held down, but would be much higher if we were actually paying for the true risk,” if I’m Bernanke and I actually say that we’re going to have crash, it reminds me, Dave, of the paradox of the person who says, “Everything I say is a lie.” Well, if he’s telling the truth, then everything he says is a lie. But you see the paradox. Put yourself back in our own shoes as investors, as people who have to survive this management, this manipulation. What do we do if we do assume the Federal Reserve is lying?
David: We have the Fed in a classic liquidity trap with a market that has grown over-dependent on the supply of money and credit from the central bank and, really, what that does is that it makes the market consequences to a change in course, that is, if they tighten policy, if they restrict the bond purchases, or limit them, or taper them, as they have liked to call them recently, they could be looking at catastrophic consequence as a result. The stakes are higher today than in past periods, and I think this is where we can step back from the current circumstances and say, loose credit, that’s not new.
Kevin: No, we can look back in history and see loose credit go terribly wrong, over and over.
David: But under the gold standard, loose credit created banking problems, and this is what David Stockman described several weeks ago. If you have a banking problem, it should burn out, as he said, “in the canyons of Wall Street, or the banking community.” In other words, you are not looking at a lot of collateral damage, and it certainly shouldn’t edge into the larger economy. The difference today, and this is what Paul Mizen has noted, he is an academic that I liked to read, he has noted that the banking crisis and subsequent currency crises are today inseparable.
Kevin: So it’s no longer the banks. We all use currency.
David: But that is a consequence of moving away from the gold standard. Now you have, no different than what we have had in any other period in history, loose monetary policies leading to a banking crisis. But the difference is, without a credibility anchor…
Kevin: Like gold.
David: … like gold, the banking crisis spills into a broader currency crisis. The issue is that you now are implicating every depositor and every currency participant, if you can call them that. If you have bank deposits, if you have coins or shekels in your pocket, we’re talking about you.
Kevin: It is interesting, David, we are seeing people having to share responsibility for things that they never created in the first place. You are talking about currency here, but you can look at Cypress, 7 or 8 weeks ago, when we had the confiscation of deposits to pay back debt. People right now don’t really realize how many different ways they can lose, but the currency crisis – this is the one that Keynes talked about being the sneakiest of all. It’s one that one in a million people understand that they are really losing a tremendous amount of value.
David: And the question is, is it controlled? Again, that’s sort of the orchestrated decline. We’ll talk a little bit about that. But the real crisis would be if they lose control, and this is where we see the plot thickening over the next 6, 12, 18 months.
Kevin: Are you talking about interest rates actually rising?
David: Yes, exactly. If you go back to the Baring’s crisis, Argentina, we were dealing with some external events and trade relationships. Argentina, all of a sudden, was at the end of…
Kevin: A huge boom.
David: Exactly. Then you had interest rates rise from about 4% to 6%. This marginal increase in interest rates in the various money centers around the world caused major problems in Argentina, which caused major problems for a particular bank. Baring’s barely made it through that period.
Kevin: This was in England, across the Atlantic. We’re talking about a century ago. What we are talking about is not instant information day. We’re talking about 100 years ago it caused a banking crisis. Now we’re more interconnected.
David: That’s just one illustration of when interests rates move, and not catastrophically. A move from 4% to 6%, we’re not talking about a spike of 6%, 8%, 10%, from zero to those levels, but even just a marginal increase caused institutional compromise, in terms of their safety, integrity, ability to operate, etc.
Kevin: Let me ask you a question, though, because we’re getting so used to zero interest rates, that it is as if they will never go up again. What would precipitate a rise in interest rates? Would it be a market crash, would it be a market boom? Tell me what would cause a rise in interest rates at this point?
David: At this point, it would be completely natural for rates to rise, because we have them set artificially low. In the U.S., it is not something strange that will raise interest rates, it is just the central bank stepping away and not purchasing 45 billion dollars’ worth of treasuries a month, artificially keeping rates lower. It’s like asking if you hold a basketball underneath the water, what is going to cause it to rise? It’s only natural that it finds equilibrium at a higher level, and maybe even goes higher still. That is Knut Wicksell’s idea that if you keep interest rates too low for too long, ultimately, they go higher than you ever expected.
Kevin: That’s an interesting analogy. If you have ever tried to sit on a basketball under water…
David: You expect it to hit the water line? No, in fact, it goes further.
Kevin: Watch your chin.
David: So you have the thought of rising rates and the consequence, in various equity markets. That was on display last week. We had the NIKKEI sell off, very hard, a 7% downdraft in a single day, and that was a healthy reminder of how quickly one trend, the seemingly unstoppable growth trend, can be turned on a dime, and move in the opposite direction. From the Thursday peak to the Friday close in the Japanese stock market, you had a decline of 12.3%. (laughter) And there is this growing awareness that the Bank of Japan may not be able to keep rates under control. Why does this matter? If you look at the nation’s banks in Japan and they have 43% of government bonds on their balance sheets. 43% of Japanese government bonds sit in the capital structures of the Japanese banks. What do you think happens to the value of those bonds, as interest rates go higher?
Kevin: That is the one way that you crush a bond price.
David: And so what happens to Japanese banks, which have done very well, in terms of their trading? A number of months ago I owned Japanese banks, personally, and sold them, looking at this and saying, “I don’t know that this is going to end well.” Maybe I sold too soon. But following Mayer Amschel’s advice, probably the better time to sell is too soon. What we see is a major catastrophe in the making there in Japan, potentially here in the United States, as well.
This is the issue. It is essentially “game over” in Japan when the general markets recognize that the Bank of Japan is not in charge anymore. And you have two things that happen. One, you have further depreciation in the yen, 20%, 40%. But two, you have this sort of rate crush. Remember that our government, and the Japanese government are in debt up to their eyeballs, Japan, obviously, even more so than we are, and the interest component – this is the real critical component – the interest component on the debt is the key variable to either solvency or non-solvency.
If you look at the amount of debt, the Reinhart and Rogoff study showed that if it’s 90% of debt to GDP, you are moving into a red zone and potentially there could be a real problem in the future. And yet, we have suspended reality in Japan, where they have well over 200%, almost 250%, debt-to-GDP, and yet they’re fine. Why are they fine? Because they’ve been able to keep interest rates so low, thus the interest component compared to the total economy is still manageable. But that means that should they lose control of the interest component, that is, interest rates, it’s game over.
Kevin: And I think we should put in perspective, Dave, back 20-25 years ago, a 1% increase in interest was nothing, because interest rates were 13%, 14%, 15%, so 1%, that’s not that big a deal. A 1% interest rate increase here in the United States is like doubling what we are paying in interest. Another percent after that and what we are talking about here is huge compounding. We can pay our debt right now with the zero interest rates, we have been. We’ve been paying the interest on the debt. What you are saying, though, is if it just goes up a couple of percent, we are really going to be damaged, and Japan is in the same position.
David: They are in the same position, indeed. Again, when interest rates become too large, as a percentage of total revenue, there is this reappraisal of the economy as a whole, and investors look at the currency as a representation of that economy, very differently. Perhaps we should reverse those two, we mentioned earlier, where essentially the market forces the yen or dollar devaluation, and that follows on the heels of an interest rate moving higher.
In any event, you have slower, sort of constant – what you were talking about earlier, Kevin – the orchestrated devaluation. That’s going to continue regardless, as a consequence of central bank intervention in the bond market. That’s what we call monetization and sort of the death of the currency by 1000 paper cuts. They are not actually printing money to go out and buy bonds, it’s just credit created on a bank ledger somewhere.
Kevin: So what follows that, David? What’s next beyond currency weakness and bond market revolt? We’ve been talking about a reversal in the bond market, and we’re finally hearing from the guys for whom that is their life, like the Bill Grosses of the world, saying, “You know what? I don’t like bonds anymore.”
David: Yes, if we are talking about Japan, Japanese banks, industrial firms with very leveraged balance sheets, they are equally vulnerable. What we are dealing with is the cost of capital. On the one hand, a cheaper currency delivers an export advantage. That’s what the managers of the Japanese and the U.S. economies have long argued.
Kevin: Sure, Toyotas are going to be cheaper this year.
David: And you don’t want to stir a currency war by devaluing too aggressively, but on the other hand, you deliver an export advantage and there is a simple assumption that you are going to improve the trade balance. Actually, that may not be the case. You could actually see it deteriorate in the case of Japan. Remember, the U.S. is very resource-rich. Why do the Japanese go to war? Why have they gone to war in the past?
Kevin: Right. It’s resources. They don’t have them.
David: They don’t have them, and they need them. So Japan is in a poor position, by comparison. They can gain an export advantage, but again, you have the rising input costs which take away a lot of the advantage for exporters. In other words, they are basically squeezing margins, so whatever is gained over here is lost over there. Arguably, a U.S. dollar devaluation delivers more of a competitive advantage, with many of our natural resources sourced locally, and that’s, on a delivered basis, cheaper. We don’t have to import natural gas or oil to the degree that Japan does, where you are talking about 100% need.
Kevin: David, there is this expectation, though, that things are going to just continue the way they are. I was explaining an amplifier to my son, and he actually knew more about them than I did. A feedback loop is interesting, because when you are trying to amplify a sound, you send that sound through the circuit once, you amplify it a little bit, and then you bring it back and loop it again, and you loop it again. What happens is, that sound becomes very loud. In fact, sometimes you will hear that feedback loop when a microphone goes to that squeal that everybody hates. All that is, is the feedback of the same sound.
The expectation in the market is zero interest rates. Maybe everyone will nod their heads and say, “Yeah, someday they’ll go up. But the expectation and the way people are investing is a feedback loop in a way, is it not?”
David: It’s a very self-justifying logic in the market. In the end, it’s circular in nature. The market is up, therefore the market is healthy, and should go up further. The next move higher justifies the next move higher, and on and on it goes, and you see the same thing today in Japan and in the U.S. Today you have real estate investment trusts in Japan, even this week, a strong rally signifies that Abe-nomics is still working, and people still believe that the Bank of Japan is going to deliver.
Well, what are we talking about here? We are talking about the Bank of Japan pledging to buy real estate investment trusts in Japan, and then the general public says, “Well, if they are buying, then we should buy, because they’re going to drive the price up.” And then as soon as the price is driven up, people start saying, “Well, the price is going up, therefore it must be a good time to be buying, and we’ll buy more.”
And that self-perpetuating momentum – you have to step back and say, “Hey wait a minute. We are talking about a completely artificial boost. The Bank of Japan has chosen asset classes to “boost the economy.” Whether it does that is a very secondary issue. It is boosting asset prices, just as we have seen in the United States. This week we have U.S. house prices rising more than at any other time in the last seven years. What does this signify? Is it a recovery in housing, or are we actually looking at the same kind of thing, this amplification of central bank policy? As much as I would like to believe that it is simply a recovery in housing, and a floor being put in, and a recovery in employment, etc., etc., you can’t step away from the fact that 100% of the mortgage-backed securities market is being funded by the Fed.
The Fed is purchasing their 40 billion, not the 45 billion they are putting into Treasuries each month, but the 40 billion they are putting into the mortgage-backed securities market. They are the mortgage-backed securities market. Take away the Fed, you take away the mortgage-backed securities market, you take away the entire mortgage market. Now how are you doing? You have, as you described, a positive feedback loop, but it’s really somewhat ephemeral.
Kevin: You use the word, momentum, sometimes, Dave. I think it’s important that we key on it sometimes so we understand the difference between a fundamental move, or a long-term secular move, or just a momentum move. This momentum move is very similar to the feedback loop. In other words, when a price rises or falls based on just other people buying and selling because of the momentum, like you were saying, that feedback never really lasts. It doesn’t change the overall trend. So the momentum right now is pushing things up over there, but the actual trend is probably down.
David: And here is where the danger lies. The weakness in logic is tested when good reasons for selling enter the market and all of a sudden you have rational selling, you have profit-taking. Call it a basic reassessment of risk. I think this is the real critical variable here. The idea of risk reassessment is one we need to keep in mind. It is a very powerful thing, when risk wasn’t being adequately accounted for in the first place, when someone steps into the market and starts buying just on the basis of everyone else buying, on the basis of positive momentum.
“The Bank of Japan is buying REITS, we, should buy REITS. The price of REITS is going up, therefore we should buy more REITS,” because the price continues to go higher in this sort of self-perpetuating cycle. But you aren’t asking questions of risk appraisal. If they are asked, now all of a sudden you have a complete recalibration of the entire schematic.
Kevin: Not to completely capitalize on Japan, the U.S. circumstances, like you were saying, may be similar. You were talking about real estate, equities, buoyant prices, talking about the Fed buying 100% of the mortgage-backed securities. That’s not reality. It may not be a lie, but it’s not reality.
David: It’s not reality, and it’s very important that people appreciate the volatility in the Japanese equity market last week as something of a foreshadowing of exactly what we can have for the United States. In the U.S. equities market, the Fed is buying 100% of the mortgage-backed securities market. They are essentially subsidizing the mortgage market, holding rates below a normal level, what we call equilibrium, and similarly, you have equity investors, this includes both retail investors and professional asset managers alike, that are offered an inexpensive means of speculating…
Kevin: Free money.
David: … via record-low rates. The most recent margin numbers bear this out. You have a new all-time high, in terms of margin numbers, 384 billion. Last time we reported 379, just under the 2007 peak. Now we’re over the 2007 peak, highest numbers we’ve ever seen in terms of margin.
Kevin: Just to remind the listener, a margin means you are owning something you don’t own. You are borrowing money to basically own more of whatever you are investing in.
David: And I think it is very important to remember that leveraged bets are temporary bets. You are using borrowed money and the trade is always on borrowed time, which is to say, you have 384 billion dollars in borrowed money for purchasing stock, which ultimately becomes at least 384 billion dollars of liquidations in the future. The more that is there, yes it perpetuates this sense of euphoria, but it is more like the sword of Damocles. It’s just hanging there by a thread.
This is what I’m saying. You are exaggerating today’s audience, when you have this 384 billion dollars in purchases today. You are exaggerating the audience who is buying. There are not that many players. You are just increasing the footprint by the few players who are still in the market.
Kevin: Right, and they are only there, David, because of low interest rates. Playing this little mind experiment that we are talking about, which is the possibility of higher interest rates, if interest rates come up at all, that free money is no longer free, that leverage doesn’t look as good.
David: Exactly, so as rates rise, leveraged players are affected, and investors may unknowingly be trapped in a losing proposition. Specifically, the sectors likely to come under pressure are REITS, the real estate investment trusts. These are highly leveraged. You have high-dividend companies. They are low in terms of their payout, in historical terms, but today people have moved into high-dividend paying companies because the payouts are high relative to Treasuries and bank deposits.
Kevin: You can’t earn interest, Dave. That’s why people are buying utilities right now. They at least need the dividend for the income.
David: So we see that sort of reversal around the corner, and most dramatically so from the income generators. You have the utilities, which in April traded to 22.9 times earnings. You have the low volatility stocks, which became very popular, and will probably be a misnomer. We could call them the high-volatility stocks of tomorrow, given the fact that in April they were trading at 24.9 times earnings.
Kevin: Let’s put that in perspective. Any time you get up around 18, 19, 20…
David: It’s rich.
Kevin: Yeah.
David: It’s rich. Now it doesn’t mean it can’t get richer, but it does mean that you aren’t buying a value, and low volatility may become the new high volatility. The utility is generally viewed as a safe bet and a good income generator. They are interest rate sensitive, and as a money-market rate begins to compete with a dividend rate, or a utility rate, or a REIT rate, where you are taking more risk for that old reward, all of sudden you say to yourself, “Why couldn’t I just sit in cash and earn the same return?” And all of a sudden you see, again, selling precipitated.
The point being, 2% 2½%, while it is compelling today, and that is the primary reason for a lot of investors moving out of their usual savings positions, and into the equity markets, what is happening is that your cash equivalent money-market or short-term CD, as it goes back to 2%, 2½%, there is no reason for you to take the risks that you have accepted in a highly manipulated environment. So the risk inherent to the equity market, if it is not reasonable, then the capital reallocation is, again, back in play.
Kevin: David, we have looked at, for years, in banks, the concept of hot money, which is just money that doesn’t really have long-term loyalty. It is somewhere because they are getting a little better interest rate. As you go bank by bank by bank, you can see one bank paying a few hundredths of a point higher than another, and so you will see a lot of money there that won’t be there the second that another bank is paying more. It sounds to me like what we’ve done is that we have converted hot money, not just from bank to bank, but we’ve turned people who would normally be long-term investors for income into hot money investors because they are just having to move anywhere they can squeeze out that last little bit of money.
David: Yes, so there is really a re-characterization of the investor who would be a “hot money investor, or a temporary investor. We think of hot money in general terms, that is, a short-term speculative commitment. It is more common with a hedge fund or a special opportunity fund, chasing a high rate of return. That sort of characterizes hot money – looking for the highest rate of return, no sense of long-term loyalty, just there for the sake of the higher rate of return, and this can sometimes be sort of arbitrage involved, where you are talking about a yen carry trade, or the U.S. dollar carry trade, where you are borrowing short-term at a very low interest rate, and then investing for that higher yield someplace else. So not just looking for the higher yield, but doing it with someone else’s money, on a borrowed or leveraged basis.
Kevin: An arbitrage market is a very high-speed market that moves from here to there, but you can’t bet your farm on arbitrage money.
David: And it’s always on a temporary basis. It’s temporary by nature, particularly when you bring leverage into the equation. That’s ultimately money that has to be paid back, and that initial trade or investment has to be unwound, so money in becomes money out, and that’s what can become destabilizing – money in, for the wrong reasons. And that’s what we are seeing now, a variety of asset classes where money is coming in for the wrong reasons. Ultimately, that becomes money out. The important thing here to remember is that it’s not sticky money.
Kevin: In other words, it’s not strong hand money. If you talk about strong hands or weak hands, this is more like weak hand money, where it just flows right past the palm into the next palm.
David: Not a long-term allocation. This is the contrast. What we have had is a change in character, in terms of hot money in the marketplace. Now, instead of that sophisticated money making a short-term commitment, you have, frankly, less sophisticated money making commitments with risks that are not fully appreciated.
Kevin: Older, retired people, who would normally just be in a CD.
David: Yes, but the primary criterion is cash flow. And the primary motivation is simply to improve income, and it’s a necessity, not able to make ends meet, looking at diminished returns on assets that you have at a bank or CD or Treasury bills, or what have you. Investors today need income and are willing to go anywhere to get it, regardless of the changed risk profile.
That’s really the tragedy here, that you’ve got REITS, you’ve got utilities, you’ve got dividend-paying stocks, high-yield bonds, junk bonds – all are now acting as substitutes for CDs and for money-market balances. These are what we could call yield curve refugees. They are temporarily housed in products that meet immediate needs.
Kevin: David, the key here is, this is really changing the character of hot money. It’s not sophisticated, professional money. It’s actually grandma and grandpa down the street, who are trying to just get some income.
David: Yes, and it’s hot money fueled by loose monetary policies. No change there, really. But it’s usually the professional investor community capitalizing on the availability of money and its cheap cost. Now what we are seeing is slightly different. We are seeing the consequence of the long duration of loose monetary policy.
Kevin: Well, it’s been years, Dave.
David: Yes, five years of low rates, and you have a discouraged and hard-pressed group of savers that, due to these ridiculously low rates, whether it’s in CDs or what have you, are just simply looking for reasonable returns and they are not finding them. So yes, maybe they’re yield curve refugees, or they are CD refugees. They are now encamped in asset classes that are far higher in risk.
When risk is reappraised, and this goes back to the Bank of Japan and the idea that if interest rates come up for any reason at all, you are going to see more volatility than you expected, in part because people have made allocations to these investments, not on the basis of wanting to own them, but on the basis of needing to own them, on the basis of needing income, and then all of a sudden as the landscape changes, the reason or justification for owning them also changes, and there is a radical increase in volatility, whether that’s low-volatility stocks, or utilities. This is what we are talking about. We are now embedding a tremendous amount of volatility and risk into generic blue chips and this is a consequence of Fed policy and the long-term duration keeping low rates for so long.
Kevin: David, one of the ways they are keeping the rates so low, for so long, is that they are basically borrowing from themselves. If our government actually had to go out and sell Treasuries, and not buy any back from themselves, they would have to raise rates to a degree that people would be willing to take the risk, but recently, they are buying almost three-quarters of all of the Treasuries that they are issuing right now.
David: Yes, when you look at interest rates today, it’s a sign and symptom of a very distorted and very controlled market. Three-quarters is right. Fed purchases up to 72% of new Treasury issuance, and I’ve made mention of this before. Bloomberg ran an article, “Out of the 770 billion dollars in new Treasury issuances, we see very healthy subscriptions, three dollars in purchases for every dollar that is offered in demand.” But low and behold, it’s the Fed who is showing up and saying, “I’ll take one, I’ll take two, I’ll take three.”
Kevin: “I’ll take those three dollars’ worth.
David: Exactly, it’s this crazy reality that doesn’t represent risk. It doesn’t represent inflation expectations. All of these things have been muted and covered over by intervention, what is essentially a command economy.
Kevin: David, I’ll tell you, it’s not necessarily blind investors who are investing this way. There are a lot of people with their eyes wide open and they are saying, “You know what? I see the risk, but everybody around me is earning an income, and my only alternative is to sit in cash and not earn an income, so I’d better take the risk, because I need it.” So, more and more, whether they are blind to the facts, or whether they see the facts, people are being sucked into this way of thinking.
David: It reminds me of hitting the golf course and riding around in the golf cart and just comparing notes, and this happens so commonly with investors today. You know, “How ya doin’?” “Oh yeah, well, the S&P is up 16%, doing really well.” Meanwhile the guy who is sheepish is either sitting in gold or cash and saying, “Well, gold is down and cash isn’t doing any good. Maybe I should be investing in equities.”
And it’s this social pressure that goes back to the Bank of Japan and the Fed perpetuating this reality, and then all of a sudden, growth feeds on growth, and people start saying, I missed it one year, I don’t want to miss it a second year in a row. I don’t want to be the man out, in terms of the discussion, as we tee off. “Yeah, I’m just still sitting with zero percent rates of return, while my neighbor, my friend, my colleague is earning 12%, 15%, 30%, whatever it may be, in the marketplace.” Again, risk is an almost perpetuating thing. Greed begins to become contagious.
Kevin: David, there are two things that seem to fuel a market. It’s either greed or fear. Fear can be just as powerful of a feedback loop, in fact, maybe more.
David: But today you have investors who are more and more of the belief that just like in the Greenspan era, where you always had support for growth in the stock market, making, basically, the stock market a one-way bet, so, too, is Ben Bernanke. So, too, is Mr. Kuroda. This is the reality. More people believe that they are safe making speculative bets, and thus become that much more bold, because of the implied support from central banks, this sort of support proportionately increasing speculation and risk-taking.
Kevin: Okay Dave, as much as it hurts, let’s pretend again like we’re Ben Bernanke. We have a challenge here. How in the world do you unwind this sense of dependency that we’ve created with low interest rates?
David: It’s almost impossible, because you have the stock and real estate markets which resemble crack babies, dependent on a substance that does not provoke normal or sustainable growth. That is the issue in play. You have the two areas which are being championed as signs of a return to normalcy and growth in the economy, utterly dependent on the Fed’s activity.
Take away the Fed’s activity and you are going to see an impact when it comes to increasing interest rates in the mortgage-backed securities market, and of course, the unintended consequences, as we were mentioning, not only in the industrial space, but anyone who has a leveraged balance sheet. Just as in Japan you find banks over-exposed to the Japanese bond market, so too, the U.S. banks also have massive fixed income portfolios. If you look at their balance sheets today, they don’t keep very many private loans on the books, they prefer to leverage their balance sheets 10-to-1 or 12-to-1, and be sitting in Jennie Mae, Sally Mae, or 10, 15, 20-year Treasuries, just playing this borrowing short and investing long.
But they are investing on a leveraged basis in assets that are interest-rate sensitive. You have our entire banking system, which is, in fact, leveraged and vulnerable, and the only reason that we maintain some stability over the next 3, 6, 12, 18 months, in our bank system, is because they don’t have to mark those assets to market. They can hold them at whatever price they want, and the balance sheet does not have to reflect the volatility that they may experience as a result of an increase in interest rates. It doesn’t change the fact that they would technically be bankrupt with the basis of an increase in interest rates.
Kevin: It is interesting, going back to Japan, because a lot of Americans will listen and say, “Why would we be watching Japan?” But you know, the acceleration with what Abe is doing right now, he decided to just go ahead and double his money supply, and double the monetary base in a two-year period. So what we are seeing, you know what it reminds me of, Dave? I just got my lawn fertilized, and it’s got the stuff in there that kills the dandelions. I remember reading how that works at one time. What it does is that it accelerates the life process so quickly that it destroys the plant almost immediately.
David: Fascinating.
Kevin: In a way, we have Abe doing the same type of thing, so it might be a microcosm of what we have coming in America later.
David: Exactly. The reason we should be watching Japan with great interest is because, just like the U.S., they are using monetary policy to absorb structural and macro-imbalances, and problems have always emerged in the currency markets when liquidity is abused. That goes back to Paul Mizen’s point, that you do see loose monetary policies impact banks, and ultimately, a banking crisis can emerge, but when you take away the gold standard and have a fiat money system, there is a direct transmission from a banking crisis to a currency crisis that is unavoidable.
From 1914 to the present, the instances, it is literally inescapable, if you have a banking crisis, you are going to have a currency crisis, because you are talking about a failure of confidence and it just passes through. Problems have always emerged in the currency markets. We care about the dollar, we care about the yen, when liquidity is abused, and we have liquidity being abused as we speak, the Bank of Japan and the Fed, to an enormous degree.
Kevin: You always have a crisis afterward. Let me ask you a question, Dave. As ironic as it is, we know how unfettered the dollar is to anything, and we know that they have created trillions and trillions. But could we actually see a dollar rally here while Japan falls apart if they ruin the yen?
David: If you had, in a very short period of time, an additional 20-40% decline in the value of the yen, you would see some sort of relative benefit, not on an absolute basis, we’re not talking about strength in the U.S. dollar, but on a relative basis, now you have the currency which is terminal and has been given the diagnosis of AIDS, but untreatable.
Yes, then and only then would you see the dollar rally on a relative basis, but following that sort of temporary support for the dollar, we face the very same set of circumstances, with currency declining, with the failure of confidence, and you have to keep in mind, failure of confidence in the dollar gets transmitted through to U.S. denominated assets as well. Anyone on a foreign basis who is interested in owning U.S. assets is owning the U.S. asset in question, but it is in U.S. dollar terms.
If the dollar weakens, they question not only the currency, but the asset, as well. That can be real estate, that can be the bond market, that can be the stock market. So there is a double whammy in terms of currency weakness and a critical point being in the currency market. When that point is reached, now it is just sell all U.S. assets, regardless of the asset quality in question.
Kevin: To keep that from happening, I guess the Fed would need to dial down all interventions and risk from this point forward. They are going to have to scale back at some point. They are probably not going to do it. They will talk as if they are, but they seem to just continue to add.
David: Well, if they don’t dial down their current interventions, you are going to see a major inflationary trend. And yet, if they do dial down, this is where they are on the horns of a dilemma. They risk the equity market and real estate market stability in doing so. This is becoming a game of chosen winners and losers. And believe it or not, that is normal in a command economy.
Kevin: A command economy like an Eastern European economy.
David: You are always choosing winners and losers, and that is what we have today, the Fed choosing winners and losers.
Kevin: David, you say command economy. We are no longer in a free market.
David: I think this is where, going back to Jean-Claude Juncker’s comment, “When it becomes serious, you have to lie.” This is what is farcical. This is where we have an imagined world of the free markets where, in fact, we have controlled markets. The lie from the Fed is that we do have a free market today.
Yet, what we have today is price fixing in the two most important areas of our economy. Housing, obviously, is a huge part of our economy – very important. And the Treasury market – if we can’t pay our bills we have to issue IOUs and there is an interest rate associated with those IOUs, and yet, we are fixing the price of our bonds by fixing interest rates.
That is an utter manipulation. It’s a deception, if you will, in terms of real values, and it transmits its way all the way through every other asset class, signifying that we have stability in the marketplace when, in fact, it is nothing but a controlled, sort of farcical market.
This brings us full circle to this notion that the Fed seems to not have an issue with a deception, with a lie, with a misrepresentation of reality, as long as the circumstances are serious enough, and that is where we are. We would not be talking about 85 billion dollars’ worth of purchases, a combination of mortgage-backed securities and Treasuries, low interest rates, the Fed funds rate set at virtually zero for the amount of time that it is, if we were not in desperate circumstances to begin with. These are extraordinary measures. And yet, the market is approaching this as if it is normal, healthy, and just temporary in nature.
Kevin: I think of the progression of the way the original economics was written, as far as Fed intervention and printing of money. They said, “Oh, we’ll only do a little at a time,” and then what happens is that it leads to a little bit more, and it leads to a little bit more. So a little is good, they tell us, even a little inflation is good. And then, a little more, well that’s not too bad.
David: I grew up in a family that focused on health concerns, longevity issues. My dad is in great shape. He’s in his 70s and I swear, he is three times as strong as I am, at a minimum! He can bench press, easily, three times what I can, and it’s not like I’m a gangly weakling. But by comparison, I am.
Kevin: He has got a lot of energy.
David: But all this to say, health concerns, longevity issues – these are issues that are on the family’s mind. And I’ve often heard it said that if a little is good, a lot is better. We’re talking about vitamin C and things like that, just as an example.
But in monetary matters, you have a little devaluation, which is perceived as good, as well, and that is our sort of stated 2% rate of inflation. And a lot is obviously not better, but it may become inevitable.
Right now we are playing with the market’s fickleness, and we are playing with risk. A mid-course reappraisal will lead to radical market volatility as a consequence, and that, I think, as we look back at last week’s volatility in the Japanese markets, is a foreshadowing of the kind of volatility that we have in the U.S. markets with a rate appraisal of risk, and the market volatility that comes with it.
Kevin: One of the things about volatility is that you can’t handle it if you are on margin. We’ve talked about this before. I think about even the gold drop five or six weeks ago that we have been talking about. The people who really got hurt were the ones on margin. That’s why 3,000 tons of gold had to be sold, ultimately, because of the margins.
But for the person who is still out there investing wisely, let’s talk about the triangle just for a moment before we wrap up. If a person has a balance of gold and silver, and a balance of strong equities, and this person doesn’t necessarily play the high price earnings ratio stocks, and then cash, even though cash is losing value right now, it is still something that is probably a whole lot better than getting out there and taking speculative risks. If a person is balancing that way, it seems like a strategy that will get them through better than a margined account in a speculative investment.
David: What we really have today, and I think this is echoed by Deutsche Bank’s co-Chief Executive. He said, “We may have good prospects for the global economy stabilizing in 2013.” But he says, “Nonetheless, the highly optimistic mood in the financial markets indicates a risk that some market participants may be underestimating the fiscal policy difficulties in the U.S. and the consequences of the European debt crisis.”
That is what we see today – underestimation of risk, and as that is reappraised, again, the kind of volatility we saw last week, but on a more global basis.
