As everyone knows, the US Dollar is the world's reserve currency. Trillions of US Dollars sit overseas.
The events of the last ten days are surely for the history books. And blogs everywhere are reviving the inflation/deflation debate.
The public often miscontrues what inflation is.
By pure definition inflation is the expansion of the monetary supply, while deflation is the decline in that supply.
Everywhere we hear about the deflation threat and this threat is cited as the justification for all the liquidity that is being pumped into the system. The US Federal Reserve has expanded the US$ money supply through USTreasury debt monetization severely the past 2 years to the tune of at least $2 trillion.
That is bigtime inflation!!
The reaction has been to protect against the price inflation (higher costs) and bond deflation (lost value) by the widespread purchase of both Gold & Silver (safe haven).
Speaking of growing the money supply (inflation) there was an interesting story over on Bloomberg Wednesday that asks: Is the European debt crisis poised to flood U.S. banks with money?
It seems that the amount of cash held by U.S. banks surged 8.4% to a record $981 billion during the week ending July 27, the Federal Reserve said in an Aug. 5 report.
That’s more than triple the amount firms had in July 2008, before the collapse of Lehman Brothers almost froze bank-to-bank lending.
According to Brian Smedley, a strategist at Bank of America Merrill Lynch in New York, even more money may be deposited with U.S. lenders if investors pull away from European banks amid concern the Greek debt crisis may spread to Italy or beyond.
Banks, apparently, are worried.
With few opportunities to lend that money out profitably, those funds may not be so welcome. U.S. firms may have to slap fees on depositors to keep returns from eroding.
Bank of New York Mellon, the world’s largest custody bank, announced plans last week to charge institutional clients for unusually high balances above $50 million. In a letter to customers, the New York-based firm said it’s “taking steps to pass on costs incurred from sudden and significant increases in U.S. dollar deposits” linked to events including the Greek crisis and the uncertainty over the U.S. debt-ceiling debate.
“There’s an enormous amount of dollar liquidity because of what the Fed has done in recent years,” said Raymond Stone, who tracks U.S. money markets as a managing partner at Stone & McCarthy Research Associates in Princeton, New Jersey.
Most of the largest U.S. banks have increased their deposits. JPMorgan Chase & Co.’s deposits rose almost 13% to $1.05 trillion at the end of June, from $930 billion at the end of December. Bank of America’s deposits climbed 3% to $1.04 trillion from $1.01 trillion.
Since late 2008, the Fed has been paying interest on deposits placed with the central bank, known as interest on excess reserves, or IOER. That rate is currently set at 25 basis points, or 0.25 percent.
At that rate, banks may struggle to profit from even non-interest-paying deposits, because the companies must pay premiums to the Federal Deposit Insurance Corp. when they route the money to the Fed.
Joseph Abate, a money-market analyst at Barclays Capital wrote in an Aug. 5 report that a game of monetary 'hot potato' could result.
The higher deposit cost, the potential need for additional capital and the flight-prone nature of these balances clearly outweigh the 25-basis-point return the banks would earn depositing the money at the Fed.
Abate wrote that any reduction in the interest rate on excess reserves - a move Fed Chairman Ben S. Bernanke told Congress in July might be possible - may create a “serial round of deposit fees” since banks would try to “push cash from their balance sheets” like a game of “hot potato.”
“Domestic banks will work very hard to shed those surplus reserves,” said Lou Crandall, chief economist at Wrightson, a New Jersey-based unit of London-based ICAP Plc, the world’s largest inter-dealer broker. “They’re not eager to expand their balance sheets with low-yielding assets even when they earn a small positive spread.”
It's been one of those days when there is so much to write about.
But one of the items that caught my eye were some comments made by Goldman Sach's Senior US Economist, Ed McKelvey.
McKelvey was ruminating on the looming prospect of Quantative Easing 2 (aka: money printing by the US Federal Reserve).
As you know, Fed Chairman Ben Bernanke is getting ready to flood bank basements with another $2 Trillion in excess reserves to stimulate bank lending.
If successful, and bank lending actually picks up, we are suddenly faced with an explosion of over 300% in the amount of currency in circulation (moving from under $1 trillion to around $4 trillion).
Wages are certainly not guaranteed to increase concurrently. So this explosion in will lead to a very rapid and drastic destabilization in the concept of a dollar-based reserve currency.
The only thing that could prevent this are the Federal Reserve's mechanisms to extract liquidity from the system.
Now Bernanke insists over and over again that he can accomplish that extraction. There has been much focus on the “tools” the Fed is readying to implement its “exit strategy.” Bernanke dwelt on how the Fed intends to eventually tighten credit in Feb. 10 Congressional testimony.
Bernanke has made it clear the rate of interest it pays on excess reserves (IOER) will play a lead role when the time comes to extract liquidity. The Fed hopes raising that rate will pull up the funds rate and other rates. The Fed has also tested reverse repurchase agreements and plans to extend their use to government sponsored enterprises, which can’t earn interest on reserves. Also in the works is a new term deposit facility, which will allow banks to convert their reserve holdings into a kind of CD.
Those tools “would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly,” Bernanke testified.
The problem is IOER process completely unproven. Should animal spirits kindle at the peak of the biggest liquidity tsunami in history, that money will inevitably make its way to Main Street, not back into the Federal Reserve coffers.
All this has made Goldman Sach's Ed McKelvey warn that should increased bank lending be the end result of QE2 then, "this would cause too much money to chase too few goods."
And, as liquidity extraction then would likely be impossible, it would be the beginning of the end: "The obvious risk to this last point is if inflation expectations surge. In a stronger growth environment than now prevails, such a surge could prove difficult to control."
When you toss into the fire the fact that the Federal Reserve will soon be forced to once again buy up Mortgage Backed Securities, REITs, ETFs and pretty much everything else, and you have the conditions for a situation that can very easily spin out of control.
Every previous economic miscalculation has always failed to consider the Law of Unintended Consequences.
And you just know there is an "oh shit" moment brewing.
Speaking of unintended events, China is gearing up for a ban on selling rare earth minerals.
Earlier this month Chinese customs officials prohibited all exports of rare earth minerals to Japan.
As the United States gears up to brand China a currency manipulator, look for these actions to expand. It is already expected that silver exports from China, the world’s largest, may drop about 40% this year as domestic demand from industry and investors climbs, according to Beijing Antaike Information Development Co.
As Business Week notes, "Reduced exports will almost certainly bolster silver prices that are trading near a 30-year high on speculation that governments worldwide will take further steps to stimulate their economies, weakening currencies and increasing demand for assets that are a store of value."
If you are not aware, this week the United States is pumping a massive amount of money into the markets (POMO) in an attempt to stimulate inflation. This is the number one reason why Gold/Silver have been taking off in value lately.
The Bank of International Settlements (BIS) has come out with a report comparing Japan with the United States as both embark on the same solution to the economic crisis (QE).
As Zero Hedge notes, the report show us that "Japan, even during its two-decade long deflationary process is far better equipped to handle the economic collapse that is unravelling for an entire generation of Japanese consumers. Which is why the Fed is now actively pumping $5 billion in the market every other day to stimulate inflation, and the stock market, as this is now the Keynesian system's Maginot line. The Fed can not allow mass perception of the the double dip to become entrenched as that would be the proverbial game over. What has worked in Japan for 20 years will fail miserably when applied in the US, simply because US consumers are in a far, far worse shape than their Japanese counterparts."
Coincidentally our friend, Gonzalo Lira has also come out with a post examining the Japan/US comparison. I'll summarize it here but I know some of you will want to read the full post so I invite you to click the link and go to Lira's blog.
Japan went through an equities and real estate boom during the 1980’s — a boom that was really a bubble. And like all bubbles, it eventually burst in 1990. Since then, Japan has been lost and the Japanese government has spent a fabulous amount of money for domestic stimulus that hasn’t helped at all. Japan is in full-on deflation—in every sense of the word.
Now a lot of people believe America is set to begin its own version of Japan’s Lost Decades and Lira argues it will be something completely different.
Lira notes the rationale for a similar path is simple and superficially persuasive:
Just like Japan in 1990, the United States went through a bubble in equities and real estate, which eventually popped in 2007–‘08. Since then — just like Japan — the U.S. has been experiencing deflation. Just like Japan, the U.S. now has zombie banks, the so-called “Too Big To Fail”. Just like the Japanese government, the U.S. government is spending - spending - spending, so as to prop up aggregate demand. The Federal Reserve — just like the Bank of Japan — is issuing enormous sums of money in order to prop up aggregate asset price levels — the Fed’s policies are so reminiscent of the BoJ’s money printing that Bernanke & Co. have borrowed the term outright: Quantitative easing.
Everything screams Just Like Japan—right? So according to the “Japan Is Us” camp, 2010 through at least 2015 will be just like Japan between 1990 and 2010: Sluggish growth, stagnation — and most important of all, deflation, deflation, deflation.
But there is one key difference that the Japan Is Us crowd conveniently ignore. They ignore it out of blindness, or incompetence, or—occasionally—out of malice. They ignore this key issue like the elephant in the room that’s gone and got drunk, and is now making a fool of himself: Balance of payments. Balance of payments (BOP) is the measure of a country’s total exchange with the rest of the world.
Lira notes that this 'current account' is the key metric, it's all about the trade surplus or deficit.
The U.S. current account has been negative for a long, long time (since 1973). Japan, on the other hand, has a current account surplus.
To finance this massive current account deficit, the U.S. has sold assets to the rest of the world, which are Treasury bonds. And as everyone knows, Treasuries might be called “assets” by the sophisticates, but they are really nothing more complicated than a loan. In other words, Americans and their government have gone into massive debt with the rest of the world, in order to finance all this spending.
Japan, meanwhile, has been carrying a current account surplus. Therefore, the Japanese government has been borrowing money not from overseas, but from its own citizen’s savings. All of the Japanese government’s stimulus spending has been paid for by the Japanese people.
This is the main difference between the United States and Japan and Lira argues it should be obvious — and ominous — what this difference means.
The U.S.— unlike Japan—cannot pay back its loans: Because the United States is broke. The Federal government is running deficits of around 10% of GDP. America as a whole has racked up $7.5 trillion in current account deficits over the last 25 years — over 50% of total GDP — with no end in sight.
So the United States — unlike Japan — has been spending what it does not have. The U.S. — unlike Japan — depends on the rest of the world to lend it money to continue on this spending spree. Americans — unlike Japan — do not produce enough to self-finance its government’s stimulus programs.
Therefore — unlike Japan — the United States will eventually be unable to pay the Treasury bonds it has issued. Therefore... there will be a collapse in the Treasury bond market (triggering) a panic in Treasuries (that) will mean a run up of commodities — which will bring about the death of the dollar, and hyperinflation in America.
But even if you don’t subscribe to my hyperinflationary scenario — even if you think I’m full of shit on this issue (and plenty of sensible people think I’m full of it to the brim) — it’s obvious that Japan is not like the United States—it’s obvious to anyone who looks at the situation evenhandedly: The contrast in the two countries’ balance of payments is enough to show definitively and unequivocally that they are not the same.
The source of the two countries’ funding is key: One produces its own stimulus from its current account surplus, while the other borrows it from abroad, adding more debt on top of its already existing debt. Therefore, one country’s spending and stimulus programs — Japan’s — are sustainable, while the other’s — America’s — is not. Which means that the mechanisms for this fiscal debt—sovereign bonds—are rock solid in Japan, but lethal in America.
Lira argues that you are seeing a promotion of the 'Japan Is Us' point of view and that is leading money managers to do the hard sell and lead their clients into Treasury bonds — because if you were in Japan in 1990, their sovereign bonds turned out to be the smartest investments in the long run.
But the U.S. is not Japan and US Treasuries have been under performing.
Lira suggests
"That’s why so many people keep insisting that Japan Is Us! - Japan Is Us! - Japan Is Us! They are selling their clients on something, or else trying to explain away their underperformance, by sheer force of personality — while ignoring the blindingly obvious fact that the U.S. is not Japan.
Which, of course, brings Lira to his foil in this debate, Mish Shedlock:
One prominent blogger in particular has been going insane, insisting day after day that Japan Is Us, to the point of psychosis — evidence to the contrary be damned. Every day, this blogger — Michael “Mish” Shedlock — bangs on the same old tired drum. Mr. Shedlock is affiliated with Sitka Pacific, whose performance leaves something to be desired. There are, apparently, a number of Sitka Pacific clients quite nervous about the direction of their investments. So it is reasonable to question whether Mr. Shedlock is ranting and raving how the U.S. is following the deflationary spiral that Japan did because he genuinely believes what he is saying, or because he is trying to convince someone — maybe his clients, maybe himself — of something that he knows in his bones might not be true.
What is true is that anyone who has made bets that Japan Is Us will soon find out if they were wise bets, or foolish ones. The Treasury bubble is soon to burst — so we’ll know the fate of the American economy soon enough.
Back to you, Mish Shedlock.
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Video clip on Bubbles
I promised a colleague I would repost these video clips from Chris Martenson on asset bubbles, the pattern they follow and past historical bubbles. It comes in two parts...
First up today is more bubble denial. Today's treatsie first came to me via our friends at VREAA (although I am told it was posted earlier on the chatboard Real Estate Talks by contibutor SethM).
Back on September 7th, 2010 Pierre Marchildon, of Marchildon Property Investment Partners, posted a video commentary, The Vancouver Real Estate “Bubble”. Marchildon dismisses all this bubble talk and explains how there are merely ups and downs in the market. No crash, no collapse.
“A bubble is when there is a major dramatic drop… but you can see there is a bunch of ups and downs on their way up. Every decade, real estate doubles… that’s the point of this exercise. Don’t try to time the market.”
Translation: Buy now or be priced out forever!
Here is Marchildon's analysis (and don't tell Pierre that the entire graph he's pointing to is the first half of the bubble)...
As I said two days ago, the biggest and most confounding debate that's going on right now in all of finance is determining what the final outcome of the US Federal Reserve's market manipulative actions will be.
Once again Lira has made some interesting points and, if the topic interests you, I invite you to visit his blog and read his lengthy post.
Finally some insight from an article in Macleans magazine.
Canadian economists Derek Holt and Gorica Djeric of Scotia Capital recently observed that most commentators are “overly sanguine with respect to the state of Canadian household finances.” Debt as a share of personal disposable income for Canadian households is at record levels, they note. While the U.S. reduces its household debt load through forced austerity measures, Canada’s number keeps getting bigger. And by some measures, the trajectory of house prices in Canada appears strikingly similar to that in the U.S. prior to the bust.
I had a post yesterday regarding local real estate for you, but I have set it aside for now.
A couple of weeks ago, on August 24th, I made a post (which you can read here) on a theoretical framework for the arrival of hyperinflation. It was reprinted from the blog of Gonzalo Lira and Lira's thread went viral on the internet.
One of the reasons it garnered so much attention is because the issue cuts to the biggest and most confounding debate that's going on right now in all of finance: what will the final outcome of the Fed's market manipulative actions be?
Will the end result be deflation, inflation or hyperinflation (which is a distinctly different phenomenon from either of deflation or inflation).
Lira's post infuriated some hard core deflationists who continue to refuse to acknowledge the possibility that in its attempt to inspire inflation at all costs, the Fed may just push things beyond the tipping point of monetary imprudence.
Recently Mish Shedlock came out with a rebuttal to Lira in a podcast on Global Edge with Eric Townsend and Michael Hampton. In the podcast, Shedlock's conclusion was that Hyperinflation is the endgame, "so it is unlikely."
Yesterday Lira responded saying that Shedlock had turned the issue into a personal attack and that Mish had taken many of his points out of context (you can see a portion of Lira's response in yesterday's comments section). Lira has proposed an open debate with Mish on the topic. We will see if Mish accepts.
I bring all of this up because it triggered a comment in yesterday's comments section AND a whole whack of emails to my inbox.
As I said at the start of this post, this topic is THE biggest and most confounding debate that's going on right now in all of finance.
With that in mind I note that John Williams has come out with another bold statement today.
John Williams runs a website (www.shadowstats.com) on which he provides a stunning amount of real, unmanipulated government data.
Williams received an A.B. in Economics, cum laude, from Dartmouth College in 1971, and was awarded a M.B.A. from Dartmouth's Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. For nearly 30 years he has been a private consulting economist specializing in government economic reporting.
His website, Shadow Stats, often paints a dramatically different picture of the state of the economy from the spin offered by government. Williams will, for example, offer you statistics on the Consumer Price Index as it existed prior to 2000. That was the year the formula for calculating inflation was changed. If you were to calculate inflation today using the same formula used before 2000, the rate is in excess of 6%!
Considering we are now force-fed statistics that pacify the masses by stating there is not inflation, that is significant.
Of course it's because the government has changed the way that figure is now calculated so - voila! - there is no inflation (even though you are feeling it in your pocketbook).
The impact of this cannot be understated. Inflation is just as present now as it was in the early 1970s. The only difference is the government now claims that many of those higher costs simply don't count (four legs good, two legs bad becomes four legs good, two legs better).
John Williams is yet another economist who has stated his firm believe that hyperinflation is in the offing. In 2009 he put out this analysis.
And today he has just released a note to clients in which he warns that hyperinflation may hit as soon as 6 to 9 months from today.
With so many established economists and pundits seeing nothing but deflation as far as the eye can see, and the US Federal Reserve doing all in its power to halt the deleveraging cycle, both in the open and shadow economies, what is Williams' argument?
Here, if you interested, is the statement from John Williams. I personally think it is important to read the likes of Lira, Shedlock and Williams to try and understand this important debate and make up your own mind on this critical economic issue.
Excerpts from statement from John Williams of the blog Shadow Stats
SUMMARY OUTLOOK: Systemic Turmoil is Unthinkable, Unacceptable but Unavoidable.
Pardon the use of the Aerosmith lyrics in the opening headers, but the image of tap-dancing on a land mine pretty much describes what the Federal Reserve and the U.S. Government have been doing in order to prevent a systemic collapse in the last couple of years. Now, as business activity sinks anew, much expanded supportive measures will be needed to maintain short-term systemic stability. Such official actions, however, in combination with global perceptions of limited U.S. fiscal flexibility, likely will trigger massive flight from the U.S. dollar and force the Federal Reserve into heavy monetization of otherwise unwanted U.S. Treasury debt. When that land mine explodes — probably within the next six-to-nine months, the onset of a U.S. hyperinflation will be in place, with severe economic, social and political consequences that will follow. The Hyperinflation Special Report is referenced for broad background. The general outlook is not changed.
What does this mean for US financial markets?
In these circumstances, the financial markets likely will be highly unstable and volatile. Looking at the longer term, strategies aimed at preserving wealth and assets continue to make sense. For those who have their assets denominated in U.S. dollars, physical gold and silver remain primary hedges, as do stronger currencies such as the Canadian and Australian dollars and the Swiss franc. Holding assets outside the U.S. also may have some benefits.
If the Lira/Shedlock debate comes together, I'll let you know.
In my little stint of bumming people out with this blog, I am constantly told that I am a negative doomsayer.
Shortly after being reminded of that, I am often asked what I perceive is the worst case scenario for what looms for real estate and the economy. Go figure.
(I guess it's like one of them bad accidents on the highway where every single person slows down to make sure they get a good look at the carnage).
If I am pressed, I usually answer the question in a word: FEAR.
The way western governments have responded to the crisis is of tremendous concern. And the worst case scenario would see the Law of Unintended Consequences kick in. And the catalyst trigger will be fear.
I continue to maintain the we still do not fully appreciate the depth and the breadth of the financial earthquake that shook the world in 2008 or of the repercussions that still emanate from it.
The fallout is causing some people to loose confidence - in government and in fiat currencies.
And while it is all fine and dandy to say that people are irrational to be buying gold, the fact of the matter is that markets can often be driven by irrationality. By fear.
Yesterday I came across this speculative post on Quantitative Easing and Hyperinflation by Gonzalo Lira.
I do not agree with all of it, but if offers a very well laid out sequence of events detailing how a dollar crisis could be triggered.
I think it is well written and worth reading even if you don't agree with it.
I hope you will indulge me and find it worth your time.
How Hyperinflation Will Happen
Right now, we are in the middle of deflation. The Global Depression we are experiencing has squeezed both aggregate demand levels and aggregate asset prices as never before. Since the credit crunch of September 2008, the U.S. and world economies have been slowly circling the deflationary drain.
To counter this, the U.S. government has been running massive deficits, as it seeks to prop up aggregate demand levels by way of fiscal “stimulus” spending—the classic Keynesian move, the same old prescription since donkey’s ears.
But the stimulus, apart from being slow and inefficient, has simply not been enough to offset the fall in consumer spending.
For its part, the Federal Reserve has been busy propping up all assets—including Treasuries—by way of “quantitative easing”.
The Fed is terrified of the U.S. economy falling into a deflationary death-spiral: Lack of liquidity, leading to lower prices, leading to unemployment, leading to lower consumption, leading to still lower prices, the entire economy grinding down to a halt. So the Fed has bought up assets of all kinds, in order to inject liquidity into the system, and bouy asset price levels so as to prevent this deflationary deep-freeze—and will continue to do so. After all, when your only tool is a hammer, every problem looks like a nail.
But this Fed policy—call it “money-printing”, call it “liquidity injections”, call it “asset price stabilization”—has been overwhelmed by the credit contraction. Just as the Federal government has been unable to fill in the fall in aggregate demand by way of stimulus, the Fed has expanded its balance sheet from some $900 billion in the Fall of ’08, to about $2.3 trillion today—but that additional $1.4 trillion has been no match for the loss of credit. At best, the Fed has been able to alleviate the worst effects of the deflation—it certainly has not turned the deflationary environment into anything resembling inflation.
Yields are low, unemployment up, CPI numbers are down (and under some metrics, negative)—in short, everything screams “deflation”.
Therefore, the notion of talking about hyperinflation now, in this current macro-economic environment, would seem . . . well . . . crazy. Right?
Wrong: I would argue that the next step down in this world-historical Global Depression which we are experiencing will be hyperinflation.
Most people dismiss the very notion of hyperinflation occurring in the United States as something only tin-foil hatters, gold-bugs, and Right-wing survivalists drool about. In fact, most sensible people don’t even bother arguing the issue at all—everyone knows that only fools bother arguing with a bigger fool.
A minority, though—and God bless ’em—actually do go ahead and go through the motions of talking to the crazies ranting about hyperinflation. These amiable souls diligently point out that in a deflationary environment—where commodity prices are more or less stable, there are downward pressures on wages, asset prices are falling, and credit markets are shrinking—inflation is impossible. Therefore, hyperinflation is even more impossible.
This outlook seems sensible—if we fall for the trap of thinking that hyperinflation is an extention of inflation. If we think that hyperinflation is simply inflation on steroids—inflation-plus—inflation with balls—then it would seem to be the case that, in our current deflationary economic environment, hyperinflation is not simply a long way off, but flat-out ridiculous.
But hyperinflation is not an extension or amplification of inflation. Inflation and hyperinflation are two very distinct animals. They look the same—because in both cases, the currency loses its purchasing power—but they are not the same.
Inflation is when the economy overheats: It’s when an economy’s consumables (labor and commodities) are so in-demand because of economic growth, coupled with an expansionist credit environment, that the consumables rise in price. This forces all goods and services to rise in price as well, so that producers can keep up with costs. It is essentially a demand-driven phenomena.
Hyperinflation is the loss of faith in the currency. Prices rise in a hyperinflationary environment just like in an inflationary environment, but they rise not because people want more money for their labor or for commodities, but because people are trying to get out of the currency. It’s not that they want more money—they want less of the currency: So they will pay anything for a good which is not the currency.
Right now, the U.S. government is indebted to about 100% of GDP, with a yearly fiscal deficit of about 10% of GDP, and no end in sight. For its part, the Federal Reserve is purchasing Treasuries, in order to finance the fiscal shortfall, both directly (the recently unveiled QE-lite) and indirectly (through the Too Big To Fail banks). The Fed is satisfying two objectives: One, supporting the government in its efforts to maintain aggregate demand levels, and two, supporting asset prices, and thereby prevent further deflationary erosion. The Fed is calculating that either path—increase in aggregate demand levels or increase in aggregate asset values—leads to the same thing: A recovery in the economy.
This recovery is not going to happen—that’s the news we’ve been getting as of late. Amid all this hopeful talk about “avoiding a double-dip”, it turns out that we didn’t avoid a double-dip—we never really managed to claw our way out of the first dip. No matter all the stimulus, no matter all the alphabet-soup liquidity windows over the past 2 years, the inescapable fact is that the economy has been—and is headed—down.
But both the Federal government and the Federal Reserve are hell-bent on using the same old tired tools to “fix the economy”—stimulus on the one hand, liquidity injections on the other.
It’s those very fixes that are pulling us closer to the edge. Why? Because the economy is in no better shape than it was in September 2008—and both the Federal Reserve and the Federal government have shot their wad. They got nothin’ left, after trillions in stimulus and trillions more in balance sheet expansion - but they have accomplished one thing: They have undermined Treasuries. These policies have turned Treasuries into the spit-and-baling wire of the U.S. financial system—they are literally the only things holding the whole economy together.
In other words, Treasuries are now the New and Improved Toxic Asset. Everyone knows that they are overvalued, everyone knows their yields are absurd—yet everyone tiptoes around that truth as delicately as if it were a bomb. Which is actually what it is.
So this is how hyperinflation will happen:
One day—when nothing much is going on in the markets, but general nervousness is running like a low-grade fever (as has been the case for a while now)—there will be a commodities burp: A slight but sudden rise in the price of a necessary commodity, such as oil.
This will jiggle Treasury yields, as asset managers will reduce their Treasury allocations, and go into the pressured commodity, in order to catch a profit. (Actually it won’t even be the asset managers—it will be their programmed trades.) These asset managers will sell Treasuries because, effectively, it’s become the principal asset they have to sell.
It won’t be the volume of the sell-off that will pique Bernanke and the drones at the Fed—it will be the timing. It’ll happen right before a largish Treasury auction. So Bernanke and the Fed will buy Treasuries, in an effort to counteract the sell-off and maintain low yields—they want to maintain low yields in order to discourage deflation. But they’ll also want to keep the Treasury cheaply funded. QE-lite has already set the stage for direct Fed buys of Treasuries. The world didn’t end. So the Fed will feel confident as it moves forward and nips this Treasury yield jiggle in the bud.
The Fed’s buying of Treasuries will occur in such a way that it will encourage asset managers to dump even more Treasuries into the Fed’s waiting arms. This dumping of Treasuries won’t be out of fear, at least not initially. Most likely, in the first 15 minutes or so of this event, the sell-off in Treasuries will be orderly, and carried out with the idea (at the time) of picking up those selfsame Treasuries a bit cheaper down the line.
However, the Fed will interpret this sell-off as a run on Treasuries. The Fed is already attuned to the bond markets’ fear that there’s a “Treasury bubble”. So the Fed will open its liquidity windows, and buy up every Treasury in sight, precisely so as to maintain “asset price stability” and “calm the markets”.
The Too Big To Fail banks will play a crucial part in this game. See, the problem with the American Zombies is, they weren’t nationalized. They got the best bits of nationalization—total liquidity, suspension of accounting and regulatory rules—but they still get to act under their own volition, and in their own best interest. Hence their obscene bonuses, paid out in the teeth of their practical bankruptcy. Hence their lack of lending into the weakened economy. Hence their hoarding of bailout monies, and predatory business practices. They’ve understood that, to get that sweet bail-out money (and those yummy bonuses), they have had to play the Fed’s game and buy up Treasuries, and thereby help disguise the monetization of the fiscal debt that has been going on since the Fed began purchasing the toxic assets from their balance sheets in 2008.
But they don’t have to do what the Fed tells them, much less what the Treasury tells them. Since they weren’t really nationalized, they’re not under anyone’s thumb. They can do as they please—and they have boatloads of Treasuries on their balance sheets.
So the TBTF banks, on seeing this run on Treasuries, will add to the panic by acting in their own best interests: They will be among the first to step off Treasuries. They will be the bleeding edge of the wave.
Here the panic phase of the event begins: Asset managers—on seeing this massive Fed buy of Treasuries, and the American Zombies selling Treasuries, all of this happening within days of a largish Treasury auction—will dump their own Treasuries en masse. They will be aware how precarious the U.S. economy is, how over-indebted the government is, how U.S. Treasuries look a lot like Greek debt. They’re not stupid: Everyone is aware of the idea of a “Treasury bubble” making the rounds. A lot of people—myself included—think that the Fed, the Treasury and the American Zombies are colluding in a triangular trade in Treasury bonds, carrying out a de facto Stealth Monetization: The Treasury issues the debt to finance fiscal spending, the TBTF banks buy them, with money provided to them by the Fed.
Whether it’s true or not is actually beside the point—there is the widespread perception that that is what’s going on. In a panic, widespread perception is your trading strategy.
So when the Fed begins buying Treasuries full-blast to prop up their prices, these asset managers will all decide, “Time to get out of Dodge—now.”
Note how it will not be China or Japan who all of a sudden decide to get out of Treasuries—those two countries will actually be left holding the bag. Rather, it will be American and (depending on the time of day when the event happens) European asset managers who get out of Treasuries first. It will be a flash panic—much like the flash-crash of last May. The events I describe above will happen in a very short span of time—less than an hour, probably. But unlike the event in May, there will be no rebound.
Notice, too, that Treasuries will maintain their yields in the face of this sell-off, at least initially. Why? Because the Fed, so determined to maintain “price stability”, will at first prevent yields from widening—which is precisely why so many will decide to sell into the panic: The Bernanke Backstop won’t soothe the markets—rather, it will make it too tempting not to sell.
The first of the asset managers or TBTF banks who are out of Treasuries will look for a place to park their cash—obviously. Where will all this ready cash go?
Commodities.
By the end of that terrible day, commodites of all stripes—precious and industrial metals, oil, foodstuffs—will shoot the moon. But it will not be because ordinary citizens have lost faith in the dollar (that will happen in the days and weeks ahead)—it will happen because once Treasuries are not the sure store of value, where are all those money managers supposed to stick all these dollars? In a big old vault? Under the mattress? In euros?
Commodities: At the time of the panic, commodities will be perceived as the only sure store of value, if Treasuries are suddenly anathema to the market—just as Treasuries were perceived as the only sure store of value, once so many of the MBS’s and CMBS’s went sour in 2007 and 2008.
It won’t be commodity ETF’s, or derivatives—those will be dismissed (rightfully) as being even less safe than Treasuries. Unlike before the Fall of ’08, this go-around, people will pay attention to counterparty risk. So the run on commodities will be for actual, feel-it-’cause-it’s-there commodities. By the end of the day of this panic, commodities will have risen between 50% and 100%. By week’s end, we’re talking 150% to 250%. (My private guess is gold will be finessed, but silver will shoot up the most—to $100 an ounce within the week.)
Of course, once commodities start to balloon, that’s when ordinary citizens will get their first taste of hyperinflation. They’ll see it at the gas pumps.
If oil spikes from $74 to $150 in a day, and then to $300 in a matter of a week—perfectly possible, in the midst of a panic—the gallon of gasoline will go to, what: $10? $15? $20?
So what happens then? People—regular Main Street people—will be crazy to buy up commodities (heating oil, food, gasoline, whatever) and buy them now while they are still more-or-less affordable, rather than later, when that $15 gallon of gas shoots to $30 per gallon.
If everyone decides at roughly the same time to exchange one good—currency—for another good—commodities—what happens to the relative price of one and the relative value of the other? Easy: One soars, the other collapses.
When people freak out and begin panic-buying basic commodities, their ordinary financial assets—equities, bonds, etc.—will collapse: Everyone will be rushing to get cash, so as to turn around and buy commodities.
So immediately after the Treasury markets tank, equities will fall catastrophically, probably within the next few days following the Treasury panic. This collapse in equity prices will bring an equivalent burst in commodity prices—the second leg up, if you will.
This sell-off of assets in pursuit of commodities will be self-reinforcing: There won’t be anything to stop it. As it spills over into the everyday economy, regular people will panic and start unloading hard assets—durable goods, cars and trucks, houses—in order to get commodities, principally heating oil, gas and foodstuffs. In other words, real-world assets will not appreciate or even hold their value, when the hyperinflation comes.
This is something hyperinflationist-skeptics never quite seem to grasp: In hyperinflation, asset prices don’t skyrocket—they collapse, both nominally and in relation to consumable commodities. A $300,000 house falls to $60,000 or less, or better yet, 50 ounces of silver—because in a hyperinflationist episode, a house is worthless, whereas 50 bits of silver can actually buy you stuff you might need.
Right now, I’m guessing that sensible people who’ve read this far are dismissing me as being full of shit—or at least victim of my own imagination. These sensible people, if they deign to engage in the scenario I’ve outlined above, will argue that the government—be it the Fed or the Treasury or a combination thereof—will find a way to stem the panic in Treasuries (if there ever is one), and put a stop to hyperinflation (if such a foolish and outlandish notion ever came to pass in America).
Uh-huh: So the Government will save us, is that it? Okay, so then my question is, How?
Let’s take the Fed: How could they stop a run on Treasuries? Answer: They can’t. See, the Fed has already been shoring up Treasuries—that was their strategy in 2008—’09: Buy up toxic assets from the TBTF banks, and have them turn around and buy Treasuries instead, all the while carefully monitoring Treasuries for signs of weakness. If Treasuries now turn toxic, what’s the Fed supposed to do? Bernanke long ago ran out of ammo: He’s just waving an empty gun around. If there’s a run on Treasuries, and he starts buying them to prop them up, it’ll only give incentive to other Treasury holders to get out now while the getting’s still good. If everyone decides to get out of Treasuries, then Bernanke and the Fed can do absolutely nothing effective. They’re at the mercy of events—in fact, they have been for quite a while already. They just haven’t realized it.
Well if the Fed can’t stop this, how about the Federal government—surely they can stop this, right?
In a word, no. They certainly lack the means to prevent a run on Treasuries. And as to hyperinflation, what exactly would the Federal government do to stop it? Implement price controls? That will only give rise to a rampant black market. Put soldiers out on the street? America is too big. Squirt out more “stimulus”? Sure, pump even more currency into a rapidly hyperinflating everyday economy—right . . .
(BTW, I actually think that this last option is something the Federal government might be foolish enough to try. Some moron like Palin or Biden might well advocate this idea of helter-skelter money-printing so as to “help all hard-working Americans”. And if they carried it out, this would bring us American-made images of people using bundles of dollars to feed their chimneys. I actually don’t think that politicians are so stupid as to actually start printing money to “fight rising prices”—but hey, when it comes to stupidity, you never know how far they can go.)
In fact, the only way the Federal government might be able to ameliorate the situation is if it decided to seize control of major supermarkets and gas stations, and hand out cupon cards of some sort, for basic staples—in other words, food rationing. This might prevent riots and protect the poor, the infirm and the old—it certainly won’t change the underlying problem, which will be hyperinflation.
“This is all bloody ridiculous,” I can practically hear the hyperinflation skeptics fume. “We’re just going through what the Japanese experienced: Just like the U.S., they went into massive government stimulus—hell, they invented quantitative easing—and look what’s happened to them: Stagnation, yes—hyperinflation, no.”
That’s right: The parallels with Japan are remarkably similar—except for one key difference. Japanese sovereign debt is infinitely more stable than America’s, because in Japan, the people are savers—they own the Japanese debt. In America, the people are broke, and the Nervous Nelly banks own the debt. That’s why Japanese sovereign debt is solid, whereas American Treasuries are soap-bubble-fragile.
That’s why I think there’ll be hyperinflation in America—that bubble’s soon to pop. I’m guessing if it doesn’t happen this fall, it’ll happen next fall, without question before the end of 2011.
The question for us now—ad portas to this hyperinflationary event—is, what to do?
Neanderthal survivalists spend all their time thinking about post-Apocalypse America. The real trick, however, is to prepare for after the end of the Apocalypse.
The first thing to realize, of course, is that hyperinflation might well happen—but it will end. It won’t be a never-ending situation—America won’t end up like in some post-Apocalyptic, Mad Max: Beyond Thuderdome industrial wasteland/playground. Admittedly, that would be cool, but it’s not gonna happen—that’s just survivalist daydreams.
Instead, after a spell of hyperinflation, America will end up pretty much like it is today—only with a bad hangover. Actually, a hyperinflationist spell might be a good thing: It would finally clean out all the bad debts in the economy, the crap that the Fed and the Federal government refused to clean out when they had the chance in 2007–’09. It would break down and reset asset prices to more realistic levels—no more $12 million one-bedroom co-ops on the UES. And all in all, a hyperinflationist catastrophe might in the long run be better for the health of the U.S. economy and the morale of the American people, as opposed to a long drawn-out stagnation. Ask the Japanese if they would have preferred a couple-three really bad years, instead of Two Lost Decades, and the answer won’t be surprising. But I digress.
Like Rothschild said, “Buy when there’s blood on the streets.” The thing to do to prepare for hyperinflation would be to invest in a diversified hard-metal basket before the event—no equities, no ETF’s, no derivatives. If and when hyperinflation happens, and things get bad (and I mean really bad), take that hard-metal basket and—right in the teeth of the crisis—buy residential property, as well as equities in long-lasting industries; mining, pharma and chemicals especially, but no value-added companies, like tech, aerospace or industrials. The reason is, at the peak of hyperinflation, the most valuable assets will be dirt-cheap—especially equities—especially real estate.
I have no idea what will happen after we reach the point where $100 is no longer enough to buy a cup of coffee—but I do know that, after such a hyperinflationist period, there’ll be a “new dollar” or some such, with a few zeroes knocked off the old dollar, and things will slowly get back to a new normal. I have no idea the shape of that new normal. I wouldn’t be surprised if that new normal has a quasi or de facto dictatorship, and certainly some form of wage-and-price controls—I’d say it’s likely, but for now that’s not relevant.
What is relevant is, the current situation cannot long continue. The Global Depression we are in is being exacerbated by the very measures being used to fix it—stimulus is putting pressure on Treasuries, which are being shored up by the Fed. This obviously cannot have a happy ending. Therefore, the smart money prepares for what it believes is going to happen next.
I think we’re going to have hyperinflation. I hope I have managed to explain why.
The hedge fund Hayman Advisors (HA) is drawing attention again.
HA is most famous for betting against subprime mortgages in 2007. When the US housing bubble popped, they made billions of dollars with their hedge. As a result, HA's economic views now received a heightened level of attention.
And the blogosphere is a tither about their latest, controversial letter to clients predicting that the U.S. may experience hyper-inflation.
Now the fact that many people think that inflation will follow the massive fiscal and monetary government stimulus that has been injected to fight the the recession and financial crisis is nothing new.
We've posted about it quite a bit.
But hyper-inflation?... that is the extreme.
Hyper-inflation would mean inflation in the ballpark of 30% per year -- at least. Generally hyper-inflation is measured by the month or day, not year, because the numbers are so high.
What has caught everyone's attention with HA's latest advice is their reference to a study by Peter Bernholz.
There have been twenty eight episodes of hyper-inflation of national economies in the twentieth century with 20 occurring after 1980. In his most recent book, Monetary regimes and Inflation; History, Economic, & Political Relationships, Bernholz analyzes the 12 largest episodes of hyper-inflation - all of which were caused by financing huge public budget deficits through money creation.
"In the 12 largest episodes of hyper-inflation the tipping point for hyper-inflation occurs when the government’s deficit exceeds 40% of its expenditures."
The study notes that according to the current Office of Management and Budget projections… the U.S. will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. In other words roughly 40% of what the US government is spending has to be borrowed.
It prompts HA to ask it's clients, "has the U.S. reached the critical tipping point?"
The hedge fund's letter is attracting significant interest for several reasons. First of all because it's a hyper-inflation argument that doesn't seem wacky - it's rooted in historical observation.
Secondly it has nothing to do with the massive monetary stimulus by the Federal Reserve, which could cause additional inflationary pressures. So even if you believe that the Fed can control their side of the equation, the government spending might still cause inflation to get out of hand.
Skeptics counter that the U.S. has a more robust, developed and sophisticated economy than most places where hyper-inflation has occurred. They say that fiscal and monetary policy would be seriously altered to avoid incredible levels of inflation if the U.S. found itself facing such a predicament.
None-the-less, successfully keeping inflation as low as it has been in recent years seems highly unlikely with each passing day. And whether you buy into the fund's logic or not, its letter is an interesting one. It also provides analysis on China and Japan.
If you have some time to kill and interest, you might want to give it a read.
On another inflation note, the Reserve Bank of Australia became the first G-20 nation to raise interest rates yesterday. The RBA bumped interest rates up 25 basis points to 3.25%, a move observers were convinced wouldn’t come until at least November. Thus, Australia is implicitly declaring the end of its economic downturn.
The move is raising alarm bells because the first hike is seen as opening a Pandora's box of interest rate hikes around the world.
Chuck Butler of EverBank says that, “if the RBA went this soon, then we can expect Norway's Norges Bank to push its rate hike earlier on the calendar, maybe even later this month! And it won't be the only one! Look for New Zealand to hike rates this year, and who knows what other country will follow after that.”
And you will recall that Bank of Canada governor Mark Carney tempered his promise to keep our nation's rate at 0.25% only if inflationary pressures didn't start to emerge.
. UPDATE: No word from the FDIC @ 7:15 pm PDT. Just doesn't feel like Friday.
Ahhh... another Friday and faithful readers are tuning in for the latest on Bank Failure Friday.
Before we get to that, let's touch on a few other things.
Real Estate Ethics
Recall last week (March 5th) we talked about the latest tactic of the Real Estate Industry to target first time home buyers. A campaign was launched insinuating that "other young couples are buying, you should too!"
Round Two of that campaign hit the streets this week. Simultaneous articles appeared all across the country. In Vancouver, the Sun’s headline was, “First-time buyers driving market,” in Calgary it was the Calgary Herald, “Entry-level buyers now driving Calgary’s home sales, report says".
Garth Turner beat me to this and you can read more about it here. Turner takes a look at the so called 'report' and notes "there is no data, no numbers, no proof, no confirmation. Just another real estate marketing gimmick – a 'report' which 'confirms new buyers are driving real estate' in almost every major centre in Canada." Turner concludes its nothing more than a fabrication of facts that amounts to a conspiracy of misinformation, unintentional or not.
It's hard to disagree.
The Economy
As we have written this week, the United States has taken huge steps to offset the collapse in asset values and bank balance sheets by buying up bad investments, stocks and debt. This is being done by printing money like it's going out of style.
Two weeks ago Britain decided to embark on the same course. Last week the Bank of Canada joined the printing press parade. And yesterday it came to light that three other countries climbed on board the ever-expanding currency producing wagon. Japan, China and Switzerland.
Market insiders say this confirms all the fears about the coming onslaught of hyper-inflation. The latest three day rally on Wall and Bay Streets saw not only stocks rise dramatically, but gold/silver/oil and mineral commodities too.
This (the rise of both stocks and gold/silver/oil) insiders say points to a bottoming out of the worst Bear market since the Great Depression and the start of the predicted hyper-inflationary period.
If they're right, buckle up folks, it means things are gonna take off like a rocket if that is the case. It's not the end of the recession or hard times in Canada, but the market is usually six to eight months ahead of the economy.
My recommendation? Now's the time to play the market. Silver stocks like First Majestic, commodities like Tech Resources, oil stocks. But beware! A rapid blowing up of the market could lead to another rapid collapse. Study the 1930s! The market recovered almost 60% after the crash of 1929. All the stimulus that has been announced will find it's way into the market - mark my words. But beware the rebound back down.
Bank Failure Friday
As our Prime Minister said, "there won't be a recovery until the U.S. financial system is repaired." So we watch the US banking developments with keen interest. And what a week it has been.
The FDIC went to Congress to ask for up to $500 Billion in extra funds to deal with failing US Banks. The FDIC is funded by insurance premiums levied against all US Banks. Those premiums are used to bail out bad banks. Well it turns out those running things believed their fund was so well-capitalized - and that bank failures were so infrequent - that there was no need to collect the insurance premiums from 1996 to 2006.
Ya gotta love it.
While we wait for today's carnage, take the time to check out this '60 Minutes' segment that follows the FDIC when they take over a failing bank on Bank Failure Friday. From the into...
"Most every Friday now the FDIC is seizing several banks. You haven't seen these takeovers happening because they're done secretly, at night, to make sure that there's no needless panic by depositors. But last week we were given extraordinary access to one of these operations... "
“The Federal Reserve is now a government within a government. It is totally out of control. Congress doesn't control it. It's funded by the banks and we either have constitutional government or we don't."
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