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The Fed: Still crazy after all these years

In a TSI commentary back in April of 2010 we wrote that the Japanese government was "still crazy after all these years", because it was still trying desperately to stimulate its economy in accordance with the Keynesian script despite blatant evidence that the policies being implemented were counter-productive. The same phrase (the title of a Paul Simon song) applies equally well to the US Federal Reserve. Despite the blatant evidence that monetary inflation is part of the problem rather than part of the solution, the Fed keeps inflating the money supply as if doing so were going to strengthen the economy.

The Fed, unbowed by its previous failures, announced yet another inflation program (QE4?) at the conclusion of this week's FOMC meeting. Here are the most important parts of its post-meeting statement:

"...the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month."

"...the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

The first of the above quotes from the FOMC statement indicates that the Fed plans to directly add $85B per month, or the equivalent of $1.02T per year, to the US money supply. This implies that the Fed's direct actions alone (that is, not accounting for any money creation by the commercial banks) will boost the US True Money Supply (TMS) by around 11% over the next 12 months. The second of the above quotes suggests that ultra-easy monetary conditions will be maintained until the unemployment rate drops to 6.5% and/or "inflation expectations" move above 2.5%. Inflation expectations are already above 2.5%, but never mind.

Private counterfeiters take note: If the Fed is right then you should redouble your efforts, because when you steal purchasing power by creating money out of nothing you are also boosting employment and facilitating real economic progress..

The market reaction to the Fed

Price inflation, de-leveraging and interest rates

Unless you believe government statistics or live in Japan or never venture out into the world to purchase basic necessities, you probably perceive a "price inflation" problem. The reason is that in every country that we know of apart from Japan, the so-called "general price level" is rising at the rate of at least 5% per year. Or, to put it more aptly, money is losing purchasing power at the rate of at least 5% per year in almost all countries (including the US). In this case, our knowledge is based on what we have directly observed in seven countries and feedback from friends and acquaintances living in many other countries. Our knowledge is also based on our investing experiences. For example, the single biggest problem faced by the gold mining industry over the past eight years, and the main cause of the remarkably poor performance of the average gold mining stock relative to gold bullion over this period, has been the rapid rate of increase in the prices of the materials and labour used by gold miners. The US$ gold price has risen at around 21% per year, but for the average gold producer the benefit of this rise in the gold price has been largely offset by a 16% per year increase in the total cost of running a gold mining business. Today we are going to deal with two questions that stem from the "price inflation" issue: First, why has there been significant price inflation during a period of 'de-leveraging' (a period of debt repayment, debt default and an increasing propensity to save)? Second, considering the obvious price inflation, why are long-term interest rates so low in so many parts of the world?

The first question is easy to answer. The fact of the matter is that on an economy-wide basis there has been no de-leveraging. Governments and central banks have prevented a natural de-leveraging process from occurring, which, to take one example, is why the US economy is no closer to commencing a sustainable recovery today than it was four years ago. The private sector has certainly attempted to shrink its collective balance sheet with some success, but the public sector has expanded its collective balance sheet by a greater amount. The net result has been the continued growth in the economy-wide level of debt. Moreover, it is important to understand that it is the change in the supply of money, not the change in the total amount of debt that ultimately determines the price level. Regardless of whether or not the overall economy is de-leveraging, if the supply of money is growing rapidly -- which it has been doing in the US and in many other countries over the past four years -- then the price (purchasing power) of money will eventually suffer a substantial decline. Increases in the demand for money can temporarily offset the effect on money purchasing power of an increase in the supply of money, but the operative word here is "temporarily". Increases in the demand for money have offset the price-related effects of increases in the supply of money over the past four years, but we know from the significant decline in money purchasing power that the offset has only been partial.

As an aside, a mistake made by almost every 'deflationist' is to treat money and debt as if they were the same. Debt is not money, it is an obligation to pay money.

As another aside, the reason the Yen has done a relatively good job of maintaining its purchasing power is that the supply of Yen has increased at a relatively slow pace up until now. Specifically, over the past 5 years, 10 years and 20 years, the rate of monetary inflation in Japan has averaged about 2% per year. Compare this to the US, where over the past 12 years the average annual rate of money-supply (TMS) growth has been around 9.5% and where over the past 4 years the average annual rate of money supply growth has been around 13%.

The second question (given the obvious price inflation, why are long-term interest rates so low?) is more difficult to answer. It is a lot easier to rule out the wrong answers to this question than to arrive at the right answer. We can, for example, immediately rule out the idea that the bond market is reacting to deflation, because there isn't any deflation. Powerful deflationary forces emerged in 2008, but they have clearly been overwhelmed by the inflationary forces created by central banks. We can also rule out the answer that goes something like this: there may well be no deflation in the present, but the market is looking ahead and discounting future deflation. We can rule this out because the following chart shows that the difference between the yield on the 10-year T-Note and the yield on the 10-year TIPS (Treasury Inflation Protected Security) is 2.55%. This yield difference is the annual rate of currency depreciation that the market expects the government to admit to over the years ahead, which is why we typically refer to it as the Expected CPI. Since everyone who has been paying attention knows that the government chronically under-reports the rate of currency depreciation, we can be sure that the Expected CPI is less than the loss of purchasing power actually expected by the market. In other words, the aforementioned yield difference tells us that the market currently expects the US$ to lose purchasing power at a rate of more than 2.55% per year. And yet, at its current price the 10-year T-Note has a nominal yield of only 1.71%. This means that the 10-year T-Note is now trading at a real yield (nominal yield minus the expected rate of currency depreciation) of negative 0.84% or lower. Why would any investor lend money to the US government, or any other government, at a nominal yield that was expected to generate a real loss over the duration of the loan?


                                          Chart Source: www.fullermoney.com

We can come up with three explanations for the negative real yield on the long-term debt securities issued by the US government, all of which are related in some way to the Federal Reserve.

First, there's the direct buying of Treasury securities by the Fed. The Fed hasn't been a net buyer of bonds since the end of QE2 (June-2011), but since the third quarter of 2008 it has added almost 2 trillion dollars of bonds to its balance sheet. It has also just promised to buy a lot more bonds in the future.

Second, and of greater importance over the past 18 months, is the Fed's zero interest rate policy at the short end. This policy involves making a copious amount of short-term money available to banks at virtually no cost. If you are borrowing and lending in the same currency and you are able to borrow at X% and lend at X+Y% then you will earn a positive real interest rate regardless of what happens to the purchasing power of the currency. Furthermore, your real return could be substantial due to the leverage factor.

Third, a significant portion of the demand for long-term low-risk bonds (such as those issued by the US federal government) comes from short-term buyers -- speculators buying with the aim of selling in less than a year and large investors looking for a place to safely park some money for a while. This short-term demand is linked to the Fed, because a) the Fed's ability and willingness to monetise an unlimited amount of US government debt eliminates the risk of direct default (the US federal government will never find itself in the same situation as the Greek government) and b) the Fed's 'commitment' to keep the official short-term interest rate near zero for a long time will reduce the short-term price risk associated with holding long-term bonds until inflation expectations get out of hand.

The phrase "until inflation expectations get out of hand" is the key to the interest-rate-suppressing, bank-and-government-supporting, savings-destroying, economy-distorting scheme perpetrated by the Fed. The above chart shows that the rate of US$ depreciation currently expected by the market is at least 2.55%. Our guess is that it is actually in the 3%-4% range. We suspect that once it moves beyond 5%, additional attempts by the Fed to suppress rates at the short end will lead to higher rates at the long end. This could happen as soon as the next few months, although a large stock market decline would likely prolong the scheme.

The Stock Market

When the Fed introduced QE3 in mid-September the Dow Jones World Stock Index (DJW) was 'overbought' and near resistance in the high-250s. The Fed news therefore didn't lead to significant additional gains. In fact, it led to a multi-week decline.

When the Fed introduced QE4 on Wednesday of this week the DJW was also 'overbought' and near resistance in the high-250s. Does this mean that the outcome will be similar this time around?

Probably, although we won't be surprised if the DJW breaks above resistance before commencing its next meaningful decline. The reason is that triple tops are uncommon. Usually, if a market has peaked at the same level twice within the preceding 12 months then a third test of the level will result in a breakout.

Our guess is that resistance in the high-250s will be breached, either immediately or after a 1-2 week consolidation. However, we doubt that there will be much follow-through to the upside before a downward trend gets underway.



Gold and the Dollar

Gold

There was almost no reaction in the gold market to the Fed's announcement of "QE4", which could mean that short-term traders have become immune to threats that more will be done to destroy the official money. However, the increased rate of money pumping will have effects on the economy and these effects will very likely result in a much higher gold price within the next 12 months. Traders can either anticipate these effects now or be surprised by them later.

One of the effects of the accelerated pace of money pumping will be a further reduction in the purchasing power of the US$, but the change in purchasing power won't be uniform. It never is. Some prices will rise quickly, some prices will rise slowly, some prices will remain the same and there will even be declines in some prices. It generally won't be possible to differentiate between a price rise due to the Fed's money pumping and a non-artificial price rise, so people throughout the economy will have no choice other than to treat all price changes as if they were the result of sustainable changes in underlying supply/demand as opposed to the result of monetary manipulations by central planners. This will lead to greater wastage of resources and the US economy being in a weaker state by this time next year. Rising prices (on average) and a fundamentally weaker economy will reduce the appeal of growth-oriented investments and increase the relative appeal of gold, leading to a much higher gold price in both nominal and real terms.

With reference to the following daily chart of the US$ gold price, it looks like the 50-day moving average has been acting as resistance over the past six weeks. Consecutive daily closes above this MA could therefore be taken as a signal that a rise to intermediate-term resistance at $1800 was in progress. And with resistance at $1800 having already been tested twice over the past 12 months, the next rise to that level will probably be followed soon after by an upside breakout.

The first significant line of support is the November low in the $1670s. If this support were breached then the more substantial support at around $1630 would probably limit the decline.



Gold Stocks

The gold-stock indices had the advantage of being 'oversold' at the time of this week's Fed announcement. Almost everyone who was likely to sell in response to short-term considerations had already sold. This enabled the HUI to gain 2.6% on Wednesday 12th December despite gold's lacklustre performance.

At this stage there's no way of knowing whether the rebound will evolve into something substantial. An important bottom could have been put in place last week shortly after the November low was breached, but we could also be seeing a counter-trend move back to the resistance that extends from the mid-450s (the 200-day moving average) to the low-460s. In our opinion, the latter scenario is the more likely. If it's the latter then there will be a decline to a new low over the coming 1-2 weeks, at which point a 'seasonal' rally -- with relative strength at the junior end of the sector -- should begin.



Currency Market Update

Add currencies to the list of markets that didn't do much in reaction to Wednesday's Fed announcement. The Dollar Index has almost made its way down to support at 79.5, but Wednesday's decline was minor.

We are anticipating a drop to 77-78.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.fullermoney.com/