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Lower US living standards are an INTENDED consequence of Fed policy

The following chart is very interesting. We found the chart in John Mauldin's latest "Thoughts from the Frontline" letter, although it was created by the Boston Consulting Group. It compares the cost of manufacturing in the top 25 exporting countries.



According to this chart, Australia is now the most expensive country to manufacture stuff. Manufacturing costs in Australia are now 30% higher than in the US, almost 20% higher than in Japan, almost 10% higher than in Germany, and about 5% higher than in Switzerland. The cost of manufacturing in the US is now slightly below the average -- at around the same level as South Korea, Russia, Taiwan and Poland. This means that the Fed is almost half way to its goal of reducing US living standards to the point where the average factory worker in the US can compete on a cost basis with the average factory worker in Indonesia.

The above comment is only partly tongue-in-cheek. Many pro-free-market commentators discuss the decline in US living standards as if it were an unintended consequence of the Fed's policies, but there is nothing unintended about it. It is a deliberate objective. The Fed will never come out and say "we are doing what we can to reduce living standards", but a policy that is designed to boost asset prices, support capital-consuming businesses and promote investments that would never see the light of day in the absence of artificially low interest rates, all while minimising "wage inflation", is also designed to reduce real wages and, therefore, to reduce living standards. The Fed surely doesn't want to reduce US living standards to Indonesian levels, but that's the direction in which its efforts are deliberately pointed.

As we've explained in previous commentaries, the root of the problem is unswerving commitment to bad economic theory. Under the Keynesian theories that all central bankers religiously follow, wealth is something that just exists. There is no careful and deep consideration given to how the wealth came to be and why some countries managed to accumulate a lot of wealth while other countries remained poor. According to these theories, people spend more during some periods due to a vague notion called rising "animal spirits". This causes the amount of wealth to grow. Then, after a while, the mysterious "animal spirits" begin to subside, causing people to start spending less. This leads to a reduction in the amount of wealth. Under this perception of the world, one of the central bank's primary tasks is to combat the unfathomable and destabilising natural force that drives the shifts in spending. This is done by indirectly manipulating prices throughout the economy, including the real price of labour.

The so-called counter-cyclical policies are destined to backfire, but the nature of the eventual backfiring is often difficult to predict. In broad terms, there are two possibilities: There could be a surge in inflation fear followed by a collapse in asset prices, a recession and a moonshot in deflation fear, or the collapse in asset prices and its knock-on effects could happen without a preceding surge in inflation fear. In both cases, the asset-price collapse and recession would likely usher-in a new round of 'stimulative' policy, because the devotion to bad theory prevents the right lessons from being learned.

The latest words from the US monetary politburo

The Stock Market

Here's some information that highlights this year's extreme divergence between the performances of the senior US stock indices and the average US stock.

The following chart shows that the NASDAQ Composite Index, a capitalisation-weighted index, is presently within 1% of the 10-year high reached at the beginning of this month. At the same time, a 16th September Bloomberg article notes that 47 percent of stocks in the Nasdaq Composite Index are down at least 20 percent from their peak in the last 12 months. In other words, we have a huge, on-going bull market in an index proxy for the NASDAQ, and at the same time we have almost half of all NASDAQ-traded stocks in bear-market territory.



Below is a rather strange chart comparing the Bank Index (BKX) with TLT (a fund that holds T-Bonds). The two halves of the chart have been offset by a few weeks to reflect the fact that BKX has tended to lead TLT by 2-4 weeks at turning points.

The chart shows that over the past 18 months BKX has trended upward when TLT was trending downward and that BKX has either trended downward or moved sideways when TLT was trending upward. Most recently, last month's upward reversal in BKX led a downward reversal in TLT by about two weeks.

An implication is that the bond market's correction will probably continue until the banking sector's short-term upward trend comes to an end, or, looking at the situation from a different angle, evidence that the bond market's correction is over would also be evidence that the banking sector's rally is close to an end.



Gold and the Dollar

Gold

In the latest Weekly Update, we wrote:

"If the gold price reverses upward and closes above $1251 (basis the December-2014 contract) on either Monday or Tuesday of this week, then last week's breakdown was false and we will have a reliable bullish signal. The most likely alternative is a decline to the low-$1200s prior to an upward reversal late this month.

A close above $1251 on any day this week would automatically shift our short-term outlook back to 'bullish'."

Gold's rebound attempts over the first three days of this week were turned back at former support (now resistance) in the low-$1240s. This means that last week's downside breakout has been confirmed and the most likely outcome is a decline to the low-$1200s prior to an upward reversal late this month.

Due to this week's price action, it would now only take a daily close above $1244 to shift our short-term outlook back to 'bullish'.



It is worth mentioning that the Central Gold Trust (GTU), a closed-end fund that holds physical gold, is now trading at a discount of 8.10% to its net asset value (NAV). The bottom half of the following chart shows GTU's discount/premium to NAV. This is the highest discount in more than 8 years and is reflective of the extremely depressed sentiment in the gold market. Buying GTU at its current price is effectively the same as buying gold bullion at $1120/oz.

The Central Fund of Canada (CEF), a closed-end fund that holds physical gold and silver, is trading at a similar discount.



Gold Stocks

In the latest Weekly Update we noted that a small, but potentially significant, positive divergence had developed between the HUI and the GDXJ/GDX ratio. This positive divergence became more pronounced over the first three days of this week.



The most plausible two near-term scenarios for the gold-mining sector are:

1) A multi-week HUI rally will begin within the next few days from not far below the current level. This scenario is consistent with the positive divergence mentioned above and with a literal interpretation of the late-1970s model. Under this scenario, the next short-term top would occur during October-November.

2) The HUI's downward drift will continue into early-October, at which time a tradable rally will begin. This scenario is consistent with the fact that while there are clear-cut signs of internal weakness in the US stock market, there are not yet any signs of weakness in the senior US stock indices. It is also consistent with the likelihood that the T-Bond correction, which has driven an upward move in real interest rates and put downward pressure on the gold price since the third week of August, is not yet complete. Under this scenario the short-term upward trend that begins in early October would probably extend into the first quarter of 2015.

The Currency Market

Event Risk

Two big events will take place later today (Thursday 18th September). One, of course, is the Scottish referendum on independence. The surveys show that the voting could go either way, but the betting at bookmakers is strongly in favour of a "no" result. Either way, there is going to be a big move in the Pound's exchange rate within the next 24 hours -- down if Scotland votes "yes" to independence and up if Scotland votes "no". As previously advised, we think that a big down move would quickly lead to a good opportunity to buy the Pound.

The other event is the beginning of the ECB's TLTRO (Targeted Longer Term Refinancing Operation). Under this program banks will be able to borrow money from the ECB at 0.15%, with the amount that they can borrow determined by the details of their loan books. The extent to which European banks participate in the TLTRO program will likely influence the FX market, with greater participation being viewed as a positive for the euro and lesser participation being viewed as a negative for the euro.

Current Market Situation

Our intermediate-term outlooks for the Dollar Index and commodities are linked. We think that an intermediate-term bullish resolution for commodities, as represented by the CCI, requires an intermediate-term bearish resolution for the US dollar's exchange rate. Therefore, if the recent rally in the Dollar Index is just the first leg of a 12-month or longer upward trend, then we shouldn't be intermediate-term bullish on commodities.

If the Dollar Index has turned higher on an intermediate-term basis then it is going to move a lot higher over the coming 12 months. As a minimum it would rise to the mid-90s and could even make it to triple digits. We can't rule out this possibility, but we don't view it as the most likely outcome. It's still more likely, we think, that a strong anti-euro sentiment swing has catapulted the Dollar Index up to the vicinity of major resistance and brought about a final capitulation in the commodity markets, and that a multi-month swing in the opposite direction will soon get underway.

Updates 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