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Today's Market WrapUp |
Reigniting Inflation
Two weeks ago several Fed governors including the “G” man gave speeches alerting the financial markets as to their future intentions. The gist of those three speeches [See Fed Archives] is expressed in the words of Fed governor Ben S. Bernanke when he said that the Fed would “take what ever means necessary” to prevent deflation. The Fed governor along with the “G”-man said the Fed still had ample tools available to work with, even if interest rates go to zero. The implication was that the Fed would intervene in the financial markets by buying assets to prop up their prices or keep interest rates within a narrow range. When discussing these additional tools, Bernanke said,
“So what then might the Fed do if its target interest rate, the overnight federal funds rate fell to zero? One relatively straightforward extension of current procedures would be to stimulate spending by lowering interest rates further along the Treasury term structure—that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term interest rates, which are complimentary and could be employed separately or in combination. One approach …would be for the Fed to commit to holding the overnight rate at zero for some specified period. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yield.”
In addition to buying government bonds, Bernanke said,
“The Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of the US government.” Bernanke cautioned that the Fed would leave the dollar policy in the hands of the Treasury. However, Bernanke mentioned the possibility of dollar intervention as well by stating, “Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, [then why mention it?] it’s worth noting that there have been times when the exchange rate policy has been an effective weapon against deflation.”
He further explained the Fed’s intentions with,
“What has this to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology called a printing press [or today, its electronic equivalent] that allows it to produce as many U.S. dollars as it wishes at essentially no cost. [no cost to the Fed, but paid for by the people in depreciable currency value] By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can reduce the value of a dollar in terms of goods and services, which is equivalent to raising prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
Bernanke then goes on to state that those who feel the Fed is pushing on a string when rates fall to zero and that the Fed has lost its efficacy to stimulate aggregate demand are mistaken. He gave a parable of what he means with the following,
“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. [Keynesian reasoning] A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his intervention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.”
Transparent Intentions and Interventions
This November 21, 2002 speech given by Governor Ben Bernanke, I believe, is the key of what is about to transpire in the financial markets. The Fed is in fact being transparent in letting the financial markets know what it is up to. It is one reason why famed bond manager Bill Gross has said the bond market rally is over. The reason is that Gross believes the Fed and the Administration will do all that is within their power to thwart deflation with every weapon at their disposal. They will run huge government deficits. They will try to keep rates pegged. Fiscal spending and stimulus packages will abound. The deficits of the 80’s will pale by comparison. Companies, citizens and investors are calling for the President and Congress to do something. After the gluttonous debt and spending orgy of the 90’s, no one wants to experience a hangover, So do something dam#*$! Who cares about the consequences -- we just don’t want any pain. The title of Bernanke’s speech, “Deflation: Making Sure 'It' Doesn’t Happen Here" echoes a famous line, “Damn the martinis, full speed ahead and don’t give up the ship.”
So there you have it. The Fed is telling the financial markets that interventions will rule the day. The U.S. is about to embark on another Grand Experiment. Welcome to the new world of John Law in the 21st Century.
The U. S. Dollar is a Key Indicator
The one thing that should become obvious is the current position of the U.S. dollar. Devaluing the dollar does a number of things, at least temporarily. It makes the price of imports go up. This action, in the Fed’s collective mind, may thwart some of the deflationary effects of China’s deflationary exports. If foreign prices rise, it could help restore pricing power with domestic manufacturers. Rising overseas prices would also theoretically reduce the U.S. trade deficits, so you can see where the Fed is heading with this. If the U.S. devalues its currency, then other nations would be forced to do so as well. Japan wants to see its currency drop to 150 yen to the dollar. Japan’s Trade and Industry minister, Seiji Murata, indicated the Japanese government may allow the yen to weaken further after its fall to 125 yen to the dollar. Other nations might follow and we may end up again like we did in the 1930’s. Nations would follow a “beggar thy neighbor” policy of competing currency devaluations. The trouble is with all governments inflating and printing unlimited amounts of money, the financial markets should be prepared for many unpleasant things to happen -- an approaching war being one of them. The Frenchman Frederick Bastiat once commented, “When goods don’t cross borders, armies do.”
Fiscal Stimulus & Spending Programs Coming Our Way
In addition to market interventions, the government is also planning a massive fiscal stimulus program of new tax cuts and spending programs. We have recently arrived at the point where our trade deficits are now approaching $500 billion a year. Government deficits should head back in the very same direction, especially if a war erupts in the Middle East with Iraq. The U.S. is ready to cite Iraq with a breach of UN resolutions by Iraq’s failure to supply undisclosed locations of biological weapons. In addition to fiscal stimulus in the form of new tax cuts and spending programs, the cost of war may and another another $100-200 billion to the government’s budget. An occupation force in the Middle East to maintain the territorial integrity in Iraq will become a necessity. The U.S. and Europe is already being called upon to fund a new 70,000-force army in Afghanistan in an effort to maintain order.
It may not have dawned on the general public, but the world is in the process of remilitarization again. Middle East countries are acquiring weapons of mass destruction and expanding their military budgets. In Asia the largest naval expansion in history is taking place as each country races to rebuild its naval forces against the hegemonic ambitions of China. China is in the process of expanding its blue water navy and its naval bases from its coastal areas all along oil routes from the Persian Gulf. The U.S. military budget will be expanded to meet these new challenges. Like the 1930’s, the world finds itself once again at war. War is great consumer of resources.
States Facing Fiscal Crises
There are other reasons that the government will fight deflation with every means necessary. State budgets are in deep trouble. California, New York, Massachusetts are running large deficits. The state of Massachusetts is facing its worst fiscal crisis since the 30’s. Not since World War II have states been in this bad of a fiscal situation according to the nationals Governors Association. Tax revenues are down everywhere. In Massachusetts, they fell by 10.4 percent and in California we are experiencing our second consecutive year of $20 billion plus deficits. People are losing their jobs, which reduces tax revenues; while states reduce spendable income by raising taxes in return.
According to Standard of Living Committee, more federal taxes were taken from citizens than the growth of personal income. From 2000-2001 GPI grew by$279.5 billion; while federal tax revenues grew by $298.6 billion. The consumer taking on more debt makes up the difference. The Fed and banking system is only too willing to oblige. Thank heavens for the American consumers' willingness to go deeper into debt to fund housing purchases or borrow equity out of their homes to finance consumption. According to the National Mortgage News, residential originators funded a record breaking $729 billion in home mortgages in Q3 and are set to come close to $2.5 trillion this year. This surpasses last year’s record of $2.066 trillion.
So what is the bottom line?
It is inflate or die. The Fed will intervene in all of the financial markets, monetizing whatever it thinks is necessary. They will buy stocks, bonds, gold mines, currencies, or foreign bonds -- whatever they think the financial recipe requires. For those who live under the delusion that we operate under free market conditions, a study of Fed research papers, speeches and market action should dispel any of these delusions.
The question is will this work? In order for Fed credit and monetary stimulus to work, you need a willing lender and a willing borrower. So far we still have both. Banks may be unwilling to lend to businesses, but they are more than willing to lend to consumers, especially when it comes to housing. We also continue have a consumer who is willing to go deeper into debt to buy bigger homes or tap into their home equity to fund consumption. The Grand Experiment continues. I would suggest buying gold and silver while you can in order to protect yourself from the alchemists at the Fed, just in case they create another monetary Frankenstein.
Today's Market
Back at the casino, stocks fell again today. The Dow and the S&P 500 fell for the fifth consecutive day. Losses this week may put an end to the Dow’s eight-week winning streak. Major indexes fell on news that United Airlines may file for bankruptcy. This impacted the shares of related companies such as Boeing, Honeywell, GE, and United Technologies. All four companies make planes or parts for planes. Volume slowed down today ahead of tomorrow's unemployment number. Volume came in at 1.24 billion on the NYSE with 408.5 million shares changing hands in the final hour of trading. Three stocks fell for every two that rose on both the NYSE and the NASDAQ. It was the second day of distribution this week. Retail stocks got hammered as result of many retailers reporting slower than expected sales. The VIX jumped 2.14 to 34.28 and the VXN rose slightly by .61 to 54.16.
Major indexes have all failed to breach key resistance levels. The Dow has fallen below last week’s intra-day high of 8680. It appears that major indexes are falling back to their 50-day moving average line. This is key since many technical trading programs operate around moving average numbers. Many stocks in the tech area such as IBM and Intel are showing signs of breaking down. While techs and retailers are showing signs of weakness, it appears that money is rotating back into “things”. Gold, silver, oil and natural gas stocks are doing well with upmoves in the XOI, XAU, and the HUI. Gold and energy may be signaling what is to come. We now have strikes in Venezuela, an impending war, and a Fed hell bent on burning the currency. We certainly live in interesting times.