The Bond Markets Vs. Peter Schiff

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 |  Includes: DIA, GLD, IEF, MBB, SPY, UDN, USDU, UUP
by: Shareholders Unite

Summary

Some market observers like Peter Schiff have warned us that many markets and even the whole economy are kept up by asset purchases by the Fed.

So we should expect the recovery to stall, the dollar, stocks and bonds to fall when the Fed stops these purchases.

Not only is this not happening, some of these markets are actually up, like the bond market. So who is right, bonds or Peter Schiff?

Peter Schiff is a popular fund manager, libertarian and proponent of the Austrian School of economics. Some of the core beliefs of the latter:

  • The Fed is usually to blame for economic crisis, which is the result of interest rates being set too low, which leads to overinvestment.

  • In case of an economic crisis, policy should do nothing and let the market do it's "cleansing" work.

Schiff, unlike at least some other Austrians, also believes that:

  • The US should return to the gold standard.

  • Inflation is hugely underreported, and as a consequence, there is no real recovery.

  • The Fed cannot stop with QE.

  • The dollar is going to tank.

  • Gold will soar to $5000.

Let's start with the inflation claims, as these are sort of central to the whole way of thinking:

Inflation is the expansion of the money supply. Quantitative easing is a euphemism for inflation. All the central banks are inflating, that's what they're doing," Schiff notes. "The gold market doesn't care about the CPI [referring to a standardized inflation measure], it cares about real inflation. This is all government propaganda trying to convince us that there's not inflation. [Moneynews]

The definition of inflation is vastly different than what you (or we, for that matter) are taught in university and we don't think it's useful to equate the expansion of the money supply with inflation (to put it mildly). Interviewing Doug Casey on his radio show, Doug argues that inflation is in the 8%-10% range. Schiff responds:

And that makes a lot more sense to me, given what I'm observing in the actual economy. The critics who argue that that's impossible, that the people who think that inflation is more than 2%-3% percent, they say they must be wrong, because that would mean that the economy has not experienced any legitimate economic growth. And to that I would say, absolutely, it hasn't. [ZeroHedge]

Of course if you equate inflation with the money supply (which one, M0, M1, M2, etc.?), rather than the CPI or the GDP deflator, one could argue this a little easier. However, by implication, if inflation is a lot higher than officially reported, economic growth is a lot lower.

This is where libertarianism gets much of its anti-establishment credentials, as for many Americans, the recovery has indeed been weak. We already have been arguing against inflation being higher, let alone much higher than the official statistics (here), so we're not going to repeat that.

However, if you don't believe the official statistics (or us), believe the bond markets. If inflation really is in the 8%-10% range, bond yields make no sense and real interest rates are vastly negative. Why would buyers of bonds buy assets that generate such enormously negative returns?

It's rather curious for someone who so believes in the power of free markets to have such a diametrically opposite view of the markets. Confronted with other predictions (about the gold price), Schiff has reacted in a curious way:

If I say this is going to happen and then it all happens that way, but the markets react differently because they don't really understand what just happened, that was my mistake in overestimating the intelligence of everybody else to figure stuff out [Bloomberg]

And, why would one worry so much about public finances (Schiff was dead set against extending the debt ceiling) when the government can borrow at minus 7% real interest rates?

However, Schiff argues that it's the Fed's asset purchases that underpin both public finances, the bond markets, and the economic recovery:

For six years the Fed has enabled an almost total lack of fiscal discipline. Easy money has forestalled a total collapse without ever allowing any corrective economic action. [Yahoo]

If the latter is more apparent than real and dependent on QE, the Fed cannot really exit without creating a real economic crisis. This is indeed exactly what Schiff argued last year:

I countered by saying that the signs of improvement (most notably rising stock and real estate prices) were simply the direct results of the QE itself and that a removal of the QE would stop the "recovery" dead in its tracks. Despite the Fed surprise, most people still believe that it is itching to pull the taper trigger and that it will do so at its earliest opportunity (although many now concede that it may have to wait until this political mess is resolved). In contrast, I believe we are now stuck in a trap of infinite QE (which is the theme of my Newsletter issued last week). [Realclearmarkets]

The economy is going to continue to deteriorate because of QE," says Schiff. "And, because the economy deteriorates, the Fed will do more QE. So, that's good for the markets but it's bad for the overall economy. [Yahoo]

Without QE to support the markets, in my opinion, the economy will likely slow significantly and the stock and real estate markets will most likely turn sharply downward. [Yahoo]

But now that the Fed has almost withdrawn all asset purchases, we see the opposite of what Schiff has predicted:

  • We don't see a collapse in the bond market; in fact bond yields have gone down, not up.
  • We don't see a collapse in public finances; the public deficit continues to narrow.

  • We don't see an acceleration of an economic downturn; if anything, recent economic figures have been, on the whole, rather benign.

  • We don't see a collapse in the stock or housing market, nor in the dollar.

Click to enlarge

Well, one could argue that the jury is still out as the Fed hasn't yet entirely stopped its asset purchases, but basically all variables are moving in the opposite direction from where Schiff argues they would go, rather than any collapse:

We're going to be the submerging market, because when the dollar tanks, and it's very close to happening, Americans aren't going to be able to buy anything [Moneynews]

Either all these markets know something that Schiff doesn't, or there is something fundamentally wrong with the way he looks at the world. We think the latter, and we've offered an alternative interpretation scheme which we think fits the facts much better.

So if you are:

  • selling or shorting bonds (or bond ETFs, like IEF or MBB)
  • selling or shorting the dollar (or dollar ETFs like UUP, UDN, or USDU)
  • selling or shorting US equities (or ETFs like SPY or DIA)
  • buying gold (or ETFs like GLD)

on the basis of Schiff's (or others of similar persuasion, like Michael Pento) argument that these first three markets cannot stand on their own feet without the Fed's QE and gold is the natural refuge for money printing, we think you're in for a bit of a disappointment, if you aren't already.

We think he has vastly overrated the importance of QE, and by extension the phasing out of it. Most academic research (see here and here from the IMF, for instance) shows that the effects of QE have been rather mild (and positive, at least on variables like economic growth and employment).

The problem starts with the definition equating "money printing" to inflation. QE is neither money printing, nor necessarily inflationary. We explained in our alternative interpretation (linked above) that in an environment of deleveraging, credit demand is low and stuffing banks with cheap reserves (which is what QE does) doesn't necessarily revive it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.