“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” [emphasis added]
— Ludwig von Mises, Human Action
At the beginning of last week I posted a LinkedIn video about an interview on 60 minutes given by Fed Chairman Jerome Powell, and I wanted to discuss that a little more. But I’ve changed my mind. The decision announcement last week and his following press conference are so dramatically important that it needs to be discussed with high priority. If you expect to at least maintain your standard of living or enrich it, you’ll want to pay attention to what is happening now more than ever.
It’s important to either listen to the 7 minutes press conference prepared remarks, or to read the separate releases found here, here, and here. If you’d rather watch or listen to the full press conference, including the prepared remarks, you can find that here. Mr. Powell speaks in very clear language that is easy to understand, even if you are not accustomed to economic terminology. He doesn’t use too much technical language during the press conference, but what he does use is very self explanatory, such as “household confidence”, “consumer confidence”, and “financial stability”.
One thing that he said, perhaps in a lucid moment, is that deficits and debt can’t grow faster than the economy indefinitely, as they are now, and it is something that needs to be addressed over time. He concluded that statement saying that he doesn’t see a credit crisis on the horizon and there is no need to try to predict one forthcoming. The first part of his statement is 100% true. However, that he thinks it is not problematic, is in itself, well, problematic. Regular readers know what I think about $22 Trillion of bonded debt and trillion dollar annual deficits. And the biggest clue you have that something could be on the horizon is when government officials categorically deny the possibility. But that’s not what I want to get at now.
Press Conference Takeaways
Powell’s prepared remarks as well as his answers during the Q&A should raise more than just a few eyebrows. The important takeaways are as follows. First is that the Fed will not be dovish enough, and it won’t come fast enough. And by dovish we mean that the Fed will lower interest rates, buy treasuries and other assets, give bailouts, or engage in other policy maneuvers to help money flow more quickly and fluidly through the economy. The Fed will be behind the curve. Any moves it makes will be reactionary rather than proactive, and they will come too little too late, like a firefighter coming to douse the flames after the house already burned down.
The second takeaway is that the Fed was expected to go to just one more rate hike by the end of the year, down from two, and instead it went to zero hikes this year. And I am telling you now that what is most likely to happen is that not only will the Fed refrain from any more rate hikes this year, but that it will rather go back to rate cuts before the year is out. This decision of no more hikes this year is pretty remarkable, especially because we’re only in March! Last year we thought it would be three hikes this year, the beginning of this year we thought it would be two hikes, and now just 2.5 months in, we’re not getting any more hikes for the remainder of the year. How fast that policy has gone from Mach 1 to sitting on the tarmac!
I too was expecting to get hikes this year, at least one and maybe two. That changed in October when the Fed started reversing its public language in interviews and official statements. From that time I wasn’t expecting any more hikes this year, and now Powell has confirmed it.
The third takeaway, and more important is that the Fed is going to end its asset sale program by September, just six months from now, and they will begin tapering off those sales immediately. Remember that this whole program started 10 years ago with only $800 billion of assets on the Fed balance sheet. It is ending with over $3.5 trillion. If the whole policy worked as they want us to believe, the Fed should close out the program with $800 billion or less, not over $3.5 trillion.
Remember that selling its assets has the same effect as raising the target rate, which means interest rates go up. What this means is that rates are not going back to normal…6–7% on the ten year treasury and over 5% on the Fed Target Rate. This will never happen unless we get serious monetary policy reform, and that won’t happen until the rest of the world forces the United States to do so, which is going to happen when the dollar collapses…meaning we’ll have an entirely new monetary system. It’s entirely possible; it has happened four times in the last 106 years right here in the United States.
The outcome of this major shift in policy will be a very long and painful recession, and the salt in the wound will be stagflation. The rug has been pulled out from the deflationary environment on assets and the economic stimulus is gone, between the effect of tax cuts and monetary policy and continued tariffs on Chinese goods. We’ll see a stagnant or shrinking economy combined with inflationary pressure on commodities like oil, lumber, pork bellies, and more, and in addition the trade war with China will not likely be resolved any time soon. That will keep elevated prices on imported goods in the mix for some time. This is a recipe for complete and utter disaster, and you better be prepared to endure because the Fed is now ready to destroy the economy as well as our entire monetary world order.
To summarize, 1) the Fed will not act strongly or quickly enough, 2) not only will we have no more rate hikes this year as Powell said, but we are more likely to have rate cuts before the year is out, and 3) asset sales are being tapered through September when they will end, leaving the Fed’s balance sheet at over $3.5T, but that will soon begin to increase once again with another, very large round of quantitative easing that will leave the Fed balance sheet more than double what it is now and our national debt over $30T. Regarding my last point, that is likely to happen before the end of Trump’s first term comes to a conclusion.
This chart above shows the current yield curve, as of March 26, 2019. Below the chart, I have the number of months on the top line and the yield beneath, so the ten year treasury bond is 120 months and 2.41%. You can find all this data at the Treasury website. The blue line in the chart with the corresponding numbers is the actual yield curve, whereas the green line is what we expect it to look like in a strong economy. The red line represents a completely inverted yield curve.
As a refresher, we want to see an inclining yield curve where the shorter the duration of the bond, the lower the interest rate. The longer the duration, the higher the rate. The difference in the yield between the 10 year (120 months) and the two year (24 months) is the spread that we typically look at to gauge the overall health of the banking system and economy. In a strong economy we want to see the 10 year bond yielding 2.50% to 3.00% higher than the two year note. Right now the yield on the 10 year is only 0.17% higher than the two year.
The problem with this is that banks like to borrow money towards the shorter durations of the yield curve, then turn around and lend it back out to individuals and businesses towards the longer durations of the curve. But it’s not the duration that matters, it’s what they pay for money versus what they earn on the money.
As the yield curve flattens out and eventually inverts, banks are less and less likely to lend. They see it as too risky to lend with such a narrow spread between their cost and their profit.
To understand it more easily, let’s imagine that you can buy a brand new smart phone, we’ll call it version X, for $100 each, and you know you can sell it for $1000 on eBay or Amazon. Sounds like a pretty nice deal, and you’ll buy as many as you can knowing you’ll earn $900 every time someone bites into your fruit. In fact, you’ll probably borrow a Mac truck and load as many phones as you can into it.
But what happens if the price you pay suddenly goes to $500, and you can still sell it for only $1000? If it’s me I’ll still buy as many as I can. But what if the price of that smart phone suddenly rises to $983, and you can still sell it for only $1000? What if your price is $1000 both to buy and sell? How about if the price you pay is $1100, and you can still sell it for $1000? As your cost rises, you will buy less and less until you won’t do it at all because you are either sure to lose money on every phone, or there is just too much risk of losing money if the phones don’t sell.
It is the same for banks, except they don’t want to sell smart phones. They want to sell you money. If it costs the bank more money than they can make, or the risk is too high that it will cost more, they just don’t lend. The big issue with this is when banks stop lending it is likened to your car engine running out of motor oil. Lending is to the economy just as motor oil is to your car engine. Without it, everything comes to a standstill. And this is where we are at in the economy with a yield curve that is partially inverted.
In addition to the yield curve now in the process of inverting, rising interest rates over the last 3 years have drained additional liquidity out of the banking system. That happened because anyone with a variable rate loan is now paying a higher interest rate than two years ago. Same for refinancing loans. Same for taking out new loans. And it applies to both individuals and households as well as businesses.
The impact of higher interest rates is that it takes additional money out of your wallet to pay for the loan, leaving you with less to spend on all kinds of stuff that you need and want. Same goes for businesses, except higher interest rates means businesses are less likely to hire more people, open more locations, spend on research and development, expand new product lines, and invest in new training, plants, and equipment.
In fact, this is exactly what we have seen going on over the last 2–3 years. We know that auto sales are falling and there are now over 7 million auto loans in default. We know that student loans total over $1.6T, and if not for forbearance or deferment, 25% of those loans would also be in default. Even if you don’t include deferrals and forbearance, 11% of loans are in default. Remarkably, home loan defaults are still falling. Yet several organizations that watch housing all report similar figures regarding housing permits and housing starts, refinance applications, new home purchase applications, total sales, etc. Zero Hedge posted a good summary of starts/permits right here. And consumer credit defaults are once again rising, as seen here, and here under farmland, credit cards, and other.
The other big drain on liquidity until now has been asset sales by the Fed. Every time the Fed sells a bond for $1000, that means $1000 less will be in that person’s pocket to spend in the economy. And it’s not like the Fed is spending to make up the difference. The Fed takes your cash and just leaves it in a vault uncirculated.
Bond Market Mistakes
With the yield curve almost fully inverted, the bond vigilantes are right to call out the fundamentals on the economy. We’re not in good shape and despite what the stock market and government want to fool you into believing, we really haven’t fully recovered from the Great Recession. And the talking heads on CNBC, Fox Business, CNN Money, Yahoo Finance, all of them…they all want you to buy the stock market now because they are trying to sell. We can see it clearly in the technical indicators. Institutions are bailing out. Don’t believe their hype either.
Contrary to what you think you are seeing, the first thing to notice here is that the February budget deficit was $234 billion. That’s the largest monthly deficit ever for February. This means that in the depths of the Great Recession headed into Spring 2009, no budget deficit was higher than now. And I know what you could be thinking…well Trump cut taxes but didn’t cut spending except the recent announcement to cut $18 million to the Special Olympics. On the one hand every little bit adds up, but on the other it was a real jerky move. Regardless of it being cruel, the tax cuts didn’t spur the amount of growth that was expected (4Q18 GDP growth was just revised down to 2.2%, and the current quarter is expected to be 0.4% by the Atlanta Fed and 0.9% on average on Wall Street). And the increased tax revenue didn’t materialize either.
This monthly deficit is just the tip of the iceberg, and if it’s this high now, just wait until the economy is recognizably in recession. Then the government will step in because the government can’t resist doing something, no matter how bad the idea is. The Fed just won’t be able to sustain unloading bonds at the same time as Treasury is trying to make up these huge budget deficits, and in fact that is probably why the Fed announced a taper and halt to bond sales. Treasury is now raising cash at a pace of over $2T annually, and for the Fed to dump additional bonds into the market makes for one hell of debasement of the dollar.
To put this monthly budget deficit in perspective, consider that the annual deficit for Bush in 2002 was just $158 billion. 2006 was about the same as February this year, coming in at $248 billion. And his worst year before the Great Recession was 2008, when his deficit came in at $459 billion. Obama’s best year was 2015 at $438B, followed by 2014 at $485B. Clinton’s worst year was 2000, when he racked up $236B in debt, and his best year was 1997, with an anemic $22B (that’s about $35B adjusted for inflation).
And that brings me to the second point which is that the longer this budget deficit money printing farce goes on, the greater the national debt will increase. If the Fed can’t normalize interest rates back to over 5% on the target rate and 6%-7% on the ten year treasury, and if the Fed can’t reduce its own balance sheet below $3.5T, all while the economy is supposedly humming along, what do they think will happen when the economy is doing poorly and the Fed balance sheet explodes to $8-$10T or more? What about when the national debt is $40T? The Fed won’t be able to do anything about that, and it is for these reasons that the next crisis will be a dollar confidence crisis, which automatically means a sovereign debt crisis. Eventually markets will figure this out and bail.
And finally, what the bond market really has wrong is that the next recession will be negative for bonds. Bonds will be totally hammered. Remember that during the Great Recession, the entire world went into a downturn, but the dollar was already low. Because of its safe haven & reserve currency status, investors rushed into the dollar, and the dollar rose over 20%.
Bond traders think that a recession means that interest rates will once again fall, which will be good for the price of bonds. And most people also think that a recession with the accompanying attempt to lower interest rates will reduce inflation. They think inflation is a function of economic growth and demand, so if the economy weakens, demand will weaken as well, and inflation will weaken commensurately. Put another way, they mistakenly believe in Philips Curve Capitalism.
This time around though, the dollar is already relatively high compared to other currencies, and because the crisis will be in the dollar itself, the dollar will fall, with support at just 2–3 levels on the way down to a dollar index of 70. 70 is the last level of support on the DXY, and if it breached, there will be severe consequences.
Bond traders don’t realize it yet, but eventually they will when the Fed goes on a printing spree that we haven’t seen since Weimar Germany. This will be a very inflationary recession because when the Fed fully reverses course on policy and goes back to rate cuts and bond purchases combined with helicopter money and bailouts, and possibly negative interest rates and bail-ins, the dollar will tank and prices will skyrocket. At that point no one will believe anymore that these measures are temporary.
The first three times around we were promised it was temporary, just like Richard Nixon promised that closing the gold window was temporary. I guess if 48 years is temporary for the gold window, then 10 years of monetary stimulus is more like a one-and-done. When it comes to making or losing trillions of dollars, Wall Street will understand what temporary versus permanent really means, and easy money policies the world over are not temporary. One and done became two and through, and that became three and free. The next time around will four and more more more. They’ll all have it figured out that the Fed won’t normalize, and that’s when the Fed becomes not just the buyer of last resort, but the buyer of only resort!
The bond market is right that we’re headed for recession, but wrong about where bonds, and the dollar, are heading.
As an aside, what is going on will probably have enormous implications for the election in 2020. If the Fed can hold the economy out long enough, The Teflon Don will likely be reelected. If you are a Democrat you should vote for Joe Biden, the most electable candidate and the one who will have the best chance to defeat Trump. The proposals of the other candidates are just too far to the left and socialist, and no conservative minded person will ever vote for that.
If the economy tanks and is still doing poorly by the time we get to the general election, the Democrats will probably put forth a very socialist candidate like Sanders or Warren, and there is a strong likelihood that middle of the road conservatives will swing left, thinking that capitalism just didn’t work out. The big BUT here is Howard Schultz. He’s running independent, and if the voters like him more than Biden or Trump, he’ll steal votes from the left and Trump will handily defeat all other candidates in a landslide victory.
Here’s the economics/markets part: Regardless of who wins in 2020, it will be more deficit spending and more dollar devaluation. During supposed good times the Trump administration is overspending tax receipts by more than $1T per year. As the economy falters, tax receipts will also fall and deficit spending will have to rise. If a Democrat is elected the deficit spending will be more than what Mr. Trump is spending now. And if a Democrat is elected, the deficit spending and bailouts and QE will be much more than if Trump is in office. Democrats and Republicans both like to spend without abandon; the Republicans are just the less dirty shirt in the hamper.
As noted, Powell said that growing deficit spending faster than the economy can grow is not sustainable and must be dealt with. He’s right. It’s just a matter of time before all of America’s creditors come knocking on the door for repayment. When that day arrives your Treasuries will be worthless.
What You Can Do Now
Here are some bold moves to make now, if it is appropriate and suitable for you, to protect your wealth and prepare for what is coming. And remember that each person’s situation is different so it’s important to consult your financial advisor and do your own due diligence before acting, as some of what I suggest might not be suitable for you.
Speaking of your financial advisor, the first and most important thing to do is call that person and ask, “What will happen with my money if the Fed goes back to quantitative easing, rate cuts, and asset purchases, amongst other policy moves?” The answer you should hear is “I am glad you called, and in fact you are one of the top ten people on my list of calls today. Many of our other clients share your concerns, because it’s very important to know what is happening and what to do. Is tomorrow afternoon good for you, or is Monday morning next week better for us to meet? And your house or my office?” On the other hand, if your financial advisor blows you off in any way, you know that you need a new advisor because the one you are using will prove himself to be nothing more than a salesman. A blow-off means he has no understanding of the very markets you are investing in. And further, most financial services professionals, regardless of the alphabet soup on their business card following their name, they don’t know what to do in a stagflationary environment. It’s been 40 years since we’ve seen serious stagflation, and even advisors who were around then and still manage money for people, they didn’t learn anything the first time around. The only books they read are study manuals for series licensing and sales techniques. They probably haven’t picked up an economics book since college.
The next point, which is very important as well, is if you want to hedge against stock market losses, the best thing to do is NOT to simply short the stock market. It’s very shortsighted if that is your only plan. We will surely see a lot of downside volatility, however, once the Fed begins easing and rate cuts again, the stock market might once again begin to rise in nominal terms. If you’ve shorted the market and it rises, you’re going to lose a lot of money. But because of high rates of inflation the market will not likely keep pace in real terms either. In plain English that means that as fast as the stock market may rise, if you factor in inflation, you may lose because your real ability to buy the stuff you need will not rise as fast.
A better hedge against the stock market would be a multi prong approach of buying gold bullion (not numismatics), buying gold mining companies (and silver too), and using options. Also, because I believe the next crisis will be a dollar confidence crisis, you can diversify into other currencies that will appreciate against the dollar. The currencies to avoid are the Euro, the Swiss Franc, the Japanese Yen, and the British Pound. Currencies that may do well are the Russian Ruble, the Chinese Renminbi (Yuan), the Indian Rupee, and Australian Dollar. The Canadian Dollar may do well against the US Dollar as well.
By the way, if you live in America, you obviously need USD to buy the stuff you need to live and make your mortgage or rent payment. I am not suggesting to eliminate your dollar holdings. Just the opposite, in fact, because as I’ve said and will say again now, a large cash position will do you very well when the opportunities arrive. As an example, would you have liked to have bought Apple (NASDAQ:AAPL) or Starbucks (NASDAQ:SBUX) in March 2009? How about houses for $150K but had a full market value of over $500K? Opportunities like this will abound once again, and you’ll need cash to be able to jump in. Not space to borrow in your margin account, but rather real, hard, cash. Do not use margin because a margin call will crush your dreams of adding an extra zero to the end of your net worth.
You may also choose to hold ultra short term treasuries because anything with 1–3 month maturity will have very little interest rate or price risk. Any bonds that mature in more than 3 months will be too risky. You might include TIPS as well for the inflation protection that is built in, but the reason I don’t like them is because the government sets the inflation rate that TIPS are set against, and the government admittedly fudges the numbers in its own favor using geometric weightings, hedonics, seasonal adjustments, and the like.
Finally, besides precious metals there are other sectors that will fare well, and there are sectors that will crash hard. Financial institutions, banks, and insurance companies will likely crash hard, and we can already see housing and automobile manufacturers not doing well either. Sectors that will do well include noncyclical consumer staples (think toiletries, primary food items, discount wholesale clubs, etc.), utilities, energy (including uranium and midstream), and healthcare.
Always do your own due diligence before making any purchases or sales, and stay patient. You’ll be rewarded.
That’s it for my Fed policy decision commentary. Make sure to leave your comments and questions down below. Thanks for reading this edition of Mad Genius Economics. If you like what I have to say, even just one word, please click on the “follow this author” button and also “like” this article. Remember there is always a bull market somewhere in the world, and on the opposite side of every crisis, there lies opportunity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimers: The contents of this article are solely my opinion, and do not represent neither the opinion of this website nor its owner(s), nor any employer whether by contract or for wages. You are cautioned to do your own research before making any investment decisions of your own. This is neither intended to be, nor should it be construed, as an offer or solicitation to buy or sell securities, or any other investment product or financial instrument available, and it does not constitute an offer to provide any investment services. I reserve the right to act upon my own advice at any time, including in regard to any security, insurance, or investment of any type herein. Contents of this article are not intended to be personal advice to any readers. Readers are encouraged to speak to their personal financial advisor, CPA, or another financial advisory professional before making any investment decisions or before acting on any information contained within.
Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein.