Craig Steiner, u.s.
Common Sense American Conservatism
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The markets, especially the stock market, have had a solid bull run since their lows in March. Mortgage rates and U.S. Government Bond yields have defied the expectations of many (myself included) by staying low far longer than many of us have expected.
I'm increasingly concerned that there will be a significant correction sometime between now and the end of April 2010. The fact that the markets have rallied so strongly may only make this correction all the more painful.
And it seems that a growing number of people are reaching the same conclusion--if not predicting the specific time frame I am, they're at least predicting what is increasingly looking like an inevitable correction.
In reality, there's not really much good news out there that justifies a 60% run-up in the stock market. A brief look at some of the problems:
Problem: Devaluing Dollar
The dollar has been on a downward trend for most of the year. The excuse the entire time has been that while last fall we had a "flight to safety" with people moving their investments into the safety of dollars-based investments, we now have the opposite happening: people are more willing to take risks overseas so they are moving out of dollars to invest elsewhere. This leads to a devaluation of the dollar. Maybe.
However, it would be naive to ignore the reckless monetary policy that the Federal Reserve is engaging in combined with the unsustainable fiscal policy the Federal Government is engaging in--the Federal Reserve has flooded the economy with trillions in new money while the Federal Government is busy running trillion-dollar deficits. While it's possible everyone is just moving their investments overseas to take more risk elsewhere, it's at least as likely that people are seeing the dollar as risky and are abandoning it. With the value continuing to plummet against major currencies, any dollar-based investment has to make even more money for the foreign investor just to break even.
And the dollar has lost 15% of its value since March. China currently holds approximately $1.6 trillion in dollar-based assets which means it has effectively lost $240 billion in the last seven months due to the devaluation of the dollar. No wonder China, in March of this year, called for a new global reserve currency to replace the dollar.
Problem: Appreciating Gold
As the value of the dollar has continued to fall, the value of gold in dollar-terms has increased. This is not surprising since gold usually moves in opposite directions as the dollar. As the dollar loses value, it takes more dollars to buy the same amount of gold--so the nominal price of gold increases.
Additionally, gold is generally considered a hedge against significant inflation. With the Federal Government and the Federal Reserve pumping trillions of new money into circulation, fewer and fewer people are accepting the Federal Reserve's official line that discounts the possibility of inflation. Simply, you don't pump this much money into the economy and not have inflation eventually. So investors are hedging against inflation by buying gold.
However, it's not just individuals and private investors that are buying gold. It would appear that the central banks of other countries are starting to do so. Two weeks ago the Central Bank of India bought 200 tons of gold from the IMF in order to "diversify its foreign-exchange reserves." That is, India doesn't want all its foreign-exchange eggs in a single dollar basket. This is not surprising since India also joined China, Russia, and Brazil in pushing for a non-dollar reserve currency. Since an alternative reserve currency has not been established and India is not comfortable with dollars, it would appear that it's simply buying gold instead.
And as I wrote this article, it's reported that now Mauritius's central bank has bought 2 tons of gold. What countries are going to start divesting out of dollars and into gold in the coming weeks and months?
Keep in mind that gold is really not a profitable investment. It doesn't pay interest. It doesn't pay dividends. And, over the long term, it doesn't really appreciate much in real value. Rather it is a store of value.
The fact that individuals, private investors, and central banks are choosing to park their money in gold rather than invest their money in dollars suggests that the price of gold will probably continue to increase and reinforces the argument in the previous section that investors aren't leaving the dollar for riskier investments... they're leaving the risky investment that is the dollar. They'd rather park their money in gold and earn no interest than risk their assets to a devaluing dollar.
Problem: Foreign Banks Buying Gold, Not U.S. Bonds
Related to the appreciating value of gold is the fact that every dollar foreign central banks use to buy gold is a dollar they don't use to buy U.S. Government Bonds.
That wouldn't be a problem if the government wasn't running $1.5-trillion annual deficits. But it is. And in order to borrow $1.5 trillion per year, the money either has to be borrowed from someone or printed. The Federal Reserve supposedly ended its $300 billion Treasury-buying (money-printing) program which means , in theory, the Federal Reserve is no longer printing new money in order to finance the deficit (though we'll have to see how long that lasts).
While it's good the Federal Reserve isn't printing money to finance the deficit, that means the U.S. Government depends on investors and central banks to loan it money. So when India and Mauritius (and probably other countries in the future) use their money to buy gold instead, that's suggesting that a significant amount of money is not being spent to buy U.S. bonds.
In the future, the U.S. will most likely run into trouble when it comes to its capacity to raise funds to finance the deficit. This will either lead to the government being forced to cut spending and services, increase taxes, or have the Federal Reserve print more money which leads to its own set of problems.
Problem: Growth Is From Government Spending
Another serious problem is that while the third quarter apparently resulted in a 3.5% growth of GDP , that was largely due to government stimulus spending, the now-expired clash-for-clunkers, and a possibly bubble-inflating homebuyer's tax credit.
The fact that the government needs to artificially inflate the housing market with this tax credit, at a total expected deficit-increasing cost of $19.3 billion , indicates that the government knows that the housing market can't fly on its own.
The result of this tax credit is that, once again, people that can't really afford to buy a home are being enticed into doing so by the government distorting the market with this tax credit. These same people are further being enticed into buying a home by interest rates that are being distorted by the Federal Reserve's efforts to keep interest rates low. And this is happening at a time of rising unemployment where, all things being equal, potential buyers are at higher risk than usual of not being able to pay back their mortgage since they could easily lose their job.
Between the Federal Government paying for some of a homebuyer's house and the Federal Reserve pushing interest rates down with printed money, we're effectively looking at the government making a concerted effort to inflate the housing bubble that already popped. Do we really want to artificially inflate that bubble again?
Problem: More Asset Bubbles
In addition to the real estate bubble that we're apparently trying to re-inflate, it seems that we may be creating other asset bubbles.
With U.S. Government policies pumping so much cheap money into the economy, investors are borrowing this money in the U.S. and investing that money overseas. This is called a "carry trade."
For example, if you can borrow $1000 at 3% in the U.S., convert that money into 700 Euros (0.70 Euros per dollar), and invest it in some European endeavor that pays 6%, then in one year you'll have approximately 742 Euros. If the value of the dollar has dropped another 20% (now 0.56 Euros per dollar) then your 742 Euros is now worth $1,325. You pay back the $1030 you owe and you've made a profit of $295.
You'll have made 29.5% profit in one year by taking money out of the U.S. and investing it elsewhere. You haven't helped the U.S. economy in any meaningful way but have helped drive the market in Europe--but did your investment help Europe? Perhaps. But if you only made that investment because you were enticed by the cheap money then you very well may be just helping run up a bubble in the European market.
And the problem is that other countries are now complaining about precisely that.
Hong Kong has expressed concern that the trillions of dollars of cheap money flowing from the U.S. has contributed to a 40% rise in real estate prices and 50% rise in the stock market in the last year. "So there is the potential risk of an asset bubble"
Our own stock market, which has rallied 60% in the last 8 months, is also most likely being driven by a lot of cheap money being invested in the stock market combined with a dollar that is worth less and less. Just like gold, if the dollar is worth less the stock market should rise because it takes more dollars to buy the same portion of a company.
Which raises the question: Is the 60% rally in the stock market this year really a rally, or is it a combination of the dollar losing value and cheap interest rates fueling another bubble in the stock market?
Against this questionable economic backdrop, many are concluding that the driving force behind the ongoing demand for risky assets now lies solely with the massive injections of liquidity that the Fed and other central banks have maintained this year. There is too much money chasing too few options, they say.
Problem: Unsustainable Government Borrowing & Spending
It goes without saying that the Federal Government is engaged in unprecedented and unsustainable borrowing and spending. The federal deficit tripled from FY2008 to FY2009. The total national debt is now growing by over $1.5 trillion per year.
This creates three problems:
Possible Upcoming Triggers For the Other Shoe
All of the problems mentioned above are significant and any of them could explode into significant problems at any time. But there are two issues between now and the end of April 2010 that could possibly trigger a significant pullback in the economy and markets:
Of course, these are just theories. And even if the theories are right it's entirely possible that the Obama Administration will just double down on their policies and kick the can further down the road. They may extend the homebuyer's tax credit again. The Federal Reserve may start printing money by buying U.S. Treasury's again. And the Federal Reserve may extend the MBS purchase-program further again. Any of these actions would help avoid a correction in the short-term.
St. Louis Fed President James Bullard set up world markets for an opening rally when he told Dow Jones Newswires on Sunday that he believes the Fed should continue its asset purchases program - often called "quantitative easing" - for as long as its benchmark rate stays near zero. The policy-setting Federal Open Market Committee had previously signaled it would soon begin paring back its purchases of mortgages and Treasurys.
So we may, in fact, be looking at the Fed and U.S. Government simply kicking the can down the road as long as it can.
Update 12/28/2009: A month after writing the article, others are drawing the same potential conclusion:
"Things don't look too bad for the next 6 to 12 months," he said. "But there is an argument that the Fed and government engineered a stop-gap measure to save the economy and delayed the inevitable. There is a potential for debasing the currency."
Update 2/24/2010: Three months after writing this article, Federal Reserve Chairman Bernanke is now hinting at the possibility of extending the MBS purchasing program.
In testimony prepared for the House Financial Services Committee, Bernanke left the door open to further purchases of mortgage backed securities and agency debt beyond March, and in response to questions from committee members, he said the Fed would also be evaluating whether it should extend its financing of new commercial mortgage backed securities past June...
But all of these approaches are just duct tape on a leaking dam. It's not going to hold back the flood forever. And the longer we keep trying to patch this economic dam with duct tape, the more "water" will build up behind it and the resulting disaster will only be more catastrophic when it finally happens.
Obviously the administration is hoping that all of these dangerous economic plans will bring the economy back to life before the other shoe drops.
We better all hope they're right.
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