The linchpin of today’s reckoning is this little headline in the Financial Times:
“Investors increase bets on US rate rise.”
Anticipating a rise in rates, rather than another cut, investors sold gold, bonds, and oil. The black goo lost $4 a barrel. Gold got slammed for a $23 loss, while yields on 10-year Treasury Notes rose over 4% (yields rise as prices fall).
Why would the Fed put rates up? Ah…that’s our story for today. It’s a story of numbskullery, tomfoolery, and chicanery…of vigilantes and blazing saddles…of war and forgetting. In short…it’s a typical financial tale, where nothing goes as hoped for…and everything goes as it should.
Let us back up.
Last year, we were writing about a ‘battle’ between inflation and deflation. The markets were deflating…but the feds were inflating. Who was going to win?
Actually, it was a mixed-up, woebegone war…with casualties all over the place and the average American household caught in the crossfire. The poor lumpenconsumer has been taking incoming from both sides for more than a year. His house sustained a direct hit from deflation. Then, his income got whacked by shrapnel from the dollar’s blowup.
Meanwhile, inflation blasts him with higher costs for just about everything – notably the essentials, fuel and food. What can he do but keep his head down?
And pity the poor guy who was lured out to a distant, new suburb by a big, new house with a big subprime mortgage! Now, he’s got to pay $4 a gallon to drive to work, while his house payment goes up and his house value goes down.
Naturally, the feds rushed to help the guy. His real problem was that he had too much credit…but didn’t stop them; they tried to give him more.
Still, when a bubble pops, it is almost impossible to pump it up again.
Henry Kissinger explains why in today’s International Herald Tribune:
“…the role of speculative capital has magnified. For speculative capital, nimbleness is the essential attribute. Rushing in when it sees and opportunity and heading for the exit at the first sign of trouble…”
Speculative capital is what the Feds create when they lend money below the inflation rate. It does not go out and invest in long term projects like steel mills. Instead, it looks for the hot, rising market…the one that will give it a quick payoff. The guy with the big house and the subprime mortgage was not really buying a house…he never paid for it. He was just speculating.
And now his speculation has gone bad…and all the Fed’s hot air goes into a new bubble. When the tech stock bubble popped, for example, the next big thing was a bubble in housing and housing-related debt. When the housing and subprime bubbles popped we guessed that the authorities would pump hard to try to reflate them…but that the Fed’s inflation would go into new bubbles – in commodities, oil, and gold. So far, so good. Oil slid up past $135. Gold shot up over $1,000. And food? Food prices are so high they’ve set off riots all over the world. The OECD says high food prices are here to stay. And farmers in Argentina are setting up roadblocks, again, to try to starve the capital into submission.
Getting back to oil…British truckers clogged up London earlier this week, demanding relief from high fuel taxes; truckers in Marseille shoved against riot police…again, complaining about the high cost of diesel fuel, which is running about $9 a gallon in France. We’re pleased to report than no mobs are forming to demand cheaper gold…but surely some bubble is in the yellow metal is bound to inflate sooner or later.
At the heart of the discontent is a very new, very disturbing, and very predictable fact: these new bubbles are not nearly as nice as the old ones.
*** The bubble in residential property made people feel good. They thought they were wealthy and thought they could ‘take out’ a little of that wealth and spend it. A bubble in oil is an entirely different matter. It makes people feel poorer every time they fill up their gas tank. And it forces them to cut back on spending rather than increase it.
Earlier this week we reported an historic downturn in Americans’ driving habits. For the first time since the ’40s, they’re seeing considerably less of the U.S.A. in their Chevrolets. This morning, comes this headline from Bloomberg:
“Sears posts net loss as consumers slow spending on clothing.”
They’re spending less on imports too – bringing the U.S. trade deficit to a 5-year low.
Remarkably, despite these huge victories for the forces of deflation, the U.S. economy is still growing and the stock market is not falling apart. The latest numbers from Washington tell us that GDP grew 0.9% in the last quarter, rather than the 0.6% previously reported. Knowing how the Labor Department suborns its numbers, however, we would want a good cross-examination before we believe them.
After the Fed intervened to save Bear Stearns, it looked for a while as if they had done the trick – as if they had succeeded in re-inflating the bubble in the financial industry. After the panic, the bank index rallied 22%. But now it’s given up almost all that gain. Banks are about 40% down from their high…amid talk of more pain and suffering in the industry. Wall Street, for example, said it had more layoffs coming later in the year.
Instead of pumping up the bubble it wanted…the Fed pumped up a bubble with a chip on its shoulder. A higher oil price doesn’t have the same agreeable effects as a higher house price. As we explained yesterday, we now have a group of “crude oil vigilantes” who race to buy oil in response to the Fed’s loose money policies. Then, higher priced energy hits the economy like an exterminating devil…it drives up prices for everything, effectively preventing the Fed from further inflating.
That’s what that headline in the FT is about; investors are betting that the Fed is going to change course…that with the economy still growing, it is going over to the other side…that it is going to turn its guns on inflation, rather than deflation.
There are three “vicious cycles” that the U.S. economy must face, former treasury secretary Larry Summers told the Financial Times . The first is a liquidity cycle, a kind of wash cycle in which unreasonably high asset prices are laundered out of the system… People are forced to sell…thereby sending prices down further. The second is a “Keynesian cycle,” in which a slump in the economy rinses out the habits of the bubble period. People begin to spend less…and save more. This, in turn, gives rise to the spin cycle – where, as we imagine it, people get dizzy and depressed because their incomes are going down; they can’t borrow; their costs are rising; and they’re getting poorer.
Where are we in these cycles? Probably only at the middle of the first cycle. Housing and finance have gone down. They probably have further to go. We have seen a foreshadowing of the second cycle too – people are not spending as freely as they did 18 months ago; consumer confidence is falling.
But wait…we’re not finished…
If the Fed really is going to reverse course and begin raising rates, we need to ask some questions:
Aren’t the bubbles in oil, commodities and gold going to pop?
Isn’t our Trade of the Decade (long gold, short stocks) going to go bad?
And how about the dollar? When Volcker came in and raised rates in the early ’80s, the dollar rose to a new high…while gold went into a 20-year bear market.
We remember those years.
“We have been a gold bug for the last 28 years,” we told a fund manager recently. “Only the last 8 of those years have been happy ones.”
Are we gold bugs doomed to another two decades of misery?
Anything is possible, of course. But we don’t see anything like the situation that greeted Paul Volcker in the late ’70s…and we don’t see anyone like Paul Volcker at the Fed either.
*** And speaking of former Fed chiefs, we mentioned that Short Fuse and Addison met the Maestro himself this past Wednesday, to interview him for I.O.U.S.A.
“Is it fair to say that Fed policy has had a dramatic impact on the nation’s savings rate?” was one of the things they wanted to pick Greenspan’s brain about.
“We paraphrase the rest of his response from memory,” says Addison. “In an era of low interest rates, the nation’s savings rate has been abnormally low, as well. Rather than save a portion of their incomes at low interest rates, Americans have opted to divert a portion of their income into their 401(k)s and homes. As capital gains from these two assets classes slow down, Dr. Greenspan expects the traditional “savings rate” to tick back up… as a larger portion of incomes are diverted back into savings accounts.
“He added, in the face of the dire fiscal policy of the federal government, there’s only so much monetary policy can do to shore up the currency in which people are trying to save.”
While Dr. Greenspan’s time was very tight Wednesday morning, he gave the film team an extra ten minutes – and even posed for a picture. Right away, we noticed some similarities between this photo and a TIME magazine cover. What do you think?
Short Fuse and Addison assure us there will be more to come from this interview. Stay tuned.