The Hole Truth

Another day, another advance in the Dow…

Other global markets follow…

It all seems so monotonous.

This investing game seems pretty easy after all. Especially when you have the Fed at the wheel…and Obama in the passenger seat.

Fed minutes out last night indicated Bernanke has no intention of halting his US$600 billion debt monetisation program this year, despite a few whimpers of dissent.

That’s just as well because the US Government deficit for the year to September will hit a massive US$1.6 trillion, which is about a US$500 billion increase on last year. Congress creates the debt, the Fed buys it.

As we pointed out to Sound Money. Sound Investments readers yesterday, if anyone thinks the US economy and market is not floating higher entirely on monetary and government stimulus, they’re not paying attention.

Consider these stats for recent and future US fiscal deficits:

  • 2008 deficit $455 billion
  • 2009 deficit $1.42 trillion (stimulus increase of $965 billion)
  • 2010 deficit $1.17 trillion (stimulus decrease of $250 billion)
  • 2011 deficit $1.6 trillion (stimulus increase of $430 billion)
  • 2012 projected deficit $1.1 trillion (stimulus decrease of $500 billion)

Then consider the Federal Reserve’s actions:

QEI, which ran from around March 2009 to March 2010, saw the monetisation of $1.75 trillion in mortgage and treasury debt.

QEII, currently underway, involves the purchase of a further $600 billion in government debt. The program kicked off formally in November 2010 (or informally in late August when Bernanke first hinted he would do it) and will run until June this year.

Now let’s look at how the market reacted to all this. Keep in mind the budget year runs from 1 October to 30 September.

Ok, we all know markets everywhere were going down the toilet in late 2008, early 2009. This was the height of the tempest…the panic liquidation phase…the crash.

But by March 2009, as QEI kicked in and as the massive $965 billion in addition fiscal stimulus began to move through the system, the market took off. It kept going right through to April 2010.

By this time QEI was over and the net contraction in deficit spending ($250 billion in 2010) was having an effect. The stock market party was over. The lack of Fed and deficit induced liquidity saw the market tank from April to August.

Then in late August, amidst increasing talk of the US economy entering a double-dip recession, the Bernank spoke about reviving QE. The market turned on a dime.

It hasn’t looked back since. And along with the benefits of QEII, this year it will enjoy a $430 billion fiscal stimulus benefit.

But what will happen later this year?

QEII ends in June. The 2012 fiscal year will see a $500 billion stimulus reduction.

Will the market fall back into a hole?

Yes it will.

Fiscal and monetary stimulus combined is incredibly powerful. When Congress spends more than it collects, which is something it does with regular monotony, it issues pieces of paper into global capital markets in exchange for cash for spending on unproductive, pet projects.

If the US private sector (business and households) funded the entire deficit, it would not really stimulate the US economy. It would merely shift spending from the private to the public sector.

But foreigners buy a lot of US government debt, and now the Fed does too. Buying by foreigners and the Fed represents additional cash or net new stimulus going into the US economy (because the funds are not taken from elsewhere).

Both the Fed and foreign governments buy US government debt with money that didn’t previously exist. The Fed simply creates additional bank reserves to fund its purchases.

And in a slightly more complex way, so do foreign central banks. The big buyers of US treasuries – the Asian central banks – do so purely to keep their currencies competitive, i.e. low.

If they were simply major buyers of US treasuries because they wanted to invest in them, they would need to sell their domestic currencies to buy US dollars in the FX market. This would push up the relative value of their currencies – and smash their export markets.

So instead of selling existing domestic currency and buying US dollars, these countries print additional domestic currency and use that as the source of their buying. This is how they keep their currencies ‘competitive’.

But in reality it’s all very inflationary. The source of the inflation is the US treasury market. This debt is monetised by the Fed and foreign central banks to keep their export dependent economies afloat.

In the US, the result is asset price inflation. In Asia, its consumer price inflation and that’s why you’re seeing tighter monetary policies across Asia.

This is not good for stock markets across the region. Check out the recent share market performance of most Asian markets, including China and India. It doesn’t look good.

Perhaps this is why the Dow keeps ploughing ahead. Money is flowing back out of these once hot markets.

Whichever way you care to look at it, markets around the world are juiced up on artificial stimulus…and we haven’t even mentioned China’s attempt to replicate the 2003-2007 US private sector credit boom.

But BHP certainly doesn’t seem to mind. Yesterday, the big Australian announced a mind-boggling half-yearly profit of US$10.7 billion. Earnings before interest and tax, usually referred to as operational profit, came in at US$14.8 billion.

The effect of global reflationary policies on the result was massive. Of the US$14.8 billion operational profit, US$8.5 billion was due to higher raw material prices.


Perhaps that’s why the shares sold off on the news. Such a free kick surely isn’t sustainable.

With China and the rest of Asia tightening monetary policy to fight inflation, with QEII set to expire in June and the US deficit to detract from stimulus next year, you really have to wonder where the growth will come from.

More importantly, you have to wonder when markets will ask the same question…


Publisher’s Note: Dan Denning is off DR duties again today. What is he up to? Stockpiling food, if this overnight headline is anything to go by…

World Bank President Robert Zoellick has stated that another 44 million people have been pushed into extreme poverty since last June by high food costs, according to USA Today.

“Global food prices are rising to dangerous levels and threaten tens of millions of poor people around the world,” Zoellick said. “The price hike is already pushing millions of people into poverty, and putting stress on the most vulnerable, who spend more than half of their income on food.”

According to the bank’s food price index, food is 15% more expensive now than it was in October 2010… and 29% more expensive than a year ago.

In countries where people spend as much as 80% of their income on food, a 29% price increase doesn’t mean avoiding restaurants or skipping meat every second meal… they mean you eat less food. In other words: starvation.

“What we’re now seeing is a trend punctuated by some great volatility,” says Zoellick, “and the poor and vulnerable have got no cushion when the prices spike.”

Thank your lucky stars you were born in the Lucky Country. Still – according to Dan Denning, this uptick in food prices is also a warning signal for Australian investors… one that could lead to a 20% to 25% correction in stock prices this year. He explains why in this note from last month. Click now and you’ll also learn three things he’s advising his readers do to prepare.

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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