“Without question, if the Fed had not stimulated the economy with zero percent interest rates, two rounds of quantitative easing and operation twist, the initial economic contraction would have been sharper.  But such short-term pain would have been constructive”.

The past week provided clear lessons not just in how central bankers have a limited ability to positively influence the economy but also how they are limited in their capacity to deliver the shortsighted policy actions that investors currently crave. The developments should provide new reasons for investors and economy watchers to abandon their faith in central bankers as super heroes capable of saving the economy.

The employment report released on Friday confirmed that the U.S. economy is stagnating at best and actively deteriorating at worst. While the numbers of jobs created in July was actually better than many economists expected, it was still far below the levels that would indicate a growing economy.  But more important than the official unemployment rate (which ticked up to 8.3%) or the number of jobs created, is the number of people who have left the workforce out of frustration or despair. This number continues to head higher. The labor force participation rate, which is the percentage of healthy working age Americans who actually have jobs, is at one of the lowest points since women first started working en masse in the 1970’s.  It’s also instructive to add back into the unemployment rate those who want full time jobs but who have had to settle for part time work. This figure, reported under the “U6” category, currently stands at 15.0%. This is just a 12% decline from the 17.1% high seen December 2009.  In contrast the “official” (U3) unemployment figure has declined 17% from its peak.

In explaining these bad results, most economists simply look at the stimulating effects of monetary and fiscal policy,not at the problems that those measures create. As a result, it is assumed that not enough stimulation, in the form of quantitative easing or federal deficit spending has been applied to the economy. The next logical assumption is that if the measures of the past few years had not been applied, we would have seen much weaker results over that time. In other words, no matter how bad things are now, defenders of the status quo will always describe how bad things “could have been” if the Fed hadn’t stepped in. This counterfactual argument gets increasingly threadbare as the years wear on.

Rather than admit that its policies have failed, the Fed statement last week gave all indications that it will continue with its current inflationary policy to the bitter end. These are the same errors that inflated the stock and real estate bubbles and ultimately resulted in the 2008 financial crisis and our continuing economic malaise. Without any fresh ideas,Fed press releases have become a Groundhog Day repetition of the same pronouncements and diagnoses. Oddly, many market watchers are frustrated that the Fed has not telegraphed that more stimulus is forthcoming. While it should be obvious that our current “recovery” is dependent on monetary support, it should be equally plain that the Fed can’t actually admit that fragility without spooking markets. To be clear, QE III is coming, but the markets should not expect Bernanke to supply a precise timetable.

Without question, if the Fed had not stimulated the economy with zero percent interest rates, two rounds of quantitative easing and operation twist, the initial economic contraction would have been sharper.  But such short-term pain would have been constructive.   By not taking away the cheap-money punch bowl, the Fed has delayed the pain and prolonged the party. But to what end?  So far all we have received is a tepid phony recovery that has sown the seeds of its own destruction.

In contrast, real economic restructuring would have resulted if the Fed had withdrawn its monetary props.  This would have paved the way for a robust, sustainable recovery.  Instead, the Fed helped numb the pain with unprecedented (and apparently permanent) liquidity injections. Its actions merely exacerbate the underlying imbalances that lie at the root of our structural problems, and thus act as a barrier to a real recovery.  So long as the Fed fails to learn from its prior mistakes, the phony recovery it has concocted will continue to fade until we find ourselves in an even deeper recession thanthe one we experienced in 2008.

Those who believe that artificially low interest rates are needed now,fail to see the price that will be paid down the road.  By keeping rates too low, the Fed continues to lead an overly indebted economy deeper into the financial abyss.  However, its ability to maintain rates at such low levels is not without limits.  Just as real estate prices could not stay high forever, interest rates cannot stay low forever.  When rates finally rise, the extent of the economic damage will finally be revealed. 

The sad fact is that no matter how impotent and dishonest Fed officials become, their elected rivals on Capitol Hill (who control the fiscal side of the equation) have become even less significant.  The complete lack of any political conviction to take steps to confront our fiscal imbalances means that Ben Bernanke and his cohorts are seen as the only cavalry capable of riding to the rescue.  But no matter how often they blow their bugles,our economy will continue to deteriorate until we stop waiting for a savior and instead fight the battle for prosperity ourselves.

Peter Schiff’s new book, The Real Crash: America’s Coming Bankruptcy – How to Save Yourself and Your Country is now available. Order your copy today. 

For in-depth analysis of this and other investment topics, subscribe to Peter Schiff’s Global Investor newsletter. CLICK HERE for your free subscription. 

“Exciting times. Sovereign debt issues have been under severe pressures as long-dated US treasuries are working on an “Eiffel Tower” top.”.

SIGNS OF THE TIMES

“Spanish banks’ bad loans jumped to an 18-year high in May.”

– Bloomberg, July 18

“Speculative-grade corporate debt in Europe is the most expensive to insure in

1 1/2 years.”

– Bloomberg, July 20

“Wall Street’s five biggest banks reported the worst start to a year since 2008.”

– Bloomberg, July 20

“Landlords are piling the most debt onto commercial properties in five years as Wall Street bundles the loans into bonds to meet rising demand from investors seeking high yields amid record-low interest rates.”

– Bloomberg, July 17

This is getting intriguing. Conservative money, and lots of it, has been finding comfort in the liquidity of US treasury bills. This has been enough to drive yields to Depression lows. Longer-dated corporate bonds are not at Depression-devastated high yields. But, are working on a momentum and sentiment high for prices.

Wall Street is again “bundling” securities, and “investors” are again reaching for yield.

What’s next?

PERSPECTIVE

Last week’s Pivot concluded that the Dollar Index was having trouble getting through the 83.5 level and that any decline would prompt some “Positive vibes”. The shelf-life was good until Friday, and Ross got onto the change with the two ChartWorks on Sunday.

The change was Spanish yields going to new highs, as the DX rose to 84.10 on Tuesday. Yesterday’s updated ChartWorks reviewed that the near term tendency will likely be down.

Overall, this works with the likelihood of choppy action through the summer.

However, as each week goes by events continue to reinforce our view that Mother Nature is adamant about keeping financial history on a fairly typical post-bubble contraction. Benighted policymakers don’t stand a chance – again.

The inability to really service sovereign debt is shown by Spain’s 10-year notes rising to 7.50% (new high) on Monday.

Hope over reality has brought relief, otherwise known as positive vibes, that could run for a week or so.

Stock market advice has been to sell the rallies.

CREDIT MARKETS

The hypocrisy of the establishment is something else again. Agit-propaganda about Barclays “manipulating” Libor has more to do with politics than improving interest rate markets. Terry Corcoran at the Financial Post has had some good pieces on the story. Yesterday’s is the latest and here is the link:

http://opinion.financialpost.com/2012/07/25/terence-corcoran-the-u-k-libor-coverup/

There are comments going back to the 1500s about a businessman complaining that some agent is deliberately setting rates too high. Then there is the seemingly endless record of “intellectuals” speculating or boasting that some agency can lower rates at will. Such examples usually appear during financial crises.

For the record, successful traders, such as Thomas Gresham (1519 – 1579), seem to be able to understand a crisis and merely observe that there is no money available – even “with double collateral”.

By a process of learning the hard way, successful traders get liquid or defensive at a speculative high.  Thus Gresham’s dispassionate reporting, rather than despairing for some agent to wave a credit wand.

Sadly, the notion that some gifted agency can manipulate interest rates for the public good or relief has become dominant. And no matter how hapless the behaviour of the Fed has been it still has its admirers.

The speculative boom in commodities that culminated in 1919 was followed by an equally outstanding crash. The objective of the Fed during the 1920s was to prevent commodities from falling further. The real price of copper plunged from 663 to 148 and spent most of the 1920s around 175. The high in 1929 was 323 and the Depression low was 84.

The attempt to prop up commodities (old losers) was not successful as excess funds roared into the stock markets (new winners). The excitement of inflation in financial assets was discovered – again. Current policymakers still do not understand inflation in financial assets during a great bubble and that great depressions have always followed. 

As head of the Fed in 1927, Ben Strong, knew about financial asset inflation with his “coup de whiskey” remark. We elaborated on this in November 2007 and the piece follows.

The problem is that interventionist economists have read economic theories, not market history.

The point is that Fed manipulations have not materially changed financial history, but have exaggerated the urge to speculate.

Why does the establishment grant central bankers the privilege of manipulating interest rates, and recently condemn what appeared to be interest rate manipulation of the non-government Libor?

In this regard, the Fed provides a special irony. It attempts to regulate economic behaviour through interest-rate manipulation via the official “Fed Funds”. Special is that the Fed is owned by a small group of large private banks.

The story gets worse. Talk to anyone who was on a Canadian bond trading desk in the 1960s and 1970s when the laws applied to traders did not apply to their equivalent at the Bank of Canada.

Offences such as wash trading to “increase” trading volume, focusing on one maturity to push the whole market up, and timing news releases to favour the market would put a private trader in jail. The central bank did it with no regard for common law.

The noise about Libor is purely political as control freaks are looking for another item to run. Perhaps part of Robert Diamond resignation from Barclays has to do with the nonsense of government functionaries impractical intrusions. Who needs it?

At one time, call money was a benchmark interest rate. This was the rate at which private banks loaned funds to brokers, who in turn provided margin to customers. Then in the insanity of yet another “new” financial era banks became brokers and putting it glibly; call money became Libor.

Now the empty suits want to take it over.

BOND MARKET

Exciting times. Sovereign debt issues have been under severe pressures as long-dated US treasuries are working on an “Eiffel Tower” top. The action is similar to the magnificent high for silver at 48.35 in April 2011.

Technically, the long bond has become another asset play that has little to do with interest rates. Representing investment-grade corporates, the LQD is carrying on with impetuous buying, impetuous enough to register some daily Upside Exhaustions. In the past these have led the high by a few weeks. We have had our eye on the top channel-line at 122. Of course, precision depends upon the thickness of the trend line.

The reversal will be interesting as most corporates could then be heading to depression-high yields.

Link to Friday, July 27 ‘Bob and Phil Show’ on TalkDigitalNetwork.com:

http://talkdigitalnetwork.com/2012/07/saving-the-eurozone/

INSTITUTIONAL ADVISORS

WEDNESDAY, AUGUST 1, 2012

BOB HOYE

PUBLISHED BY INSTITUTIONAL ADVISORS

The following is part of Pivotal Events that was

published for our subscribers July 26, 2012.

“If this credit bubble pops, the depression could be so severe that I don’t think our civilization could survive it.”

 07/26/12 Vancouver, Canada – Ain’t we got fun?

The Dow up 58 yesterday…nothing important there.

Gold up $31. Hmmm…what does the gold market see? More QE?

Last week, it was the IMF. It urged the Europeans to increase their money-printing efforts to avoid deflation. This week, the Financial Times tells Ben Bernanke to get off his cushy derriere and take bold, decisive action in the fight against the Great Correction.

Sebastian Mallaby, writing in the FT, says Bernanke is acting like a wimp. He needs to come up with some new weapons, new strategies, and new tactics. C’mon Ben, “show some real audacity.”

Ben Bernanke, hero of ’08, will not want to see himself stripped of his medals. He will not sit on his hands and watch as the US follows Japan down that long, lonely road towards stagnation. He will not want his resume blemished by a splotch of failure just when he faced his greatest challenge.

No, dear reader, he will ‘do something!’ — no matter how dimwitted it may be.

And here’s a BBC sage reminding Ben Bernanke what the greatest economist of the 20th would have done. “What would Keynes do?” he asks.

Of course, the answer is obvious to anyone who ever thought much about Keynes. He would have done just the wrong thing!

But that’s not the way John Gray sees it:

…The influential Cambridge economist has figured prominently in the anxious debates that have gone on since the crash of 2007-2008. For most of those invoking his name, he was a kind of social engineer, who urged using the power of government to lift the economy out of the devastating depression of the 30s. That is how Keynes’s disciples view him today. The fashionable cult of austerity, they warn, has forgotten Keynes’s most important insight — slashing government spending when credit is scarce only plunges the economy into deeper recession.

Even Richard Duncan urges the Fed to action. Duncan is unusual, though. He sees the problem clearly…which is to say, he sees it like we do. Here, CNBC reports on an interview:

“When we broke the link between money and gold, this removed all constraints on credit creation. This explosion of credit created the world we live in, but it now seems that credit cannot expand any further because the private sector is incapable of repaying the debt it has already, and if credit begins to contract, there’s a very real danger that we will collapse into a new Great Depression,” he [Duncan] argued.

“If this credit bubble pops, the depression could be so severe that I don’t think our civilization could survive it.”

Duncan argues that governments in the developed world should borrow “massive” amounts of money at the current low interest rates to invest in new technologies like renewable energy and genetic engineering.

What could he be thinking? Of course the money would be wasted. That’s what government does. It borrows money from people who have proven they know how to make money and gives it to people who have proven only that they know how to take it.

One will offer to build a bridge to nowhere. Another will propose to assassinate a foreigner. Millions will put out their hands for retirement/health/unemployment and other forms of assistance.

And what will happen to the money? It will be gone…with only more debt…like “dead soldiers” left on the table after a party…to show for it.

Still, Duncan thinks that even if the money goes down a rathole, it still might make sense:

Even if this is wasted, at least we could enjoy this civilization for another ten years before it collapses,” he said.

That’s what separates a real pessimist from us optimists. It would be nice to see what Mr. Market would do. Left to do his work, he’d surely separate many of the rich from their money…he’d blow the doors of the banks…and flatten hundreds of corporations. He’d put a swift end to this Great Correction…and then we could get back to work.

But he wouldn’t wipe out our whole civilization! You have to be a genuine pessimist…to believe the correction will be fatal to our civilization.

Who knows? Maybe Richard Duncan is right. We’re all going to die anyway. In the meantime, and in between time, ain’t we got fun!

Regards,

Bill Bonner
for The Daily Reckoning

Read more: How Ben Bernanke Can Prevent the End of Civilization http://dailyreckoning.com/how-ben-bernanke-can-prevent-the-end-of-civilization/#ixzz22EljBQ00

We’re in the midst of a major global restructuring that has been happening for the last decade. (For the full interactive edition, please CLICK HERE)

Technology is replacing the traditional methods of manpower – much like that of the auto industry where machines have taken over the assembly and production of automobiles.

Last week the U.S. Postal Service announced that it would be unable to meet billions of dollars in payments that are coming due in August and September for future retiree health benefits. Post offices all over the US are being cut back as digital communications have taken over.

Newspapers and magazines around the world are struggling as people move away from print to online media. Publishers everywhere are feeling the heat as new and less wasteful forms of books are published in digital format.

The days of walking to your neighbourhood video rental store are gone. The once famous Blockbuster stores and Canada’s own Rogers Video stores are all but obsolete. I still remember grabbing the free popcorn and browsing the aisles of the Jumbo Video stores – but that is a distant memory never to be relived again.

Innovation is human evolution. Yet as we advance in technology, more jobs will be destroyed and replaced by more efficient robotics and digital technology. Movies where humans lose their jobs to robots and technology are no longer fiction – its reality.

Manufacturing has long moved to emerging markets where costs of production are far below anything in N. America. That means the technology created here are sent overseas to be mass produced.

The Big Problem  

Economies grow through mass consumption. The more we consume, the bigger the economy. That is why the US is the number one economy in the world; it is the ultimate consumer.

To fuel that consumption, an economy must be able to sustain itself through the production of goods and services. It must be able to create wealth through job creation. But the problem is there is no job creation.

Unemployment rate has been stuck above 8 percent for more than three years in a row (real unemployment rate is easily double that number) with little signs of hope. Confidence among U.S. consumers dropped in July to the lowest level this year.

Revised GDP numbers are now showing a 2.5 percent growth in the 12 months after the contraction ended in June 2009, compared with the 3.3 percent gain previously reported. The government also revised down corporate profits and personal income for each of the past three years.

The US knows it needs to create more jobs to fuel consumption – to increase GDP. But where will the new jobs come from?

The Truth About the Bubble

A couple of years ago in the letter, “The Truth About the Bubble” I wrote:

Over the past few decades, we have witnessed two very significant bubbles: the dot-com bust and the recent housing/commodities bubble.   

During the rally of the dot-com days, everyone got excited about the Internet boom. The NASDAQ 100 doubled in less than a year and kids from their basements were becoming multi-millionaires.

In 1996 Alan Greenspan warned that the U.S. economy was suffering from “irrational exuberance” as the stock market, led by the high-tech and Internet sectors, boomed. Yet he and the Fed took no action, and added billions of dollars into the economy. Greenspan knew he should have put a hamper on the stock market craze with rate hikes, but he didn’t – until it was too late.

The dot-com crash wiped out $5 trillion in market value of technology companies in two years.    

A few years after the dot-com boom, recovery was slow and tedious. This put pressure on the fed to once again cut the Fed Funds rate dramatically over the next few years from a high of 6.25% in 2001 down as low as 1.5% in 2004. This, of course, created yet another bubble.    

The Housing and Commodities Bubble     

Because of the low rate, housing prices were climbing and many of the homes increased by as much as 200% in less than a few years.     

First time home buyers were eagerly racing to snag up homes with low interest rate mortgages. They took on half million dollar mortgages on houses that were worth less than 200k just years ago.     

Combine that with offers from mortgage companies that were far too good to be true, it led to the subprime mortgage crash, and thus 2008 unfolded.

A Credit Bubble  

Where I am I going with this?  

For the last decade, most American consumption came as a result of low borrowing costs. This led to the major bubble in 2008. Yet here we are again and the only choice politicians have is to give away free money to avoid the same disaster caused by giving away free money.  

In Q2 America added $2.33 in debt for every $1 in GDP; the US added $274.3 billion in debt while adding $117.6 billion in GDP. Never have I studied a scenario like this that hasn’t ended in disaster.

There is no way to avoid the collapse of a credit boom. There are only two simplified choices:

1. Let the world’s financial system collapse
2. Print more money/expand credit, destroy currency

Most people believe that printing more money causes inflation. But what they don’t realise is that it doesn’t always happen right away. Too much austerity can, and will, lead to a deflationary spiral – especially when combined with a world economy that is in surplus. Years of deflation will occur, followed by a fast and major rise in inflation as the economy recovers and grows.  

The world is producing far more than it can consume as a result of a mentality that the only way out of this credit bubble is to increase spending. But when the spending comes from debt, it only creates a larger bubble. What would happen if the US couldn’t print more money? What would happen if the dollar was no longer the world’s reserve currency?

Still Number One…But for How Long?

The only reason America has not already collapsed under the weight of its massive debt is because of its status as the world’s reserve currency. That status means it can print massive amounts of dollars and people will still buy them. But surely this won’t last.

I have mentioned before in my letter, “The Biggest Buyer of Garbage” that China is secretly and cautiously introducing its currency to the world by untangling itself from its substantial reserves of US dollar. I also talked about how China and Russia have already abandoned the dollar in bilateral trade dealings, resolving to use their own currencies instead (see It’s Already Here).

Many major banks, including British banking giant HSBC, have already openly said the Renminbi could soon become another world reserve currency. These banks are already setting up in preperation for this occurence by allowing major transactions to be done in the Renminbi. HSBC has just recently created the first Renminbi bond issue outside of China and Hong Kong, a move toward the internationalisation of the renminbi, and in the UK’s efforts to expand its financial links with the world’s largest emerging market.  

If it were freely convertible today, the Renminbi will be the second-largest currency in the world.

What Happens if China Sells Out? 

China is the largest holder of US bonds. If China were to sell its $1 trillion plus of US bond holdings, the prices of US bonds would drop and interest rates would rise (yield moves opposite to price in bond markets. The rate of interest from a bond does not change, so the price of that bond fluctuates to adjust to current yields. The bigger the yield, the bigger the risk associated with the issuing country.)

Higher interest rates would obviously be bad for business. As the world’s largest manufacturer, China cannot afford bad business. As a result, China would not be looking to unleash all of their US bonds. Rather they would slowly diversify their holdings for gold and other commodities.

It’s not a coincidence that the US is both the largest holder of gold bullion and the world’s reserve currency; it has more than 76% of its foreign holdings in gold. China, on the other hand, owns less than 2% of its foreign holdings in gold. Furthermore, the US has nearly 8 times more gold than China.

China will be increasing its gold reserves.

I mentioned a few weeks back that banks in Europe will soon have to recapitalise their tier 1 assets in gold bullion. What many are unaware of as well is that the recent proposal from the Germans on the European redemption facility requires that gold be posted as collateral by those who participate.  

That’s a clear sign that countries and central banks trust gold over any other currencies.  

Gold to Breakout?

From a technical standpoint, gold is looking to rebound with some serious momentum. If gold were to break through $1640 and stay above this level, we should see a renewed rise in gold.

Gold mining shares are looking strong – finally.  

Despite the drought, the GDX’s MACD has finally turned up towards a buy signal and RSI is also positive. Bellwether Agnico Eagle’s price action is looking much stronger – especially considering the beating it took after its $2-billion write-down earlier this year at its shuttered Goldex mine.

By September, Hong Kong will have completed construction and opening the doors to its largest gold vault.  It will hold nearly 22% of the gold that Fort Knox has.   

China, currently the world’s second largest consumer of gold, is clearly making a statement that it wants to expand its holdings of physical gold bullion.  

You don’t build a vault that big just for show.

Until next week,

Ivan Lo

 (For the full interactive edition, please CLICK HERE)