Friday’s release of disappointing August payroll numbers should have been a jarring wake-up call warning Wall Street that the economy has been treading on thin ice. Instead the alarm clock was stuffed under the pillow and Wall Street kept sleeping. The miss was so epic in fact (the 142,000 jobs created was almost 40% below the consensus estimate) that the top analysts on Wall Street did their best to tell us that it was all just a bad dream. Mark Zandi of Moody’s reacted on Squawk Box by saying “I don’t believe this data.” The reliably optimistic Diane Swonk of Mesirow Financial told Reuters the report “sure looks like a fluke, not a trend”.

But the opinions of those that really matter, the central bankers in charge of the global economy, are likely taking the report much more seriously. Given that this is just the latest in a series of moribund data releases, such as news today that U.S. mortgage applications have fallen to the lowest levels in 14 years, caution is justified. Unfortunately very little good comes from central bank activism. Recent statements from Fed officials across the United States and recent actions from ECB president Mario Draghi reveal their growing resolve to fight too low inflation, which they believe is the biggest threat to recovery. There are many things that are contributing to the global woes. But low prices are not high on the list.

Since the markets crashed in 2008, central banks around the world have worked feverishly to push up the prices of financial assets and to keep consumer prices rising steadily. They have done so in the official belief that these outcomes are vital ingredients in the recipe for economic growth. The theory is that steady inflation creates demand by inspiring consumers to spend in advance of predictable price increases. (The flip side is that falling prices “deflation,” strangles demand by inspiring consumers to defer spending). The benefits of inflation are supposed to be compounded by rising stock and real estate prices, creating a wealth effect for the owners of those assets which subsequently trickles down to the rest of the economy. In other words, seed the economy with money and inflation and watch it grow.

Thus far the banks have been successful in creating the bubbles and keeping inflation positive, but growth has been a no show. The theory says the growth is right around the corner, but like Godot it stubbornly fails to show up. This has been a tough circle for many economists to square.

Two explanations have emerged to explain the failure. Either the model is not functioning (and higher inflation and asset bubbles don’t lead to growth) or the stimulus efforts thus far, in the form of zero percent interest rates and quantitative easing, have been too timid. So either the bankers must devise a new plan, or double down on the existing plan. You should know where this is going. The banks are about to go “all in” on inflation.

Despite their much ballyhooed “independence”, central bankers have proven that they operate hand in glove with government. They are also subject to all the same political pressures and bureaucratic paralysis. There is an unwritten law in government that when a program doesn’t produce a desired outcome, the conclusion is almost never that the program was flawed, but that it was insufficient. Hence governments continually throw good money after bad. The free market discipline of cutting losses simply does not exist in government.

This is where we are with stimulus. Six years of zero percent interest rates and trillions and trillions of new public debt have failed to restore economic health, but our conclusion is that we just haven’t given it enough time or effort. My theory is a bit different. Maybe zero percent interest rates and asset bubbles hinder rather than help a real recovery. Maybe they resurrect the zombie of a failed model and prevent something viable and lasting from gaining traction? This is a possibility that no one in power is prepared to consider.

But what if they succeed in getting the inflation, but we never get the growth? What if we are headed toward stagflation, a condition that in the late 1970s gripped the U.S. more tightly than Boogie Fever? It may come as a surprise to the new generation of economists, but high inflation and high unemployment can coexist. In fact, the two were combined in the 70s and 80s to produce “the Misery Index.” But according to today’s economic thinking, the Index should not be possible. Inflation is supposed to cause growth. If unemployment is high they say there is no demand to push up prices. But it’s the monetary expansion that pushes prices up, not the healthy job market.

The tragedy is that if the policy fails to produce real growth, as I am convinced it will, the price will be paid by those elements of society least able to bear it, the poor and the old. Inflation and stagnation mean lost purchasing power. The rich can mitigate the pain with a rising stock portfolio and more modest vacation destinations. But they won’t miss a meal. Those subsisting on meager income will be hit the hardest.

Many economists are now trying to make the case that the United States had hit on the right stimulus formula over the past few years and is now reaping the benefit of our bold monetary experimentation. They continue the argument by saying Europe and Japan were too timid to implement adequate stimulus and are now desperately playing catch up. But this theory is false on a variety of fronts. First off, the U.S. is not recovering but decelerating. Annualized GDP in the first half of 2014 has come in at just a shade over one percent, which is lower than all of 2013, which itself was lower than 2012. The unemployment rate is down, but labor participation is at a 36-year low, and wages are stagnant. We have added more than $5 trillion in new public debt, but very little to show for it. We are not the model that other countries should be following but a cautionary tale that should be avoided.

It is also spectacularly wrong to assume that the problems in Europe and Japan can be solved by a little more inflation. Higher prices will just be a heavier burden for European and Japanese consumers, not an elixir that revitalizes their economies. The problems in Europe, Japan and the U.S. all have to do with an oppressive environment for savings, investment, and productivity that is created by artificially low interest rates, intractable budget deficits, restrictive business regulation, antagonistic labor laws, and high taxes. Since none of the governments of these countries have the political will to tackle these problems head on, they simply hope that more monetary magic will do the trick.

So as the Fed, the ECB, the Bank of Japan, and all the other banks that follow suit, push all their chips into the pot and hope that a little more inflation will save us from the abyss, we can wish them luck. It’s going to take a miracle.

Best Selling author Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital. His podcasts are available on The Peter Schiff Channel onYoutube

Catch Peter’s latest thoughts on the U.S. and International markets in the Euro Pacific Capital Summer 2014 Global Investor Newsletter!

Stocks Are Fairly Valued – The action in Major Markets is pretty much what Lance Roberts covers in this extremely well laid out report. This weeks his main topics are:

Followed by his:

Click on either list above to go to Lance’s great analysis – Rob Money Talks Editor

Ouzilly, France 

Dear Diary, 

The summer is slipping away. In the morning, mists hang over the fields. The chestnut trees have already turned a rust color. We start a fire in the kitchen fireplace to keep our mother warm. 

It wasn’t much of a summer in Europe this year. Still, we’re sorry to see it go. This weekend we will pack up the house… turn off the water… close the shutters… and head for the airport.

We’re headed to China first. Stay tuned… 

Meanwhile, the first revision of the GDP numbers for the second quarter. We expected them to show substantial weakness. Instead, they show what looks like strength. The US economy expanded at a 4.2% rate in the second quarter, adjusted for inflation. 

The economy may be growing. Stocks may be near a record high. But the typical American owns no stocks and his prospects are depressing. Here is a report from the New York Times: 

For five years, the United States economy has been expanding at a steady clip, the stock market soaring, the headlines filled with talk of recovery. Yet public opinion polling shows most Americans still think the economy is pretty miserable. 

What might account for the paradox? New data from a research firm offers a simple, frustrating answer: Middle-class American families’ income is lower now, when adjusted for inflation, than when the recovery began half a decade ago.

This is hardly news to us. We’ve been following the real economy – as best we could – for the last 15 years. Dear readers already know household income, hourly wages and household wealth were all down – for most people. 

The averages are distorted by the few at the very top, but the typical American suffered a big plunge in wealth in 2008-09… and has never recovered. In fact, he is worse off today than he was at the bottom of the hole in 2009. 

In June of that year, according to Sentier Research, the median family earned $55,589. Today, that figure is $53,891, adjusted for inflation. That “median” family is right at the middle of all US households. So, half of the people you see on the streets or in the shopping malls have suffered even bigger income losses. 

But it wasn’t just the damage done by the crisis of 2008-09 that has lowered incomes. The problem is bigger, deeper. It’s the core defect in the debt-fueled growth model. 

As we explore in our new book, Hormegeddon, a little bit of debt may be a good thing. But add more, and it depresses growth. Keep adding debt, and the whole shebang blows up. 

Sentier’s numbers show the deterioration in household income began at least 14 years ago. Today, the typical middle-income family earns less than it did when the 21st century began – despite the biggest wash of cheap credit the world has ever seen. 

In other words, policymakers’ efforts to increase real demand have failed miserably. 

Go figure. 

But our guess is the feds will not spend much time figuring out why their “stimulus” model doesn’t work. It’s the only tune they know. As it fails, they will merely keep singing, louder. 

How? 

Bypassing the banks, they will put their newly digitized money directly into the hands of the people whose votes they need to buy. This kind of flagrant money creation is becoming intellectually respectable, as a kind of final solution to the problem of insufficient demand. 

Martin Wolf, the influential chief economics commentator at the Financial Times, has already suggested it publicly. Now, here comes an article in Foreign Affairs magazine titled: “Print Less and Transfer More: Why Central Banks Should Give Money directly to the People.” 

Recognizing that QE and ZIRP are not making it to the top of the charts, the establishment is getting behind more direct inflationary measures. The article explains: 

It’s well past time, then, for US policymakers – as well as their counterparts in other developed countries – to consider a version of Friedman’s helicopter drops. […] 

Many in the private sector don’t want to take out any more loans; they believe their debt levels are already too high. That’s especially bad news for central bankers: when households and businesses refuse to rapidly increase their borrowing, monetary policy can’t do much to increase their spending. […] 

Governments must do better. Rather than trying to spur private-sector spending through asset purchases or interest-rate changes, central banks, such as the Fed, should hand consumers cash directly.

Are you still holding government bonds, dear reader? Make sure you get rid of them before the music stops. 

Regards, 

Bill

Further Reading: At midnight on Wednesday, September 3, we’re ending our offer to get a hardback copy of Bill’s new book, Hormegeddon, a yearlong subscription to The Bill Bonner Letter and a host of other valuable items for just $49. Act right now… or risk missing out for good. Click here to order now.

 Market Insight:

The euro crisis may have started in Greece… but it’s now being felt in Europe’s largest economy, Germany. 

Investor sentiment in Germany just dropped to a two-year low. And the economy there shed 2,000 jobs in August versus the consensus expectation of 5,000 new jobs added. 

News that the Russian army has rolled into eastern Ukraine isn’t helping either. 

This has sent investors scurrying into government bonds – pushing up prices and pushing down yields (which move in the opposite direction). 

This has left 10-year German bonds yielding 0.87%… 10-year Austrian bonds yielding 1.1%… 10-year Belgian bonds yielding 1.2%… and 10-year French bonds 1.2%. Meanwhile, investors earn just 0.4% annual interest lending 10-year money to the Swiss. 

In this environment, 2.3% on the 10-year Treasury note seems like a relatively good deal. 

Of course, given the deteriorating situation in Europe, it won’t be long before Mario Draghi will feel compelled to “do something.” And that will likely be a “big bazooka” QE program. 

And as Bill says, pressure is building in the US, too, for more aggressive monetary policy. 

This is when what looked like safety in bonds… will turn into something very different. In the meantime, the bond market will continue to reward sellers with high prices. 

And if you’re looking for an alternative way to earn extra income – without touching stocks or bonds – our income-investing experts Jim Nelson and Kelly Green recently prepared a presentation about one of their favorite strategies. It’s something they call “Instant Dividends.” And you can learn more about it here.

Full disclosure, there is a bias within the following words.  I have tried for a few weeks now to create more balance within this post, but in the face of effective interest rates of 53.38% (read on), it was exceedingly difficult to find significant strength in the ‘Pro’ stance.

 Short Version

Contemplating a cashback mortgage?  Please read on for the effective costs of such a move, there is no ‘free lunch’.

Top of mind should always be that Lending Institutions are Profit Driven Corporations beholden to Shareholders. This is the economic model we have adopted.  The age old debate between Capitalists and Socialists about the merits is a healthy one for our society to continue to have.  Being aware of the nature of the entity one is dealing with is always helpful.  Lenders are Capitalistic, not benevolent, in nature.

Within Lending Institutions there is an inherent drive to create superficially simple and attractive offerings for consumers.  The presentation of which tends to belie the underlying complexity of financial instruments itself.  The sole purpose of any product offering is to increase profits and drive market share in favour of the lender.  These products are laced with seemingly innocuous restrictions (prepayment penalties) designed to keep the client (i.e. borrower) locked into a cyclical relationship with their lender.

Long Version

The vast majority of Mortgage Brokers are aware that for their clients a cashback mortgage stands to create greater pitfalls than benefits.  The downside of (breaking) a cashback mortgage can be devastating.  Once an applicant understands all the metrics involved they often arrive at an alternate solution.  In life rarely do the easiest and best moves align with each other. Of 928 mortgages written in our office to date, only a single applicant has opted for the cashback product.  This was for a client with a truly unique profile;

• Significant gross personal income
• A detailed & manageable plan to pay the entire mortgage off in less than five years.
• A recent life event had removed all savings and liquidity from their life, as well as their dwelling.
• Renting was not an option for their specific circumstances

Basically 1 in 1000 clients found this product to be an effective lending solution.

The aforementioned client profile is the exact opposite of most who consider a cash-back mortgage product.  Often the applicant considering a cashback option has slipped into debt that they cannot keep up with, or have been unable to save up a down payment for a purchase.  In either instance a hard look at budgets and behaviour may indicate that a different long term solution is a safer choice.  Consider that past inability to budget properly may reflect future long term habits which are being temporarily glossed over and not truly corrected with this product.

What is a ‘cash-back mortgage’ exactly?

Essentially a mortgage which is signed at a higher than market interest rate, (this would be the ‘give’ from the client to the lender).  In exchange the client receives X% of the gross mortgage back in the form of cash at the time of signing (the ‘take’ from the lender for the client).

The % amount of cash back offered tends to range from 2% to as much as 5% which can be a very attractive amount of money.

The dazzle of the lure, the cash, often distracts from the barbed hook, i.e. the proportionately higher interest rate which effectively funnels all of the upfront cash back to the lender with significant interest over the term of the mortgage.

There is no free lunch.

It is important for clients to take a step back, pause, and review the mathematics.  Mathematics which often are not set out clearly at all during the approval process. We will use an example in the mid-range of options in the market, the numbers are that much more aggressive with increased percentages of cashback as the interest rates rises notably with the percentage of cashback offered.

We are happy to run the math on your own personal scenario.

A $100,000 3% cashback mortgage (as of Aug 2014 offered at 3.9% for 5 years – a 1% premium over current market rates) effectively costs an additional $4,989.60 in interest over the first five year term. In other words, the lender grants $3,000 up front, and claws back $4,989.60 in additional interest over the 5yr term… but this is only the beginning.

The $3,000.00 should not be viewed as 3.9% money, rather one should consider that there is a 1% premium being paid on the full $100,000 amount simply to create access to the  $3,000.00. Thus the entire excess interest paid on the $100,000 should be applied to only the $3,000.00 to get an accurate cost of the ‘free’ money.

The true cost of this $3,000.00 ‘gift’ equates to a 53.38% annual interest rate.

This is assuming an effective amortization of 5 years, same as the mortgage term. Unfortunately the $3,000 is in fact not fully amortized (paid off) during the first 5 years.

You may be asking yourself at this point what interest rate is considered ‘usury’ in Canada?  The answer is 60%, so this arrangement is all good…for the lender.

back to the numbers…

Ending balance comparisons 60 months later;

$86,901.89 – $100,000 mortgage 3.9% amortized over 25 years. (The cash-back rate)

$85,309.67 – $100,000 mortgage 2.9% amortized over 25 years. (The standard rate)

Despite paying the additional $4989.60 in interest for the first five years, the outstanding balance at the end of the five-year term remains $1592.22 higher than would the mortgage balance of a non-cashback mortgage with its lower effective interest rate.

The ripple effect

Assuming mortgage renewal into a standard mortgage is chosen.  (A second cashback would serve to magnify the negative impact significantly) We still see the continued ripple effect of the initial cash back decision ten years later. For the purposes of this example, we will assume interest rates are exactly the same as today.  Higher interest rates only serve to exacerbate the numbers, deepening the impact of a questionable decision made years earlier.

$86,901.89 – renewed at 2.9% over a 20 year amortization, as opposed to renewing a standard mortgage (also at 2.9% over a 20 year amortization) will which would have lower balance of $85,309.67 – results in;

• $207.60 in additional interest over the second five-year term
• $1,275.42 higher ending balance 10 years after the initial decision.

There is ‘really-really’ no free lunch…really!

Let’s assume 10 years later that the client writes a cheque for the $1275.42 difference to get to an even balance with the standard mortgage holder, the cash-back borrower is, ten years later, effectively paying a total of;

• $4989.60 – additional interest or the first five years
• $207.60 – additional interest over the second five years
• $1275.42 – additional outstanding mortgage balance at the end of 10 years

This is a grand total of $6472.62.

Ten years earlier the client received $3000 ‘cash-back’ which felt like free money.  The reality is that to wind up with the same mortgage balance 10 years later as their neighbor that did not opt for the cashback mortgage they have paid an additional $6472.62.

This equates to an annual interest rate on the $3000 initially advanced of; 31.86% annual interest rate over a 10 year period.

But that’s not all folks, there’s more…

There remains an additional landmine within this product.  Prepayment Penalty Implications. This becomes a very lender specific issue, with nearly all Chartered Banks and Credit Unions falling into one category (ultra-aggressive) and non-bank lenders falling into a notably more generous camp. If/When a mortgage is broken early, the pre-payment penalty is rarely the 3 months interest so many expect, far more often it is the IRD – Interest Rate Differential penalty calculation that is implemented.

Stats show that 6 out of 10 Canadians break their mortgage an average of 38 months into the term. At this point the cash-back client has also paid $83.16 in additional interest per month, per $100,000 of mortgage money advanced. At 38 months this is an additional $3160.08 in interest per $100,000 of mortgage advanced.

Click here for a Chartered Banks prepayment calculator and you will quickly see that the penalty 38 months into a 60 month term is approximately $4500.00 per $100,000.00 of mortgage money.  About $3,750.00 MORE expensive than with this more favourable lender.

Read more on the heat being applied to the Chartered Banks byzantine penalty calculations here, along with one lenders stats on the % of CDN’s breaking mortgages each year (including year 1).

Then we have the (rotten) cherry on top;  In most instances the initial cash advance of $3000.00 (per $100,000) ‘cash-back’ is also clawed back.  This completely negates any perceived advantage remaining. The entire experience potentially costing, on average, $6810.08 in additional interest and penalty expenses – per $100,000 borrowed as opposed to taking a superior non-cash-back mortgage with a more forgiving non-bank lender.

One is arguably better served charging the $3,000.00 to a line of credit or even a credit card.

This last statement seems a pretty clear indictment of the ‘cash-back’ product a very poor solution for ‘debt consolidation’. Instead it typically clears the path for repeat bad habits taking suddenly cleared credit cards right back to their limits once again in short order.

Consider whether or not it is a Financial Institutions mandate to;

1. Design simple money saving products which a consumer can easily understand and benefit from?

OR

2. Design complex profit generating products which both consumers and regulators with find too difficult to analyze effectively but ‘feel’ OK with? The cumulative impact of such products combined with complicated prepayment penalty calculations conspire to take from the average CDN, and give to the average CDN Bank-Stock-Shareholder.

Moral #1 of this story – Buy Banks Stocks

Moral #2 of this story – Consult with an Accredited Mortgage Professional and have us ‘Do The Math’ on your behalf.

Thanks for your time!

Dustan Woodhouse –AMP