Quantcast
Real Crash 2014
federal reserve
The Bond Trap
Posted by Peter Schiff on 06/23/2014 at 8:13 AM

The American financial establishment has an incredible ability to celebrate the inconsequential while ignoring the vital. Last week, while the Wall Street Journal pondered how the Fed may set interest rates three to four years in the future (an exercise that David Stockman rightly compared to debating how many angels could dance on the head of a pin), the media almost completely ignored one of the most chilling pieces of financial news that I have ever seen. According to a small story in the Financial Times, some Fed officials would like to require retail owners of bond mutual funds to pay an "exit fee" to liquidate their positions. Come again? That such a policy would even be considered tells us much about the current fragility of our bond market and the collective insanity of layers of unnecessary regulation.

 

Recently Federal Reserve Governor Jeremy Stein commented on what has become obvious to many investors: the bond market has become too large and too illiquid, exposing the market to crisis and seizure if a large portion of investors decide to sell at the same time. Such an event occurred back in 2008 when the money market funds briefly fell below par and "broke the buck." To prevent such a possibility in the larger bond market, the Fed wants to slow any potential panic selling by constructing a barrier to exit. Since it would be outrageous and unconstitutional to pass a law banning sales (although in this day and age anything may be possible) an exit fee could provide the brakes the Fed is looking for. Fortunately, the rules governing securities transactions are not imposed by the Fed, but are the prerogative of the SEC. (But if you are like me, that fact offers little in the way of relief.) How did it come to this?

 

For the past six years it has been the policy of the Federal Reserve to push down interest rates to record low levels. In has done so effectively on the "short end of the curve" by setting the Fed Funds rate at zero since 2008. The resulting lack of yield in short term debt has encouraged more investors to buy riskier long-term debt. This has created a bull market in long bonds. The Fed's QE purchases have extended the run beyond what even most bond bulls had anticipated, making "risk-free" long-term debt far too attractive for far too long. As a result, mutual fund holdings of long term government and corporate debt have swelled to more $7 trillion as of the end of 2013, a whopping 109% increase from 2008 levels.   

 

Compounding the problem is that many of these funds are leveraged, meaning they have borrowed on the short-end to buy on the long end. This has artificially goosed yields in an otherwise low-rate environment. But that means when liquidations occur, leveraged funds will have to sell even more long-term bonds to raise cash than the dollar amount of the liquidations being requested.

 

But now that Fed policies have herded investors out on the long end of the curve, they want to take steps to make sure they don't come scurrying back to safety. They hope to construct the bond equivalent of a roach motel, where investors check in but they don't check out. How high the exit fee would need to be is open to speculation. But clearly, it would have to be high enough to be effective, and would have to increase with the desire of the owners to sell. If everyone panicked at once, it's possible that the fee would have to be utterly prohibitive.

 

As we reach the point where the Fed is supposed to wind down its monthly bond purchases and begin trimming the size of its balance sheet, the talk of an exit fee is an admission that the market could turn very ugly if the Fed were to no longer provide limitless liquidity. (See my prior commentaries on this, including May 2014's Too Big To Pop)

 

Irrespective of the rule's callous disregard for property rights and contracts (investors did not agree to an exit fee when they bought the bond funds), the implementation of the rule would illustrate how bad government regulation can build on itself to create a pile of counterproductive incentives leading to possible market chaos.

 

In this case, the problems started back in the 1930s when the Roosevelt Administration created the FDIC to provide federal insurance to bank deposits. Prior to this, consumers had to pay attention to a bank's reputation, and decide for themselves if an institution was worthy of their money. The free market system worked surprisingly well in banking, and could even work better today based on the power of the internet to spread information. But the FDIC insurance has transferred the risk of bank deposits from bank customers to taxpayers. The vast majority of bank depositors now have little regard for what banks actually do with their money. This moral hazard partially set the stage for the financial catastrophe of 2008 and led to the current era of "too big to fail."

 

In an attempt to reduce the risks that the banking system imposed on taxpayers, the Dodd/Frank legislation passed in the aftermath of the crisis made it much more difficult for banks and other large institutions to trade bonds actively for their own accounts. This is a big reason why the bond market is much less liquid now than it had been in the past. But the lack of liquidity exposes the swollen market to seizure and failure when things get rough. This has led to calls for a third level of regulation (exit fees) to correct the distortions created by the first two. The cycle is likely to continue.

 

The most disappointing thing is not that the Fed would be in favor of such an exit fee, but that the financial media and the investing public would be so sanguine about it. If the authorities consider an exit fee on bond funds, why not equity funds, or even individual equities? Once that Rubicon is crossed, there is really no turning back. I believe it to be very revealing that when asked about the exit fees at her press conference last week, Janet Yellen offered no comment other than a professed unawareness that the policy had been discussed at the Fed, and that such matters were the purview of the SEC. The answer seemed to be too canned to offer much comfort. A forceful rejection would have been appreciated.  

 

But the Fed's policy appears to be to pump up asset prices and to keep them high no matter what. This does little for the actual economy but it makes their co-conspirators on Wall Street very happy. After all, what motel owner would oppose rules that prevent guests from leaving? The sad fact is that if investors hold a bond long enough to be exposed to a potential exit fee, then the fee may prove to be the least of their problems.

 

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.







Tags:  bond mutual fundsexit feeFederal ReserveFinancial Timesinterest rates
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
Too Big To Pop
Posted by Peter Schiff on 01/06/2014 at 10:41 AM

Most economic observers are predicting that 2014 will be the year in which the United States finally shrugs off the persistent malaise of the Great Recession. As we embark on this sunny new chapter, we may ask what wisdom the five-year trauma has delivered. Some big thinkers have declared that the episode has forever tarnished freewheeling American capitalism and the myth of Wall Street invincibility. In contrast, I believe that the episode has, for the moment, established supreme confidence in the powers of monetary policy to keep the economy afloat and to keep a floor under asset prices, even in the worst of circumstances. This represents a dramatic change from where we were in the beginning of 2008, and unfortunately gives us the false confidence needed to sail blindly into the next crisis.

Although the media likes to forget, there was indeed a strong minority of bearish investors who did not drink the Goldilocks Kool-Aid of the pre-crisis era. As the Dow moved up in 2006 and 2007 so did gold, even though a rising gold price was supposed to be a sign of economic uncertainty. The counter intuitive gold surge in those years resulted from growing concern among a committed minority that an economic crisis was looming. In the immediate aftermath of the crisis in 2009 and 2010, gold shifted into an even higher gear when those investors became doubly convinced that the extraordinary monetary measures devised by the Fed to combat the recession would fail to stop the economic free fall and would instead kick off a new era of inflation and dollar weakness. This caused many who had been gold naysayers and economic cheerleaders to reluctantly jump on the gold band wagon as well.

But three years later, after a period of monetary activism that went far beyond what most bears had predicted, the economy has apparently turned the corner. The Dow has surged to record levels, inflation (at least the way it is currently being measured) and interest rates have stayed relatively low, and the dollar has largely maintained its value. Ironically, many of those former Nervous Nellies, who correctly identified the problems in advance, have thrown in the towel and concluded that their fears of out of control monetary policy were misplaced. While many of those who had always placed their faith in the Fed (but who had failed - as did Fed leadership - from seeing the crisis in advance) are more confident than ever that the Central Bank can save us from the worst.

A primary element of this new faith is that the Fed can sustain any number of asset bubbles if it simply supplies enough air in the form of freshly minted QE cash and zero percent interest. It's as if the concept of "too big to fail" has evolved into the belief that some bubbles are too big to pop. The warnings delivered by those of us who still understand the negative consequences of such policy have been silenced by the triumphant Dow.

The proof of this shift in sentiment can be seen in the current gold market. If the conditions of 2013 (in which the Federal Government serially failed to control a runaway debt problem, while the Federal Reserve persisted with an $85 billion per month bond buying program and signaled zero interest rates for the foreseeable future)could have been described to a 2007 investor, their conclusions would have most likely been obvious: back up the truck and buy gold. Instead, gold tumbled more than 27% over the course of the year. And despite the fact that 2013 was the first down year for gold in 13 years, one would be hard pressed now to find any mainstream analyst who describes the current three year lows as a buying opportunity. Instead, gold is the redheaded stepchild of the investment world.

This change can only be explained by the growing acceptance of monetary policy as the magic elixir that Keynesians have always claimed it to be. This blind faith has prevented investors from seeing the obvious economic crises that may lay ahead. Over the past five years the economy has become increasingly addicted to low interest rates, which underlies the recent surge in stock prices. Low borrowing costs have inflated corporate profits and have made possible the wave of record stock buybacks. The same is true of the real estate market, which has been buoyed by record low interest rates and a wave of institutional investors using historically easy financing to buy single-family houses in order to rent to average Americans who can no longer afford to buy.

But somehow investors have failed to grasp that the low interest rates are the direct result of the Fed's Quantitative Easing program, which most assume will be wound down in this year. In order to maintain the current optimism, one must assume that the Fed can exit the bond buying business (where it is currently the largest player) without pushing up rates to the point that these markets are severely impacted. This ascribes almost superhuman powers to the Fed. But that type of faith is now the norm.

Market observers have taken the December Fed statement, in which it announced its long-awaited intention to begin tapering (by $10 billion per month), as proof that the dangers are behind us, rather than ahead. They argue that the QE has now gone away without causing turmoil in the markets or a spike in rates. But this ignores the fact that the taper itself has not even begun, and that the Fed has only committed to a $10 billion reduction later this month. In fact, it is arguable that monetary policy is looser now than it was before the announcement.

Based on nothing but pure optimism, the market believes that the Fed can somehow contract its $4 trillion balance sheet without pushing up rates to the point where asset prices are threatened, or where debt service costs become too big a burden for debtors to bear. Such faith would have been impossible to achieve in the time before the crash, when most assumed that the laws of supply and demand functioned in the market for mortgage and government debt. Now we "know" that the demand is endless. This mistakes temporary geo-political paralysis and financial sleepwalking for a fundamental suspension of reality.

The more likely truth is that this widespread mistake will allow us to drift into the next crisis. Now that the European Union has survived its monetary challenge, (the surging euro was one of the surprise stories of 2013), and the developing Asian economies have no immediate plans to stop their currencies from rising against the dollar, there is little reason to expect that the dollar will rally in the coming years. In fact, there has been little notice taken of the 5% decline in the dollar index since a high in July. Similarly, few have sounded alarm bells about the surge in yields of Treasury debt, with 10-year rates flirting with 3% for the first time in two years.

If interest rates rise much further, to perhaps 4% or 5%, the stock and real estate markets will be placed under pressure, and the Fed and the other "Too Big to Fail" banks will see considerable losses on their portfolios of Treasury and mortgage-backed bonds. Such developments could trigger widespread economic turmoil, forcing the Fed to expand its QE purchases. Such an embarrassing reversal would add to selling pressure on the dollar, and might potentially trigger an exodus of foreign investment and an increase in import prices. I believe that nothing can prevent these trends from continuing to the point where a crisis will be reached. It's extremely difficult to construct a logical argument that avoids this outcome, but that hasn't stopped our best and brightest forecasters from doing just that. 

So while the hallelujah chorus is ringing in the New Year with a full-throated crescendo, don't be surprised by sour notes that will bubble to the top with increasing frequency. Ultimately the power of monetary policy to engineer a real economy will be proven to be just as ridiculous as the claims that housing prices must always go up.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.  

Subscribe to Euro Pacific's Weekly Digest: Receive all commentaries by Peter Schiff, John Browne, and other Euro Pacific commentators delivered to your inbox every Monday! 

Don't forget to sign up for our Global Investor Newsletter.



Tags:  federal reservequantitative easing
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
The Long And The Short Of Gold Investing
Posted by Peter Schiff on 01/02/2014 at 10:43 AM

There are two types of gold investors: those trying to make money on short-term market timing and those looking for long-term asset preservation. It was the fear-driven trading of the former that helped gold break $1900 in 2011, and for good reason - stormy markets steer investors to safe havens.

But gold's fortune has shifted in the past two years, and finishing 2013 down 28% seems to have sealed its fate - at least in the eyes of the short-term speculators. In reality, the same forces that are stabilizing stocks and suppressing gold are also the fundamental reasons long-term investors have been buying gold since the turn of the new millennium. The so-called recovery we're now experiencing is just a lull in a storm that hasn't yet abated. 

Losing Touch With Reality

From the fiscal cliff at the beginning of the year to the budget stalemate and government shutdown in the fall, the US was not exactly a model of financial stability in 2013. Yet with each of these stories, the markets shrugged off any large dips and went on to reach record high after record high. The stock market exceeded most expectations - the S&P and Dow rallied 29.6% and 26.5% respectively, with the volatility index staying remarkably low.

The official explanation for this market behavior is that the economy really is improving. A growing GDP and improving jobless rate are the leading economic indicators that support this conclusion. 

However, the real reason behind 2013's stability in spite of mixed economic news was the extremely accommodating Federal Reserve policy. Markets have become hyper-aware of this Bernanke Put over the course of the year.

Compare the markets' taper tantrums earlier in the year to their reaction to the Fed's December announcement of "taper-lite."

In both June and August, with the mere talk of tapering, the S&P and Dow tumbled. The assumption was that when the Fed started tapering their Quantitative Easing (QE) program, interest rates would also start to rise. Overvalued stocks plunged in preparation for a higher interest rate environment.

However, this December, when the Fed set an official January date for tapering, these indices did not drop as they had before, but immediately jumped to new highs. Why the different reaction to essentially the same news?

Because the Fed's December announcement was not the same.

Normal No Longer Means Healthy

The key element of Bernanke's "taper-lite" was not the $10 billion-per-month cut to QE, but the explicit commitment to maintain low interest rates for the foreseeable future. Bernanke basically guaranteed the fed funds rate would remain near 0% for at least a couple more years.

This commitment to artificially suppressed interest rates ruins the charade that the economy is getting healthier. Why on earth does a healthy economy need the support of free money?

The short-term data may appear good on its face, but people are waking up to the bigger picture of this so-called recovery - namely that it isn't a recovery at all.

It's well-recognized now that most new jobs are low-wage, low-skilled placements. Often these are part-time or temporary retail or restaurant positions. This may be why both median income and the percentage of the population employed remain well below pre-crisis levels. The jobless rate has only improved because people have simply given up trying to find employment.

Meanwhile, the latest data from the Bureau of Economic Analysis shows that in the last months of 2013, personal spending rose more than personal income, while the savings rate dropped. In other words, we're back to digging the hole that caused the Panic of '08.

This is one of the longest and slowest recoveries the US has ever experienced, but the mantra of Wall Street maintains that all is well because the stock market is up. We're supposedly returning to normal.

The truth is that "normal" no longer means "healthy" when it comes to the economic stability of the United States. It really means that we are back to where we were prior to the Panic of '08. 

Selective Memory

Only a short-term mindset could ignore the parallels between our economy today and ten years ago. Heading into 2004, the headlines sounded almost identical to today's, with talk of an improving economy that still suffered from less-than-optimal employment numbers.

More importantly, it was in 2003 that Alan Greenspan cut the fed funds rate to 1% - the lowest it had been for more than 40 years.

We all know how that story ended. Most economists agree that the interest rate policy of Greenspan's Fed spurred the irresponsible lending practices and speculation that drove the US into a housing crash and then a financial meltdown.

Yet here we are again, with the fed funds rate at record low levels. Nothing has changed in ten years - the supposed recovery we're experiencing now is simply a product of this endless cheap money.

A Sober Analysis

In times like these, long-term gold investors feel like the designated drivers in the corner of a frat party. It might seem like we're missing the fun, but we must remember that we're playing a different game than the short-term speculators.

 Our drunken friends have had some cheap thrills in 2013, but this stock market growth rests on an unstable foundation of artificial stimulus and cheap money. We are more interested in waking up without a hangover, a wrecked car, or worse. The longer interest rates remain suppressed, the crazier markets will behave when rates rise. And if Greenspan's one year at 1% rates helped trigger the crash we saw in '08, imagine imagine what three years and counting of Bernanke's/Yellen's 0% rates portends for the next crash.

Peter Schiff is Chairman ofEuro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices. 

Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts. 

And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.



Tags:  Ben Bernankefederal reservegold
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
The Eastern Lust For Gold
Posted by Peter Schiff on 12/04/2013 at 10:23 AM
Having replaced savings with debt on both the national and individual levels, I think it's well past time for Westerners to take a few lessons from our creditors in the East. Many Americans consider gold a "barbarous relic," but in Asia, the yellow metal remains the bedrock of individual savings plans. This means that either greater than half of the world's population are barbarians, or they've held onto an important tradition that our culture has forgotten.

A Culture of Gold

One of the most important elements of Eastern gold demand is that it is not limited to educated investors or the higher classes, as often seems to be the case in the West. Throughout Asia, no matter one's social status, precious metals are the first assets people choose to protect their wealth. There is not even a glimmer of doubt about the enduring value of hard money.

A recent Bloomberg article quotes a Chinese woman, "I don't know anything about the stock market and I don't have enough money to buy property, so I figured gold is the safest choice."

Some might write off this philosophy as naïve, but her logic is founded in centuries of tradition, borne of hard-won experience. The same goes in India and across South Asia, where gold is an essential part of local religious customs. From wedding dowries to temple offerings, gold carries a caché in Asia that most Westerners can't fathom.

Consider the US as a comparison. Here, newlyweds are more likely to receive a house full of fancy appliances than any assets that might form the foundation of long-term financial independence.

After a couple of generations of US-dollar dominance, Americans have become lazy with our wealth. While we exploit our economic power by going into debt for fancy cars, big-screen TVs, and expensive smart phones, our creditors are steadily stockpiling gold.

A River of Gold from West to East

Asia's love affair with gold became worldwide news when the price of the yellow metal dropped last April. Asian consumers saw the price drop as a fortunate buying opportunity, and metals dealers were swamped with orders for both bullion and jewelry. Premiums skyrocketed across the continent, but this did not slow demand.

With all this demand, shouldn't gold's global spot price have continued rising? Unfortunately, many Westerners were selling into the Eastern demand. In fact, the stagnant spot price concealed a historic transfer of real wealth.

The rising price of gold over the past decade had lured many Western investors into the paper gold market through precious metals exchange-traded funds (ETFs). To ETF investors intent on fast growth rather than long-term capital preservation, the recent drop in price was viewed as a sell signal, not an opportunity.

By the end of September, gold ETFs had sold off about 700 metric tons of physical gold - more than half of it in just the second quarter. The World Gold Council reports that the majority of these outflows have been absorbed by Asian demand.

However, Western selling was enough to keep the global spot price from recovering. Instead of more capital flowing into gold, it was the gold itself which was flowing from Western financial institutions to Eastern households.

The latest data shows that consumer demand for physical gold in the first three quarters of 2013 hit a historical record of 2,896.5 metric tons. 90% of the year-over-year increase in this demand came from Asia and the Middle East.

Meanwhile, Americans have been distracted by one record high after another in the domestic stock market.

Governments Intervene

When reporting on Asian gold demand, the Western media tends to focus on nations like India, which has practically declared war against gold buyers this year in a misguided attempt to curb its trade deficit.

The Indian government raised tariffs on the metal to a record 10%, and now requires importers to re-export 20% of their gold. India's central bank even went as far as asking temples around the country to divulge how much gold they were storing, though many refused.

Thailand and Vietnam have taken similar steps to subdue their populations' gold demand, even though the primary outcome has been to increase gold smuggling.

These governments' measures have received the most attention because they fit nicely into the Western narrative that gold is an old-fashioned asset that does more harm than good in modern economies. But the truth is that the only ones harmed by gold are Western governments!

China Rising

Last month, China officially surpassed India as the world's largest consumer of gold. Unlike New Delhi, Beijing is encouraging its citizens' gold lust by easing restrictions on the gold trade. The People's Bank of China (PBOC) is preparing to expand the number of businesses allowed to import and export gold on a large scale. It has also increased the amount of tax-free gold citizens are allowed to bring into the country.

Meanwhile, China is finally pulling away from the US dollar. A month after China's government news agency called for a "de-Americanized world," a deputy governor at the PBOC said, "It's no longer in China's favor to accumulate foreign-exchange reserves."

Simply put, China is planning to wind down its own stimulus program of buying US dollars, and instead allow the value of the yuan to appreciate. In preparation for this shift, China has been diversifying its foreign exchange reserves into gold. The PBOC has not released official numbers on its gold reserves since 2009, but experts have begun to speculate that its current holdings are far larger than previously estimated.

A Rude Awakening

This is the time when the West realizes that its great reservoir of wealth has run dry, as the gold has all flowed East.

When China stops buying US Treasuries, the Fed will remain the only major buyer of US debt. This will drive interest rates up, thereby sticking the US government with obligations it cannot possibly fulfill. Ultimately, this will be the death knell for the dollar, as the Fed will be forced to significantly expand its QE program to assume the role as Treasury-buyer of last resort.

Mom-and-pop gold buyers throughout the East probably do not understand all the subtleties of the foreign exchange markets, but an undying appreciation for gold is built into their culture. Make no mistake: the East is the engine of the 21st century global economy - and it is riding on rails of gold.

This holiday season, consider breaking with our recent Western tradition of giving gifts of no enduring value. Instead, take the opportunity to turn some of your paper dollars into gifts that will still have value when your kids are grown.

Peter Schiff is Chairman of Euro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices. 

Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts. 

And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.



Tags:  Chinafederal reservegold
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
Debt Ceiling Delusions
Posted by Peter Schiff on 10/11/2013 at 12:38 PM

The popular take on the current debt ceiling stand-off is that the Tea Party wing of the Republican Party has a delusional belief that it can hit the brakes on new debt creation without bringing on an economic catastrophe. While Republicans are indeed kidding themselves if they believe that their actions will not unleash deep economic turmoil, there are much deeper and more significant delusions on the other side of the aisle. Democrats, and the President in particular, believe that continually taking on more debt to pay existing debt is a more responsible course of action. Even worse, they appear to believe that debt accumulation is the equivalent of economic growth.

If Republicans were to inexplicably prevail, and the federal government were to cut spending so that its expenditures matched its tax revenues (a truly radical idea) the country's financial mess would be laid bare. The government would have to weigh the relative costs and benefits of making interest payments on Treasury debt (primarily to foreign creditors) or to trim entitlements promised to U.S. citizens. But those are choices we will have to make sooner or later anyway. In fact we should have dealt with these issues years ago. But generations of mechanistic debt ceiling increases have allowed us to perpetually kick the can down the road. What could possibly be gained by doing it again, particularly if it is done with no commitment to change course?

The Democrats' argument that America needs to pay its bills is just hollow rhetoric. Paying off one's Visa bill with a new and bigger MasterCard bill can't be considered a legitimate payment of debt. At best it is a transfer. But in the government's case, it doesn't even qualify as that. Treasury debt is primarily bought by the Fed, foreign central banks, and major financial institutions. None of that will change with a debt ceiling increase. We will just go to the same people for greater quantities. So it's like paying off your Visa card with a bigger Visa card.

According to modern economists, an elimination of deficit spending will immediately cause a dollar for dollar decrease in GDP. For example, if the government stopped sending food stamp payments to poor people, then grocery stores would lose business, employees would be laid off, and the economy would contract. But this one dimensional view fails to appreciate that the purchasing power of the food stamps had to come from somewhere. The government can't create something from nothing.  Taxation transfers purchasing power from people living in the present to other people living in the present. In contrast, borrowing transfers purchasing power from people living in the future to people living in the present. The good news for politicians is that future people don't vote in current elections (and current voters don't seem to appreciate the cost to their future selves of current policy).

The Obama Administration has congratulated itself for turning around the contracting economy that it inherited from President Bush. But even if you take the obscenely low official inflation statistics at face value, we only grew at an anemic 1.075% annual pace from 2009 to 2012 (far below the between 3% and 4% that the U.S. averaged post World War II). Sadly, this growth pales in comparison to the accumulation of new debt that we are borrowing from the future.

U.S. GDP is measured at roughly $15 trillion per year. 2% growth means that each year the GDP is approximately $300 billion larger than the prior year. But in the less than five years since Obama took office, the federal government has added, on average, about $1.3 trillion per year in new debt, a pace that is four times higher than the growth. If the deficit were subtracted from GDP, America would be shown to be stuck in a severe recession that Washington can't acknowledge. But such a reality is more consistent with the dismal job prospects and stagnant incomes experienced by most Americans.

The belief that deficits add to the economy, and that debt can be dealt with in an imaginary future (that never seems to arrive) is the foundation upon which the President can chastise the Republicans as irresponsible suicide bombers. Using this logic, he can argue (with a straight face) that borrowing is the equivalent of paying. That the President can make this delusional argument is not so surprising (no lie too great for the typical politician to attempt). What is alarming is that the media and the public have swallowed it so willingly. As they call for limitless increases in borrowing, Democrats have offered no plan to reduce the current debt and they are unwilling to negotiate with Republicans on that topic. Yet somehow they have been perceived as the party of fiscal responsibility.

While the Republicans have a dismal track record of their own when it comes to budgetary management, it can't be disputed that the minor dip in that rate of increase in spending that resulted from the recent Sequester, happened only because they dug in on the issue. Without the 2011 debt ceiling drama, there is no chance that any spending would have been touched.

Democrats had warned that the $85 billion in sequestration cuts slated for fiscal year 2013 (about 2% of the Federal budget) would be sufficient to bring on economic Armageddon. But guess what? We survived. Recently, Senate Majority Leader Harry Reid continued with such rhetoric by declaring that there are no more cuts to be found anywhere in the $3.8 Trillion dollar federal budget. (Apparently he missed last week's 60 Minutes piece on the spreading epidemic of federal disability fraud.)

We have to acknowledge what even the Republicans haven't fully grasped. We are in such a deep debt hole that there is no solution that does not involve serious economic pain. Tea Party Republicans rightly believe that government spending is a drag on economic growth. As a result, they conclude that immediate spending cuts will help with the "recovery". But they are confusing real economic growth with the delusional expansion created by deficit spending (which is actually damaging the real economy). If they cut the deficit, this phony economy may likely implode and cause widespread distress. 

So even though a reduction in government borrowing and spending does help the economy, it won't feel very helpful tomorrow. The more we borrow and spend today, the more we will suffer tomorrow when the bills come due. Ironically, cutting government spending now helps the economy by allowing

the economic adjustment to happen sooner rather than later. But this type of long-term thinking is very difficult for politicians to consider. 

Unfortunately our debts don't leave us much in the way of choices. We can choose to pay now or try to pay later. But the longer we wait the steeper the bill.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Subscribe to Euro Pacific's Weekly Digest: Receive all commentaries by Peter Schiff, John Browne, and other Euro Pacific commentators delivered to your inbox every Monday! 

Don't forget to sign up for our Global Investor Newsletter.



Tags:  debt ceilingDemocratsfederal reserveGDPrepublicans
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
The Taper Fakeout
Posted by Peter Schiff on 10/03/2013 at 10:52 AM

Anyone who bought the media buzz about a September reduction of QE - called the "taper" - was very surprised when the Federal Reserve announced that stimulus would continue unabated. According the the official narrative, inflation is under control and the labor market is steadily improving. Why wouldn't a modest taper be announced?

The reality is that the economic indicators the Fed claims to rely on to decide when to taper are all dependent on stimulus money. This is not a mystery to Ben Bernanke. Instead, this entire saga amounted to little more than a "taper fakeout" which sent hard asset investors for a loop. 

Months of Anticipation

We can forgive the financial media for being blindsided by the Fed's non-taper. Even after decades of deception, journalists by-and-large still believe that it is their job to report official pronouncements as fact. Every month of 2013, one Fed official or another has openly discussed the need for or possibility of tapering. In January, it was Lockhart; in February, Bullard; Plosser brought it up in March; and Williams talked taper in April.

Bernanke finally took up the taper torch in May, but it wasn't until June that he hinted the Fed might start tapering QE "later this year" and end it entirely by the middle of 2014.

The markets went wild on these progressively foreboding statements, sending Treasury and mortgage rates upward and driving gold and silver into their biggest correction since the secular bull market started a decade ago. In spite of Bernanke's caveats that the bulk of the stimulus would continue for the foreseeable future and that the federal funds rate would remain at record lows, the markets braced for the easy-money spigot to begin closing.

I was on the major news networks calling the Fed on its bluff, but once again, my forecasts were dismissed by anchors and co-panelists. [See the new video: Peter Schiff Was Right - Taper Edition] Then, on September 18th, the Fed did exactly what I expected.

A Möbius Strip

When the Fed announced that it was backtracking on its previous indications, Bernanke cited the "tightening of financial conditions observed in recent months" as a major reason for delaying the taper.

As an academic economist focused on the history of monetary policy, Bernanke had to know that warning of tapering would cause the market to prepare by raising rates. This is part of a clever strategy to appear serious about withdrawing stimulus but have a convenient excuse to (forever) delay the exit.

After all, if interest rates surged on the mere talk of tapering, imagine what would happen if tapering actually began!

Taper Talk Is Cheap

Bernanke may not understand how to grow a healthy economy, but he's not foolish enough to dream that he can end QE without affecting interest rates. The real message behind Bernanke's excuse for putting off tapering is that there is never going to be a taper. If the economy shows sign of improving, the Fed will start talking about tapering again. This will send interest rates higher, which the Fed can point to as "tight financial conditions" in need of further stimulus. 

Sure enough, the day after the fakeout was announced, St. Louis Fed Chief James Bullard jumped onto the airwaves claiming that a tightening decision might come as early as October. 

While some analysts think the Fed is in disarray, I think they're trying to have their cake and eat it too. By hinting but not delivering on tightening, they can keep investors second-guessing themselves and ignoring the fact that the promised recovery never materialized.

Regime Uncertainty

On September 18th, the S&P and Dow closed at new record highs on news of the Fed's taper fakeout. Precious metals surged as well. Whether this precipitated Bullard's renewed advisory on tapering the following day I do not know, but his comments had the effect of smacking down the previous day's gains.

Uncertainty over the Fed's intentions leaves US investors in a bind. Even prominent Wall Street money managers are truly frightened by this market.

My advice remains the same: focus on long-term fundamentals, take advantage of discounts, and avoid the US Treasury bubble. While unfortunate timing may have cost some gold buyers short-term losses, the difference between $1300 and $1800 for gold will look less important when it is trading at $3000 or $5000.

This much is certain, when QE does unravel, the fallout will be devastating. In the meantime, opportunities abound for the precious metals investors.

Just this week, when gold failed to rally on the government shut down, as many assumed that it would, it promptly sold off $40 per ounce, as disappointed speculators bailed out. However, gold investors know that a government shut down in-and-of-itself is not bullish for gold. What is bullish for gold is that the shut down will soon end, and any government functions that were temporarily shut down will start right back up again.

In the end, it's the government that will shut the economy down. But the one thing they will never shut down is the printing press. Now that is really bullish for gold.

Peter Schiff is Chairman ofEuro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices. 

Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts. 

And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.



Tags:  federal reserveFedsTaper
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
Peter Schiff Was Right - Taper Edition
Posted by Peter Schiff on 09/26/2013 at 10:25 AM
This video below was compiled from interviews with Peter Schiff over the last few weeks. Mr. Schiff first caught the public attention in 2008 with a similar video regarding his ultimately accurate predictions about the housing and financial crises.

Over the last few weeks, as the overwhelming majority of economists, reporters, and Wall Street insiders expressed certainty that the Fed would begin to taper its QE program, I did my level best to make the public understand that the Fed would do no such thing. As a result, last week's "surprise" announcement provides us with fresh confirmation that most market pundits remain clueless about the true state of our economy. I knew, as they seemed not to, that the Fed is caught in a stimulus trapthat will require them to keep the monetary spigots wide open. For my efforts I was treated to another round of snickers, eye rolls, and outright dismissals. You would have hoped that they would have learned better by now.

Fortunately all their dazzlingly wrong predictions are caught on tape. In retrospect it makes for hilarious viewing. Click below to view. 

 

Unfortunately, they have failed to learn anything from their mistakes. The same pundits that were revered before their colossal miscue are still afforded equal respect. The markets still believe the popular consensus that a Fed taper will arrive in October, or maybe by January at the latest. In contrast, I believe that we are now stuck in a state of permanent QE.   But these views remain in the lunatic fringe. How many more times will the markets have to get it wrong before an alternate reality is considered?   In the end it will not be the Fed that voluntarily tapers by easing up on the monetary gas pedal, but an adverse reaction in the currency and bond markets than forces the Fed to slam on the breaks.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.  



Tags:  federal reserveFedsTaper
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
The Taper That Wasn't
Posted by Peter Schiff on 09/18/2013 at 9:22 PM

The Fed's failure today to announce some sort of tapering of its QE program, despite the consensus of an overwhelming percentage of economists who expected action, once again reveals the degree to which mainstream analysts have overestimated the strength of our current economy. The Fed understands, as the market seems not to, that the current "recovery" could not survive without continuation of massive monetary stimulus. Mainstream economists have mistaken the symptoms of the Fed's monetary expansion, most notably rising stock and real estate prices, as signs of real and sustainable growth. But the current asset price bubbles have nothing to do with the real economy. To the contrary, they are setting up for a painful correction that will likely be worse than the one we experienced five years ago.

Given the strong anticipation for a taper announcement, today's relief rally should come as no surprise. However, the Fed's inaction should be perceived by many as an admission that the economy is fundamentally weak. Once that possibility takes hold, today's euphoria is likely to dissipate. Perhaps the Fed's inaction may cause many to wonder if the economy is not as strong as they believed. This could ultimately lead to an even bigger sell off than what we would have seen today if the Fed had come through with a taper announcement. 

The Fed knows that the appearance of economic health would evaporate if stimulus were withdrawn. But like Jack Nicholson in A Few Good Men, it also knows that the markets can't handle the truth. Over the past year Ben Bernanke and other top Fed officials have tried mightily to communicate to the markets that no decisions had been made on the future and timing of QE reductions and that its moves would depend on the data. On many occasions they even hedged the automatic nature of their data triggers and moved the goal posts that supposedly guided their policy. But as a result of this continuous obfuscation, the Fed lost control of its message.

Despite its efforts toward vagueness, the markets nevertheless made definite conclusions.  In addition to the overwhelming consensus of economists who had predicted a taper announcement for today, many even offered precise measures of how big the taper would be (median forecasts were that bond purchases would be trimmed by between $10 and $15 billion per month). As the Fed had not dashed these expectations strongly enough, today's non-event comes as a surprise to most. However, as I have mentioned many times in the past, the Fed has checked into a monetary Roach Motel. Getting out will be infinitely harder than getting in. In fact it will be likely impossible to get out without tipping the country back into recession.

If stock and home prices continue to rise, and if the unemployment picture appears to brighten as a result of a shrinking workforce, the Fed may have an increasingly difficult time explaining why they are failing to cut back on a policy that many mistakenly assume is no longer needed. Look for the rhetorical pretzels to get ever more complex and the goalposts that would trigger an action to become completely mobile.

But the reality is that the economy will never regain true health as long as the stimulus is being delivered. Despite trillions already administered, the workforce is shrinking, energy usage is down, the trade balance is widening, savings are depleting, inflation is showing up in inconvenient places, debt is up, and real wages are declining. So while QE has succeeded in hiding the truth, it hasn't accomplished anything of substance. Unfortunately, the Fed is only interested in the headlines.

We also must understand that even if the Fed were to deliver a small reduction in bond purchases, such a move would change nothing. The Fed would still be continuously adding to its enormous balance sheet while presenting no credible plans to actually withdraw the liquidity. As I have pointed out many times, it simply can't do so without pushing the economy back into recession. Although this would be the right thing to do, you can rest assured that it won't happen.

We should also recall where this all began. When QE1 was first launched Bernanke talked about an exit strategy. At the time I maintained the Fed had no exit strategy. But now questions about an exit strategy have been replaced by much more delicate taper talk. But easing up on the accelerator without ever hitting the brakes will not stop the car or turn it around.

Bernanke has maintained that his purchases of government bonds should not be considered "debt monetization" because the Fed only intends to hold the bonds temporarily. In recent years however talk of actively selling bonds in the portfolio have given way to more passive plans to simply hold the bonds to maturity. But this is a convenient fiction. When the bonds mature, the Fed will have little choice but to roll the principal back into Treasury debt, as private bond buyers could not easily absorb the added selling that would be required to repay the Fed in cash. Judged by his own criteria then, Bernanke is now an admitted debt monetizer.

Following this playbook, the Fed will likely maintain the pretense that tapering is a near term possibility and that it has a credible plan on the shelf to bring an end to QE. In reality the Fed is stalling for time and hoping that the economy will inexplicably roar back to life. Unfortunately, hope is not a strategy.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Subscribe to Euro Pacific's Weekly Digest: Receive all commentaries by Peter Schiff, John Browne, and other Euro Pacific commentators delivered to your inbox every Monday! 

Don't forget to sign up for our Global Investor Newsletter.



Tags:  federal reserveFedsquantitative easing
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
Tapering The Taper Talk
Posted by Peter Schiff on 06/21/2013 at 12:52 PM

As usual the Federal Reserve media reaction machine has fallen for a poorly executed head fake. It has fallen for this move many times in the past, and for its efforts, it has tackled nothing but air. Yet right on cue, it took the bait once more. Somehow the takeaway from Wednesday's release of the June Fed statement and Chairman Ben Bernanke's press conference was that the central bank is likely to begin scaling back, or "tapering," its $85 billion per month quantitative easing program sometime later this year, and that the program may be completely wound down by the middle of next year. 

Although this scenario is about as likely as an NSA-sponsored ticker tape parade for whistle blower Edward Snowden, all of the market segments reacted as if it were a fait accompli. The stock market - convinced that it will lose the support of ultra-low, long-term interest rates and the added consumer spending that results from a nascent housing bubble - sold off in triple digits. The bond market, sensing that its biggest and busiest customer will be exiting the market, followed a similarly negative trajectory. The sell-off in government and corporate debt pushed yields up to 21 month highs. In foreign exchange markets, the dollar rallied off its four-month lows based on the belief that Fed tightening will support the currency. And lastly, the gold market, sensing that an end of quantitative easing would eliminate the inflationary fears that have partially fueled gold's spectacular rise, sold off nearly five percent to a new two-and-a-half year low.
 
All of this came as a result of Bernanke's mild commitments to begin easing back on permanent QE sometime later this year if the economy continued to improve the way he expected. The chairman did not really elaborate on what types of improvements he had seen, or how much farther those unidentified trends would need to go before he would finally pull the trigger. He was however careful to point out that any policy shift, be it for less or more quantitative easing, would not be dependent on incoming data, but on the Fed's interpretation of that data. By stressing repeatedly that its data goalposts were "thresholds rather than triggers," the chairman gained further latitude to pursue any stance the Fed chooses regardless of the data. 
 
Yet the mere and obvious mention that tapering was even possible, combined with the chairman's fairly sunny disposition (perhaps caused by the realization that the real mess will likely be his successor's problem to clean up), was enough to convince the market that the post-QE world was at hand. This conclusion is wrong.   
             
Although many haven't yet realized it, the financial markets are stuck in a "Waiting for Godot" era in which the change in policy that all are straining to see will never in fact arrive. Most fail to grasp the degree to which the "recovery" will stall without the $85 billion per month that the Fed is currently pumping into the economy.
 
What exactly has convinced the Fed that the economy is improving? From what I can tell, the evidence centered on the rise in stock and real estate prices, and the confidence and spending that follow as a result of the wealth effect. But inflated asset prices are completely dependent on QE and are likely to reverse course even before it is removed. And while it is painfully clear that expectations about QE continuance have made a far bigger impact on the stock, bond, and real estate markets than any other economic data points, many must be assuming that this dependency will soon end.
 
Those who hold this belief have naively described QE as the economy's "training wheels." (In reality the program is currently our only wheels.) They are convinced that the kindling of QE will inevitably ignite a fire in the larger economy. But the big lumber is still too dampened by debt, government spending, regulation, and high asset prices to catch fire - all we have gotten is smoke instead. A few mirrors supplied by the Fed merely completed the illusion. The larger problem of course is that even though the stimulus is the only wheels, the Fed must remove them anyways as we are cycling toward the edge of a cliff. 
 
Although Bernanke dodged the question in his press conference, the Fed has broken the normal market for mortgage backed securities. While it's true that the Fed only owns 14% of all outstanding MBS (the "small fraction" he referred to in the press conference), it is by far the largest purchaser of newly issued mortgage debt. What would happen to the market if the Fed were no longer buying? There are no longer enough private buyers to soak up the issuance. Those who do remain would certainly expect higher yields if the option of selling to the Fed was no longer on the table. Put bluntly, the Fed is the market right now and has been for years.
 
A clear-eyed look at the likely consequences of a pull-back in QE should cause an abandonment of the optimistic assumptions behind the Fed's forecast. Interest rates are already rising rapidly based simply on the expectation of tapering. Imagine how high rates would go if the Fed actually tried to sell some of the mortgages it already owns. But the fact is the mere anticipation of such an event has already sent mortgage rates north of 4%, and without a lifeline from the Fed in the form of more QE, those rates will soon exceed 5%. This increase will greatly impact the housing market. Speculative buyers who have lifted the market will become sellers. More foreclosure will hit the market, just as higher home prices and mortgage rates price any remaining legitimate buyers out of the market. Housing prices will fall to new post bubble lows, sinking the phony recovery in the process. The wealth effect will work in reverse: spending and confidence will fall, unemployment will rise, and we will be back in recession even before the Fed begins to taper.
 
In fact, the rise in mortgage rates seen over the last month has already produced pain in the financial world, with banks reporting a rapid decline in refinancing applications. By the time rates hit 5%, the current rally in real estate will have screeched to a halt. With personal income and wage growth essentially stagnant, individual buyers are extremely dependent on the affordability allowed by ultra-low rates. A near 50% increase in mortgage rates, which would result from an increase in rates from 3.25% to 5.0%, would price a great many buyers out of the market. Higher rates would also cool much of the housing demand that has been coming from the private equity funds that have been a factor in pushing up real estate prices in recent years. Falling home prices would likely trigger a new wave of defaults and housing related bankruptcies that plunged the economy into recession five years ago.
       
A similar dynamic would occur in the market for U.S. Treasury debt. Despite Bernanke's assurances that the Fed is not monetizing the government's debt, the central bank has been buying nearly 70% of the new issuance in recent years. Already, rates on 10-year treasury debt have creeped up by more than 50% in less than two months to over 2.5%. Any actual decrease or cessation in buying - let alone the selling that would be needed to unwind the Fed's multi-trillion dollar balance sheet - would place the Treasury market under extreme pressure. Since low rates are the life blood of our borrow and spend economy, it is highly likely that higher rates will lead directly to lower stock prices, lower GDP growth, and higher unemployment. Since rising asset prices and the confidence and spending they produce is the basis for Bernanke's rosy forecast, new lows in house prices and a bear market in stocks will likely reverse those forecasts on a dime. 
 
Lost on almost everyone is the effect higher interest rates and a slowing economy will have on federal budget deficits. As unemployment rises, tax revenues will fall and expenditures will rise. In addition, rising rates will not only make it more expensive for the Fed to finance larger deficits, it will also make it more expensive to refinance maturing debts. Furthermore, the profit checks Fannie and Freddie have been paying the Treasury will turn into bills for losses, as a new wave of foreclosures comes tumbling in. 
 
It's fascinating how the goal posts have moved quickly on the Fed's playing field. Months ago the conversation focused on the "exit strategy" it would use to unwind the trillions in bonds and mortgages that it had accumulated over the last few years. Despite apparent improvements in the economy, those discussions have given way to the more modest expectations for the "tapering" of QE. I believe that we should really be expecting a "tapering" of the tapering conversations.
 
As a result, I expect that the Fed will continue to pantomime that an eventual Exit Strategy is preparing for a grand entrance, even as their timeline and decision criteria become ever more ambiguous. In truth, I believe that the Fed's next big announcement will be to increase, not diminish QE. After all, Bernanke made clear in his press conference that if the economy does not perform up to his expectations, he will simply do more of what has already failed. 
 
Of course, when the Fed is forced to make this concession, it should be obvious to a critical mass that the recovery is a sham. Investors will realize that years of QE have only exacerbated the problems it was meant to solve. When the grim reality of QE infinity sets in, the dollar will drop, gold will climb, and the real crash will finally be upon us. Buckle up.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Subscribe to Euro Pacific's Weekly Digest: Receive all commentaries by Peter Schiff, John Browne, and other Euro Pacific commentators delivered to your inbox every Monday! Or get the Global Investor Newsletter.

And be sure to order a copy of Peter Schiff's recently released NY Times Best Seller, The Real Crash: America's Coming Bankruptcy - How to Save Yourself and Your Country

Tags:  Ben Bernankeeconomyfederal reservehousinginflationquantitative easing
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
Flying High on Borrowed Wings
Posted by Peter Schiff on 04/01/2013 at 12:50 PM

After selling off an astounding 56% between October of 2007 and March 2009, the S&P 500 has staged a rally for the ages, surging 120% and recovering all of its lost ground too. This stunning turnaround certainly qualifies as one of the more memorable, and unusual, stock market rallies in history. The problem is that the rally has been underwritten by the Federal Reserve's unconventional monetary policies But for some reason, this belief has not weakened the celebration.

Although the Fed has been tinkering with interest rates and liquidity for a century, nothing in its history could prepare the markets for its activities over the last four years. (See 'The Stimulus Trap' article in my latest newsletter). And while most market analysts give credit to Ben Bernanke for saving the economy and sparking the rally, they have not fully grasped that market performance is now almost completely correlated to Fed activism. A detailed look at stock market movements over the past four years reveals a clear pattern: upward movements are directly tied to the delivery of fresh stimulants from the Fed. Downward movements occur when markets perceive that the deliveries will stop. In other words, the rally is really just a bender. The rest is commentary. 

Since 2008, the Fed has injected fresh cash into the economy with four distinct shots of quantitative easing and has added two kickers of Operation Twist. In recent months, the Fed has dispensed with the pretense of designing, announcing, and serving new rounds of stimulus and is now continuously monetizing over $85 billion per month of Treasury and mortgage-backed debt. The new cash needs a place to go, and stocks, which now often provide higher yields than long term Treasury bonds, and which offer much better protections against inflation, provide the best outlet.

But the four year rally has been punctuated by several sharp and brief drops. It is no coincidence that these episodes occurred during periods in which the delivery of fresh stimulus was in doubt. If the Fed were ever to follow through on its promise to exit the bond market, we believe the current rally would come to an immediate halt. This provides yet another reason to believe that stimulus is now permanent. 

A close look at the performance of the S&P 500 over the past four years tells the story. 

 

 

Source: Yahoo! Finance, Euro Pacific Capital. Past performance is no guarantee of future results. (Click here to enlarge)

In May 2007, with the "Goldilocks" economy of 2005 and 2006 still in control, the S&P finally eclipsed the March 2000 high of the dotcom era. It ultimately hit an all-time high of 1565 in October 2007. But later in the year, things began to unravel when bankruptcies of premier subprime lenders signaled real trouble. A blood bath, though, did not materialize. As late as August 2008, the S&P was trading at nearly 1300, down a less-than-tragic 16% from its high. But when Lehman Brothers, Fannie Mae and Freddie Mac, and AIG imploded almost simultaneously in September 2008, the markets panicked. Hundreds of billions of dollars of potentially worthless debt now sat on the books of the nation's financial system. No one knew where the next bomb would explode. A stampede thus ensued. (A minor replay of this dynamic just occurred in Cyprus. See my recent commentary for more on this).  

Less than a month later the index fell below 900, a fall of more than 30%. By November 21, the S&P had lost another 100 points. Four days later, the Fed introduced the first round of what would come to be commonly known as "quantitative easing". This consisted of purchasing $600 billion of government-sponsored enterprises debt and mortgage-backed securities. By the day of the announcement (even though nothing had yet been done), the S&P rallied almost 50 points to 851. Still encouraged by the Fed, the S&P was at 931 on January 6, 2009, significantly higher than in late November. 

Despite the first round of asset purchases, the market was still in chaos and had not yet stabilized. By early March, the S&P had lost an additional 25%, bringing total "peak-to-trough" losses at more than 50%. On March 18, 2009, the Fed announced that it was going to expand the size of its stimulus program. This time it really got the stock market's attention. The new guidelines called for a total purchase of $1.25 trillion of MBS and $300 billion of Treasury debt. On the day of the announcement, the S&P opened at 776 and by the time the asset purchases were complete a year later, in March 2010, the S&P was trading at 1171, an increase of 50%.

When the spigots of quantitative easing shut down in the second quarter of 2010 the S&P turned south, declining to a low of 1022 in July (a 13% decline from March). In late August, just before Bernanke delivered his 2010 Jackson Hole speech, in which he would hint at the next round of stimulus (to be later dubbed "QE2"), the S&P was still hovering a full 10% below its post QE1 high. But the expectation of another shot was enough to ignite a rally. When the formal announcement of QE2 came in November, the index had already advanced to 1193. When the program expired at the end of the 2nd quarter of 2011, the S&P stood at 1307, a 25% increase from before Bernanke jawboned the markets at Jackson Hole.

The market response to QE2 was in many ways similar, if less spectacular, than its prior response to QE1. And like the first go-round, the rally ended with the withdrawal of stimulus. In addition, after the cessation of QE2, the markets had to contend with the farce of the U.S. debt ceiling drama. As a result, the S&P declined from a high of 1343 on July 22 to 1123 by August 19, a drop of 16%. This is also the same time period when the U.S. received its downgrade by Standard and Poor's. Ironically, the U.S. eventually got a temporary reprieve from the spotlight when its problems became overshadowed by funding tensions in Greece and Southern Europe, causing the market to once again flock to the so-called "safe haven" of U.S. assets.

The cover from Europe could only go so far. Pressure soon began to build on the Fed to deliver once again. It acted in September 2011 with its "Operation Twist", a program that consisted of buying longer-term treasuries while selling an equal amount of shorter dated paper. Although Twist was advertised as being balance sheet neutral, the short-term sales the Fed made were somewhat offset by the extension of credit lines to Europe and an extended commitment to the 0% interest rate policy that at the time called for an end date of mid-2013. The day the Fed announced Operation Twist, the S&P opened at 1203. By the following April it had reached 1400, a return of 16%.

But once again the stimulus began to fade. In the second quarter of 2012, a sell off took hold, and by June 5, the S&P traded as low as 1277, a decline of 9% since April. Cue the Fed! On June 20, the Fed announced the extension of Operation Twist, sparking a new rally which has continued into 2013. This buoyancy has been maintained, in part, by the announcement of QE3 on September 13, 2012, which also included another extension of the zero interest rate policy until at least mid-2015. By October, Fed governors were already mentioning inflation targets and when QE4 was launched on December 12, they clarified that zero interest rate policies would be in place until unemployment fell below 6.5%. The current leg of the rally has been somewhat non-linear as the election, the Fiscal Cliff, and the endless empty headlines out of Europe have continued to put pressure on the markets. Despite these obstacles, the S&P has rallied past 1500 and on March 5, 2013, it closed at 1538, within shouting distance of its all-time high of 1576 on October 11, 2007.

When the Fed made the first round of asset purchases in November of 2008, the market was still in a state of flux. However, since the system stabilized in mid 2009, there has been a reliable correlation between the timing of the programs and the performance of the markets. This intention was stated explicitly in Ben Bernanke's November 4,2010, Washington Times Op-ed in which he provided the rationale for QE2:

"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."

With the Fed on pace to expand its balance sheet by over $1 trillion in 2013, there can be little doubt that much of that money is headed straight into the stock market. Treasury bonds are still offering negative real yields and so there is less incentive than ever to own government paper.

Recently, the New York Post's Jonathan Trugman pointed out that Citigroup could be considered the poster child of the dubious rally. Since the crisis began, he reports that the Bank has received $45 billion in TARP funding, an additional $45 billion line of credit from the Treasury, and a government guarantee of $300 billion for its own troubled assets. At the same time, its cost of capital (the money it borrows from the Fed) is near zero, while it earns 3% to 5% on mortgages and 12% to 18% on credit cards. But from an operational standpoint, those gifts have failed to create a flourishing, self-sustaining, business. The company had shed almost 100,000 employees from its period of peak employment a few years ago (down to 260,000 employees) and it announced three months ago that an additional 11,000 cuts are to come. But Citi's share price has risen more than 85 percent since June of 2012, despite scant evidence that the company has turned itself around.

But look what all the Fed intervention has wrought. Each time they have intervened the resulting rally has diminished in intensity, and a sell-off has always ensued when the drug wore off. Through the years, the cycle of stimulus administration has quickened pace and has now arrived at a stage where it is continuous. Currently, the Fed is talking about a potential exit strategy, but as we have argued in the past, and as the chart above surely indicates, any withdrawal of stimulus could likely have dire implications for stocks which will not be tolerated by Washington.

Japan has been unsuccessfully trying to inflate its way out of these problems for the past 20 years(see 'Japan's Dangerous Game' in my latest newsletter). Now many of the indebted nations of the developed world seem intent to follow that example. But the monetary experiment of unending stimulus has, up to now, never been tried on a global scale. No one knows when or how it will end, but I believe it will end badly.

Investing in stocks is supposed to be a way to harness real economic growth, not a way to front run stimulus. Our advice for stock investors is to recognize that and to get as far away from artificially induced highs as possible. More fundamentally sound markets exist. We just have to find them.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Subscribe to Euro Pacific's Weekly Digest: Receive all commentaries by Peter Schiff, John Browne, and other Euro Pacific commentators delivered to your inbox every Monday

And be sure to order a copy of Peter Schiff's recently released NY Times Best Seller, The Real Crash: America's Coming Bankruptcy - How to Save Yourself and Your Country

Tags:  federal reserveFedsquantitative easing
PERMALINK | ADD YOUR COMMENT | EMAIL | PRINT | RSS  Subscribe
<< Back1234Next >>
BECOME A PREMIUM MEMBER!
Tom Woods Right Banner
newsletter
MARKET NEWS
Proudly show you are a Peter Schiff fan with this Schiff Head Cap.
America's Coming Bankruptcy - How to Save Yourself and Your Country
Display stickers that send the perfect message.
Join Schiff Premium now and get unlimited access to SchiffRadio.com.
Proudly show you are a Peter Schiff fan with this Schiff Head Cap.
America's Coming Bankruptcy - How to Save Yourself and Your Country
Become a Sponsor
Nothing discussed on the show is an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns if measured in U.S. Dollars. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. Investments may increase or decrease in value and you may lose money. International investing may not be suitable for all investors.
Copyright © 2002-2014 SchiffRadio.com. All rights reserved. Terms & Conditions  |  Privacy Policy  |  Acknowledgments
This site is Created and Managed by Nox Solutions LLC.
Support Our Sponsors
Audible.com Ad
The Real Crash updated
The Global Investor
Euro Pacific Weekly Digest