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So act that you use humanity, whether in your own person or in the person of any other, always at the same time as an end, never merely as a means - Immanuel Kant's Formula of Humanity

Tuesday, June 25, 2019

The Fed trap

The Fed stepped-in to assure the market this week by saying, it will do what it takes to support the present economic expansion. It looks pretty much a July cut is on the horizon and more likely more cuts this year and again next year. Markets exactly wanted to hear that, and started rallying. The S&P hit an all- time high the same day. What is different this time is, in the past - when the S&P and the broader indexes hit historic highs, the Fed would increase the interest rate to cool down the economy. On contrary - the Fed is promising to decrease it, to keep the economic expansion going. Ever expanding expansion of the economy ie., prolong current boom. Particularly with the way the world economy operates these days where there is constant boom and bust cycle - it is a given that the boom market will always lead to a proportional bust market. If we go with that theory - the longest ever bull market that we are in, should definitely create a longest bear market. The longest bear market can only be preceded by a crisis scenario.

The US stock market is roughly 140% of GDP. Historically, it has always been 30-60%. The great crash of 1987 - often referred to as black Monday, stocks crashed 20% on a single day. Even though the crash wiped out the share value by a fifth, it did not affect the real economy in a big way, because the stock market merely reflected less than 30% of GDP. After easy money for more than 10 years, we have an economy were asset prices are GDP. Financial assets are biggest chunk of it. Any stock market correction, is deemed to reflect an economic correction. The fed has the numbers and knows it. Fed Chairman Powell really got a first glimpse of the economic scare in the last quarter of 2018. There were no takers of the junk market bonds for 41 days, after the Fed insisted on its policy of auto-pilot. The economy was spilling over, with all indexes (dow, nasdaq, s&p and russel 2000) all going down 20% essentially starting the bear market. Once Powell raised the rates in December, it was the last rate hike of the cycle.

The last time, the Fed promised to cut interest rate (after a series of rate hikes) was in 2007. The funds rate at that time was little more than 5%. The Fed had the luxury of reducing the interest rate by 500 basis points to provide a boost to the economy - and still could not avoid a financial crisis in 2008. The Fed brought the interest rate to 0% in 2008. Even that wasn't sufficient to recover the economy from its historic slump. The Fed introduced QE not once but thrice in the next four years. What is interesting is - every QE-n was bigger that its QE-(n-1). From what has happened with those monetary experiments - we can clearly derive that with the current rate of 2.25-2.5% of Fed funds rate, the Fed doesn’t have enough room like last time. It only has just half the ammunition. Going to zero alone is not sufficient. QE has to come sooner rather than later. Also - the economy should have its head above water during this whole period. Any lapse in liquidity or promise to liquidity will choke the economy. It’s a really tricky spot to be in, for Fed chairman Powell. He just can't afford a mis-step. A slowdown will expose all the mal-investments of the last decade., fueled by the fed itself.

As I have already mentioned in my earlier blogs, Ben Bernanke and Janet Yellen are primarily responsible for having persisted with easy money policy for too long. When testifying to the Congress when introducing the US economy to QE., the then Fed chairman Ben Bernanke told the congress that he is not monetizing the debt. He told QE and ZIRP are temporary. Balance sheet accumulation is temporary. Also promised that as economy starts to recover, he will somehow wind down the 4 trillion debt and restore it to its pre-crisis levels. None of them are true. The Fed's balance sheet is just below 3.85 trillion and with fed about to reduce the interest rates, we can safely assume that the debt on fed's balance sheet is not going to go lower than that. Ben Bernanke initiated the mess, Janet Yellen continued with that mess, and it fell on Powell to do the clean-up act, which was way overdue and impossible. Just say the Fed doesn't raise interest rates in July as expected by the market - the stocks are going to plunge. In fact the market wants a 50 bps cut rather than the usual 25 bps. The market is holding a knife at the Fed's throat.

On the political side, President Trump cannot afford is allow the recession to set in. It affects his reelection campaign of 2020 and in general the scope of the economy. No one knows that better than President Trump. As candidate Trump in 2015 he told correctly that the whole economy is one big fat ugly bubble based on ZIRP and QE.  He promised to act on the rising US trade deficit with all its trading partners and is taking some action on it (which may or may not be right). Candidate Trump also acknowledged that the shrinking of the work force participation percentage which has dropped significantly since the financial crisis of 2008. The government released unemployment rate doesn't capture this variant and its published to be lower than what it actually is. Trump during his campaign repeated multiple times, that the real unemployment rate is lot higher than what is officially reported and he even says it is as high as 20% or more. He was so right on that and it resonated with the US electorate. After coming to office though, Trump began to endorse the very same bubble economy as economic prosperity and even took credit for doing it. In fact - He calls it the Best economy in the history of the United States. The numbers do not support it whatsoever.  Because he owned the boom, unfortunately he will have to own the bust too.

The 10-year treasury yield which is used as reference rate for many long-term bonds, notably the US mortgage rates is trading at 2%. The Bond market is right - they are predicting that a 2% interest on a 10-year bond is more lucrative than the annual percentage growth that is going to happen in the next decade. But what it doesn't price in - is the inflation effect. The inflation rate is hitting the 2% level already. It will most likely make its ascend north. The Fed has already indicated that the inflation effect is "transitory of 2%" - which translates to - the inflation is going beyond the 2% mark very soon. With that happening around the corner, there is absolutely no reason for the longer term securities to have a coupon rate of less than that. In general - the longer dated treasury's interest rate are heading higher. It started to happen in last quarter of 2018 and that is where the stock market panicked. Any interest rate hike on long term bonds directly affects the leverage on corporate borrowing. With rising interest rates - rolling over existing debt is not an option anymore and the earnings will have to go down.

The slowing US economy usually takes the dollar with it. The dollar index has broken key levels since the Fed's meeting and is drifting downwards. Gold on the other hand, is breaking the $1400 an ounce and marching higher. To retrace its historic high, it needs to go to $1930 an ounce. It is definitely going there. It has made the price of gold for Asian economies higher. For example, In Indian currency, with the current exchange rate tied to the dollar index, the price of gold has already hit a historic high of Rs. 3580/- for a gram of gold. If we project it proportionally, if the price of gold hits the $1930 dollar mark, the corresponding rupee price for a gram of gold is Rs. 5000/-. This is politically not acceptable and panic would set in for a gold-rush or mania in the Indian gold market. So the only way to avoid this is to allow the Indian Rupee to appreciate against the falling dollar. It is possible then that the price of Indian rupee can move from its current Rs. 70/- rupee mark to say something around Rs. 50/-. That would be logical. The other asset class that is responding better to a falling dollar is bitcoin. As it stands now, it is already over 11K. When bitcoin as an asset class loses confidence and investors are jumping out, the trade is going to the traditional safe haven asset like gold, which is only going to accelerate the price higher in dollar terms.

In the month of May, the US government spent more than any month in its history. The debt accumulated every month is astronomical and has no historical precinct. The debt accumulated in 2018 (budget deficit and unfunded liabilities) is more than the nominal GDP (GDP not adjusted to inflation). This means that, if hadn’t for the rise in national debt (zero borrowing),  US economic expansion would have recorded a negative growth for the year.

If it can go wrong, it will. When it does, it will do so in spectacular fashion: breathtaking collapses, ghastly whitewashes and complete annihilation of confidence. Even though it was always on the cards, it appears more imminent that ever before. As Peter Schiff rightly puts it - Having the economy on ZIRP and QE are addictive in nature. Even though it feels good, they cause more harm than good. Withdrawal symptoms after heavy addiction are always painful. A recession is the absolute cure. Re-introducing ZIRP and QE again to make it work, may not work anymore!