Critics of “New Age” monetary policy have been predicting that central banks would eventually run out of ways to trick people into borrowing money. There are at least three reasons to wonder if that time has finally come: 

Wage inflation is accelerating
Normally, towards the end of a cycle companies have trouble finding enough workers to keep up with their rising sales. So they start paying new hires more generously. This ignites “wage inflation,” which is one of the signals central banks use to decide when to start raising interest rates. The following chart shows a big jump in wages in the second half of 2017. And that’s before all those $1,000 bonuses that companies have lately been handing out in response to lower corporate taxes. So it’s a safe bet that wage inflation will accelerate during the first half of 2018. 

The conclusion: It’s time for higher interest rates. 

The financial markets are flaking out The past week was one for the record books, as bonds (both junk and sovereign) and stocks tanked pretty much everywhere while exotic volatility-based funds imploded. It was bad in the US but worse in Asia, where major Chinese markets fell by nearly 10% — an absolutely epic decline for a single week. 

Normally (i.e., since the 1990s) this kind of sharp market break would lead the world’s central banks to cut interest rates and buy financial assets with newly-created currency. Why? Because after engineering the greatest debt binge in human history, the monetary authorities suspect that even a garden-variety 20% drop in equity prices might destabilize the whole system, and so can’t allow that to happen. 

The conclusion: Central banks have to cut rates and ramp up asset purchases, and quickly, before things spin out of control. 

So – as their critics predicted – central banks are in a box of their own making. If they don’t raise rates inflation will start to run wild, but if they don’t cut rates the financial markets might collapse, threatening the world as we know it. 

There’s not enough ammo in any event
Another reason why central banks raise rates is to gain the ability to turn around and cut rates to counter the next downturn. 

But in this cycle central banks were so traumatized by the near-death experience of the Great Recession that they hesitated to raise rates even as the recovery stretched into its eighth year and inflation started to revive. The Fed, in fact, is among the small handful of central banks that have raised rates at all. And as the next chart illustrates, it’s only done a little. Note that in the previous two cycles, the Fed Funds rate rose to more than 5%, giving the Fed the ability to cut rates aggressively to stimulate new borrowing. But – if the recent stock and bond market turmoil signals an end to this cycle – today’s Fed can only cut a couple of percentage points before hitting zero, which won’t make much of a dent in the angst that normally dominates the markets’ psyche in downturns. 

Most other central banks, meanwhile, are still at or below zero. In a global downturn they’ll have to go sharply negative.

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So here’s a scenario for the next few years: Central banks focus on the “real” economy of wages and raw material prices and (soaring) government deficits for a little while longer and either maintain current rates or raise them slightly. This reassures no one, bond yields continue to rise, stock markets grow increasingly volatile, and something – another week like the last one, for instance – happens to force central banks to choose a side.

They of course choose to let inflation run in order to prevent a stock market crash. They cut rates into negative territory around the world and restart or ramp up QE programs.

And it occurs to everyone all at once that negative-yielding paper is a terrible deal compared to real assets that generate positive cash flow (like resource stocks and a handful of other favored sectors like defense) – or sound forms of money like gold and silver that can’t be inflated away.

The private sector sells its bonds to the only entities willing to buy them – central banks – forcing the latter to create a tsunami of new currency, which sends fiat currencies on a one-way ride towards their intrinsic value. Gold and silver (and maybe bitcoin) soar as everyone falls in sudden love with safe havens. 

And the experiment ends, as it always had to, in chaos.

“When is the cheapest time to buy a Christmas tree?” I asked my kids.

My kids guessed that the earlier you bought it, the better.

Trees should be cheaper if you bought them earlier because, well, they have little use until Christmas, according to them.

For them, a Christmas tree means Santa and presents.

So it’s of little value to them until Christmas Eve, when its value spikes up.

It took a bit of explaining to get them to see that trees crash in price as Christmas approaches.

If you’re in the business of selling Christmas trees, you know there is no market for trees after Christmas Eve.

Though my way of looking at it is less exciting than my kids’ way of seeing things, it’s the way things actually work for Christmas trees — and in financial markets.

In simple terms, it means looking at supply and demand.

Right now, demand for certain investments is set to plummet. When that happens, you’ll see the prices of all these things drop through the floor.

Here’s why this is going to happen starting now…

Supply and Demand and Corporate Bonds

You see, the Federal Reserve started raising interest rates regularly starting late in 2015.

Since then, the interest rate for one-month government bonds has rocketed up from essentially zero to a high of 1.33%. And these interest rates are continuing to go up.

It took a bit for these short-term rates to start affecting bonds that go out longer. However, by late 2016, interest rates on longer-term bonds like 10-year government bonds started to go up too.

The 10-year bond is used by professional investors to gauge the attractiveness of all investments and set the price of all assets.

That’s because worldwide, governments, big companies and rich people are willing to buy the bonds of the U.S. government at all times. They see these bonds as safe, knowing they’ll get their interest and the money back when they’re due.

Now, when you can get higher interest rates on something that’s seen as safe, the demand for things that are less safe goes down. And with demand lower, the prices of other assets that people hold for safety and income go down.

So, for example, many people have bought corporate bonds issued by companies at very low rates over the last 10 years.

These corporate bonds are less safe because unlike the U.S. government, companies can’t print money, and they can go bankrupt.

These bonds benefited when interest rates were very low because investors were willing to take on more risk.

Now these corporate bonds are a worse deal because you can get the same interest rate on government bonds. Because of this, prices of these bonds are going down and are going to continue to go down.

A Global Recovery

People who bought the stocks of no-/low-growth companies like Kellogg Co. (NYSE: K) and Campbell Soup Co. (NYSE: CPB) for their dividends are seeing losses. That’s because fewer people want these stocks now. These two stocks are down 20% to 30% from their highs, and they’re going to keep going down.

Next, many people have bought into gold, collectibles and tangible assets like diamonds because they believe the U.S. and global economy are going to go through another Great Depression. I believe the mania in cryptocurrencies like bitcoin began because of a similar reason.

Many people distrust the government and stocks after the 2008 financial crisis, and cryptocurrencies are another place that people have put money into as a safe haven against another crisis.

However, the U.S. and global economy are growing today. In fact, there is a synchronized global recovery going on right now. Every major economy in the world is showing growth, and I believe this is going to continue for some time.

Very low interest rates were used by governments and central banks to soften the blow of the financial crisis. And now economies around the world are growing again.

That’s good for almost everyone … except for investments that depend on another Great Depression.

You see, the likelihood of a financial crisis is how corporate bonds, slow-growth dividend stocks, gold and bitcoin are priced today.

Now, with economic growth happening worldwide and interest rates rising, the prices of these investments are going to get clobbered as people sell them.

One More Thing…

You might be thinking: What about stocks?

Stocks that are the beneficiaries of economic growth are going to keep going up.

I believe that the benefits of economic growth are going to be big enough and go on for long enough that the stocks of growing companies are going to keep rising even as interest rates rise.

Regards,

Paul Mampilly

Editor, Profits Unlimited

While investors are justifiably focused on what may be the opening crescendo of a long overdue sell-off in stocks, there is not, as of yet, as feverish a discussion of the parallel sell-offs in bonds and the U.S. dollar, which have been underway for at least a year and a half in bonds and 14 months for the dollar. I contend that this should be widely understood as the root causes of the jittery Dow, and are ultimately far more important. A continued decline in the dollar and bonds holds the potential to ignite inflation while increasing mortgage rates, borrowing costs, and federal deficits. These developments would strike at the very heart of the economic foundation that has supported the country since the Financial Crisis of 2008, and threaten to push the economy into a recession that the Fed may be powerless to confront.

Secretary of the Treasury, Steve Mnuchin, stunned markets late last month when he said that a cheaper dollar would be a welcome development for the U.S. economy. The dollar sold off sharply as Mnuchin’s words appeared to be taken as proof that the Trump Administration overtly embraced a weaker dollar. To quell the uproar, President Trump himself, freshly arrived in Davos, Switzerland, had to “clarify” the Secretary’s comments, explaining, as only ‘the Donald’ can, that by “weaker” Mnuchin really meant “stronger.”

The exchange did provide a fresh twist on our decades-old “strong dollar policy,” which traditionally works like this: The President and/or senior Fed officials refer all questions about the health and trajectory of the U.S. dollar to the Secretary of the Treasury, who proclaims loudly and clearly, with no trace of irony, that “a strong dollar is in the national interest.” These comments reassure the markets, the dollar rises, and the operation is complete. Although this protocol is one of the simplest Washington has to offer, the Trump Administration managed to get it wrong on its first try.

Despite the fact that Trump’s vocal support for a “strong dollar” was not accompanied by any indication that he would actually do anything to support it, his words temporarily reversed the dollar’s 24-hour skid. But apart from reacquainting us to the absurdity of a “policy” that is simply based on mouthing a canned phrase, the episode raises a couple of key issues. Trump claimed that the economy is surging and, as a result, the dollar will keep getting stronger and stronger. The problem with these assertions is that neither is true.

Last week’s newly released Q4 GDP report from the Bureau of Economic Analysis (BEA) shows that the economy grew at 2.6% in the Fourth Quarter, bringing the entire year’s GDP growth rate to 2.4%, only .2% higher than the 2.2% GDP growth that we have averaged over the prior three years (2014-2016). And while 2.4% is marginally higher than the average growth we have had since the end of the 2008 financial crisis, it is still significantly below the average over the past century, and even weaker than two years of Obama’s second term.

The news is also surprisingly weak on the trade and employment fronts, another two areas for which Trump has shown particular enthusiasm. Contrary to the supposed “record job creation,” average monthly job gains in 2017 were 17% slower than the combined averages in 2015 and 2016, based on data from the Bureau of Labor Statistics. In fact, job growth in 2017 was its slowest pace since 2010. Similar disappointments can be found in America’s trade balance, which, according to Trump, has improved dramatically due to his “tough” negotiations and our resurgent manufacturing sector. But according to the U.S. Census Bureau, average monthly 2017 trade deficits (through November) were 11% wider than 2016, and 14% wider than the average over the prior 4 years. What’s worse is that these increases come at a time when a falling dollar, in theory, should have narrowed the gap!

Given all this, one would be hard-pressed to find the “boom” Trump describes, especially if one is also claiming that such windfalls were not occurring under Obama. But since when have facts ever mattered in Washington or on Wall Street?

So if Trump is wrong about the economy, jobs, and trade, what should we make of his view that “the dollar will get stronger and stronger?”

While the financial media has been focused on the stock market, most have dismissed the significance of the declining dollar. 2017 saw the first annual; decline in the dollar in five years and its largest decline in 14 years. 2018 is off to an even worse start, with the dollar registering its steepest January decline since 1987. In fact, against the Chinese yuan, January was the weakest month for the dollar since 1994. The current decline in the dollar index that began in December 2016 is now the longest continuous decline in the last 12 years. And while other recent declines have been steeper (see chart below), this one is distinct because it is occurring against a set of economic conditions that should be bullish for the dollar. Economic growth is assumed to be strong, consumer confidence is high, and the Fed is expected to keep raising interest rates and actually shrink its balance sheet (which would diminish the supply of dollars).

 Data from Yahoo Finance, BEA, & Bloomberg

Created by Euro Pacific Capital

So if the dollar is falling now, with everything supposedly going in its favor, what should we assume will happen if the dollar’s luck runs out? A recession, which typically brings with it a decline in GDP and consumer confidence, and which may cause the Fed to reverse policy, may likely knock out the remaining supports for the dollar and result in deep declines. But given the nearly universal optimism that prevails in financial and political centers, it’s unlikely that these concerns are widely shared.

Over the past century, the U.S. economy has experienced a recession, on average, every six and a half years. Despite the fact that more than a decade has passed since our last recession began, few forecasters see another one looming. But interest rates are currently creeping up further and faster than nearly anyone had predicted. At 2.85%, the yield on the 10-year Treasury is currently at its highest level in nearly 4 years. Except for a few days in December 2013, yields haven’t been higher than 3% since mid-2011. It’s very possible that rates on the 10-Year Treasury will relatively soon break through 3%, perhaps lifting mortgage rates and bank loan rates into territory that we haven’t seen for well over a decade.

But it’s absurd to expect that yields won’t go considerably higher than 3%, especially given how the supply of Treasury bonds coming to market will balloon in coming years. As reported last week by the Wall Street Journal, the Treasury Borrowing Advisory Committee – a group of private banks that advises the Treasury – estimated that $955 billion of Treasury debt will come to the market this year (up from $519 billion last year), and that the issuance will surpass $1 trillion in fiscal 2019 and 2020. The Journal reports that the Committee ramped up its estimates due to the recently passed tax cuts. So the issuance of Treasuries may spike just as demand for them may wane due to a possible slowing economy and a falling dollar. Just today, the Associated Press reports that a potential budget deal being discussed in Congress would grant both parties their respective spending priorities, resulting in a $1 trillion deficit as soon as next year. Recall that the only other times that we ran deficits that large were the years 2009-2012, a period in which the Federal Reserve was buying nearly half a trillion per year of Treasury debt through its Quantitative Easing program. But now the Fed has promised to effectively sell bonds to shrink its balance sheet, in a process that could be called “Quantitative Tightening.” This is a recipe for an enormous decline in the bond market, which could send yields much higher.

Does anyone really expect that our current economy could absorb rates on the 10-year that might hit 4% or higher without slowing? Perhaps they are just too numbed by success to care at this point. In fact, if rates rise above 4%, what is there to prevent them from surging much higher? It’s ironic that as stock market investors ignore the collapse in bond prices, the one thing that might prevent a bond market crash would be for the stock market to crash first, thereby forcing the Fed’s hand. Yet the markets seem unconcerned.

Since the Federal Reserve and the U.S. Government began intervening in the markets in the wake of the 2008 financial crisis, there has been almost no downside volatility in stocks. With the exception of a trivial 8% decline in the opening two weeks of 2016, the nearly 300% rally in the Dow since March of 2009 has been achieved with hardly a step backwards. The 10% and 20% corrections that were fairly commonplace throughout much of the 20th Century, now seem to be relics of the past. In fact, despite the recent breakneck speed of ascent (40% gain in just 15 months) and the record level valuations (stocks trading around 27 times trailing earnings), the volatility index, which is commonly viewed as a measure of investor fear, is remarkably, almost historically, low. 

It does seem that fear and worry have been thoroughly banished from Wall Street.

But the dollar itself may be a window into the troubled souls of otherwise carefree investors. Even in the market surge of the past decade, there have been some isolated moments when daily declines are significant. By looking at what “safe haven” choices investors make on the market’s worst days, we can potentially see what may happen if the market experiences sustained selling.

If we look at the average of 10 worst market days each year during the five years from 2008 to 2012, 50 days when the Dow dropped by at least 100 points, we can see that the dollar tended to rally in the panic. During those days, the dollar index rallied 80% of the time, and on average rose .6% on the day. This seems to reflect that the dollar maintained its “safe haven” status. But, in more recent years, that has changed considerably. Averaging the 10 worst market days of each year in the market from 2013 to 2017, the dollar fell on those 50 days by approximately .3%, and it only rose 26% of the time.

Data from Yahoo Finance, BEA, & Bloomberg

Created by Euro Pacific Capital

Past performance is not indicative of future results

This shift in sentiment could be extremely significant in the years ahead. This is why a simultaneous collapse in bond prices and the dollar could be so significant. It could show that rising interest rates do not reflect improved growth, as so many stock market bulls conveniently claim, but a loss of confidence in the dollar and the creditworthiness of the United States.

The onset of both of our previous recessions (2000 and 2008) inspired the Fed to cut interest rates by at least 500 basis points. Currently the Fed Funds rate is still under 1.5%. If a recession comes, 150 basis points in cuts before the rate hits zero may not be nearly enough to provide the stimulus that the markets have come to expect. That may mean that the next recession might almost assuredly bring with it another round of quantitative easing from the Fed. But the Fed has already prepared the currency markets for its balance sheet to shrink. Imagine the reaction when the opposite occurs.

A recession that brings on another dose of QE could help to create the perfect conditions to help push the dollar to record lows, continuing its long-term bear market that began in the early 1970s. The low for the dollar Index in 2008, just before the dollar was saved by the financial crisis, was just above 70. It is currently just above 89, having traded above 104 as recently as January of 2017. My guess is the next leg down could take the dollar index to 60. To support the currency, the Fed would have to follow the example of Paul Volcker, who hiked interest rates in the 1980s when the dollar was collapsing. Of course, such moves to prop up the dollar during a recession will be acutely unpopular and may bring on a recession worse than the one seen in 2008. If the Fed lacks the courage to administer such medicine, a dollar index at the 40 level might not be ruled out.

All this adds up to a possibly rough road for investors who maintain 100% exposure to the U.S. dollar.

Read the original article at Euro Pacific Capital