The Other Side of the Coin
By James J Puplava CFP, July 21, 2003
Cheap money was supposed to be the cure. Falling interest rates and plenty of credit were going to resurrect the economy and the financial markets. So far the results aren't measuring up. The economy has muddled through a recession and the stock market has recovered this year. However, things aren't going as they should or at least as policymakers would want them to be. The economy has recovered, but there has been no recovery in the job market. One of the reasons the National Bureau of Economic Research delayed declaring the recession over is because unemployment has worsened. Since the recession was declared over in November of 2001, close to a million additional workers have lost their jobs. If the recession ended nearly two years ago, then why aren't jobs more plentiful? If we are indeed in a recovery, then why has there been no noticeable pickup in business spending? If this is a recovery, it sure hasn't been a normal one. Since the recession was declared over in 2001 the Federal Reserve has found it necessary to cut interest rates an additional two times, once in 2002 by half a point and once again in June of this year by a quarter of a point. We now have the lowest interest rates in half a century and still no signs of an improving job market.
One of the problems is that the Fed can expand credit in the financial system, but it has no control over where it goes or how it is used. In the case of consumers, lower interest rates have produced a debt and consumption binge never seen before. The reaction by consumers to lower interest rates has produced just the opposite reaction as in previous recessions. In the '91 recession, consumers used lower interest rates to refinance and pay down debt. The cash saved from lower mortgage rates was then used to build up savings. So when the economy improved, consumers were in better financial shape. There was pent up demand and strong balance sheets to give consumers the confidence to spend when the economy improved.
In this last recession we have seen just the opposite behavior. Consumers have used lower interest rates to buy new homes and new cars. They also used lower mortgage rates to refinance debt and extract additional equity out of their homes to buy furniture, home entertainment systems, make home improvements, go on vacations, buy recreational vehicles and other consumer toys. This spending binge on the part of consumers was all debt-based consumption. This additional spending that was financed by debt is what made the recession of 2001 so mild. Instead of pulling in their horns on spending as businesses did, the consumer went all out on a wild spending orgy that is not show signs of abating. The consequence of this change in behavior is that consumer spending now makes up close to 90% of U.S. GDP.
The other side of this over-consumption on the part of consumers is America's burgeoning trade deficits and the collapse in savings over the last five years. Americans save very little and borrow money to maintain a style of living that is unsustainable. Consumers have been able to keep up their spending only because they have kept on borrowing money. The household debt to household income ratio has risen to 105% from 90% in the early 90's. Today the consumer may find that lenders are virtually paying them to borrow money. But cheap money has a downside as when the economy weakens, prices deflate, and unemployment rises. The combination of all three could be devastating on household budgets by making debt more onerous. In a credit deflation that always follows a credit boom the cost of debt becomes more burdensome, especially if personal income growth and the job market weakens. Consumers could then find their debt burdens to be overbearing. If the job market doesn't improve and if income growth further deteriorates with a weakening job market, the cost of that debt will become more expensive. Even worse is if interest rates begin to back up as they are now doing. Then the cost of all variable rate debt begins to rise.
This may be what is beginning to happen now. There are plenty of new stories each week of rising foreclosures and bankruptcies at the consumer level. Last week's Rocky Mountain Times reported that home foreclosures in the seven county areas from Boulder to Broomfield County are up 38.5% in the first six months of the year. In the Boulder area foreclosures are up 61.6%. The latest real estate trend is that people aren't able to hold on to expensive homes, so they are walking away. The loss in jobs in the job market is slowing down home sales, causing prices to weaken. As is the case with many two-income households, we are seeing one of those incomes disappear with a job loss. When that happens the couple is no longer able to maintain their home. Evidence of this trend is surfacing more and more around the country as the job market worsens. As we see more signs of a deteriorating job market, consumers are beginning to tighten their belts. Retail sales have been soft and manufacturers are starting to lighten up on inventory. Basically, the stuff isn't moving out the door, so everyone is pulling back.
Less Bang for a Fed Buck
As debt levels continue to mount each month, consumers are starting to slowly recognize they have overdone it. As this reality starts to set in, they slowly begin to retrench on their spending plans and concentrate on pairing back debt levels. It may be one reason that money velocity is starting to shrink. As the two graphs below of M3 indicate, the Fed is pumping money into the economy as never before. However, M3 money velocity is falling rapidly, so each dollar injected into the system isn't producing the same impact. Essential, the Fed getting less bang for the buck.
Money velocity can slow down even while the money supply expands initially due to the delay in preferences for money. One reason why money velocity may be slowing down now is the effect on prices and the prospects for further change or reduction in price. If consumers expect prices to fall in the future, they may want to hold on to their cash expecting lower prices in the future. A second and close corollary to lower money velocity is the ability to substitute holding other assets as a substitute form of money. If the money supply is rapidly increasing as shown in the graph above, it pays to hold other assets rather than money itself. I believe this is what we have seen in the financial markets over the last few years. As the supply of money has expanded, it becomes more beneficial to hold other assets such as bonds, or recently stocks, in preference to cash. At today's low interest rates of 1%, cash returns are negative after taking into account taxes and inflation. The rapid drop in interest rates since the beginning of the year has caused money to move out of cash and into the bond and stock markets fueling this year's rally in financial assets.
As the supply of money increases, lowering its value, it pays to hold other assets or money substitutes in the belief that these other assets offer inflation protection. If they can be sold for more money than what they cost in the future, then purchasing power is protected. As the value of the currency depreciates consumers and businesses will increasingly look for money substitutes. The consumer will put his money in cash substitutes, currently the bond and stock markets, while businesses may want to hold on to the commodity they produce. This trend is visible in certain commodity producers such as gold mining companies where the producers are holding back some of their production. Eventually as the supply of money increases, its value will also depreciate forcing businesses and consumers to seek out hard assets rather than to keep their funds in cash. As inflation accelerates, it pays even the ordinary consumer to hold commodities as a source of cash rather than cash itself "above all, gold and silver or less rapidly inflating foreign currencies."
This is what I believe is happening now to the dollar. Money is moving out of the dollar, into foreign currencies that are depreciating at a much slower rate than the U.S. The spec community has been moving out of the dollar along with foreign institutions. This accounts for the dollar's rapid fall this year as dollar trades are unwound. Meanwhile, to keep their currencies from appreciating too rapidly against the dollar as a result of large trade surpluses with the U.S., Asian central banks have been buying dollars. Year-over-year Treasury bond purchases by foreign central banks are up $149.4 billion bringing foreign central bank holdings of U.S. Treasuries up to $941.5 billion. The Fed has also been monetizing U.S. Treasury debt to the tune of $60 billion over the last 12 months. However, at the rate that the U.S. trade imbalance is growing it may become impossible for foreign central banks to completely neutralize their own currency depreciation, meaning further dollar depreciation is inevitable.
As the dollar continues to depreciate and the preference for cash diminishes, the value of gold and silver will continue to rise. The gold and silver markets are still in the early stages of a new decade-long bull market. The rise in gold has just begun, and the rise in silver should be explosive when it erupts.
Meanwhile, the business sector is failing to react in ways that have been expected as a result of cheap money. Companies are using today's low interest rates not to expand and invest in new plant and equipment, but to instead repair their balance sheets. Profits still remain depressed due to excess capacity globally. This is one of the man reasons that job growth has been non-existent. You are not about to hire more workers, if you can’tkeep your existing plant and machines running at full capacity. The problem is excess capacity globally in just about every manufactured good. Instead of the liquidation of all of the credit boom's malinvestments, those malinvestments have been kept on life support systems through low interest rates. Low interest rates have allowed financially-strapped and near-bankrupt companies to remain alive through the refinancing of existing debt or the issuance of additional debts. This keeps excess capacity on line, further depressing prices and profits.
In addition to supporting excess capacity through debt issuance, low interest rates have also impeded profits by increasing pension liabilities. As pension liabilities keep growing the lower interest rates fall. A good example of this was GM's recent $13.2 billion June bond issue, the largest debt issuance in U.S. history. GM needs the money to plug a $19 billion gap in its pension fund. Last year they needed to issue a couple billion in debt to shore up the company's medical plan.
Low interest rates have been creating havoc with pension plan returns. As interest rates drop the present value of future pension obligations increase in current dollars. This means that companies have to fund more dollars into their pension plans today to make up for lower returns in order to fund future liabilities. This is turning out to be one of this year's big profit killers. Last year it was goodwill write-offs and restructuring charges. This year it is restructuring chargers and pension obligations that are killing profits.
In the end the expansion of credit and lowering of interest rates have done nothing more than to have postponed the inevitable adjustment process from an over inflated credit bubble that turned into multiple asset bubbles in stocks, bonds, real estate, mortgages and consumption. Until all of these malinvestments are liquidated the economy and the job market will fail to improve in real terms. By continuing to pump credit into the system in order to keep asset bubbles from deflating, the Fed is creating the very deflation monster it now fears. We will either get the inevitable deflationary depression that accompanies all credit bubbles, or the Fed through failing to recognize the root causes of the present deflation overacts and leads us into a hyperinflationary storm.
A parade of disappointing earnings caused investors to dump stocks. Merck reported profits that came in a penny less than expected. Lexmark reported lower earnings as did many other companies. Motorola also warned today that a roll out of new cellular phones this year will hurt profits going forward. The company said it will miss profit forecasts for the 2003. Analysts remain bullish despite the recent disappointments. So far second quarter results of those companies reporting have exceeded estimates by about 6 percent. This shouldn't come as a surprise since estimates have been dramatically lowered for the second quarter. The bar for earnings has been lowered so much that companies can now exceed them. The real test will come in the next two quarters where expectations border on the miraculous.
Investors still remain confident which is evident in the movement into lower quality debt and equity issues. The top performing equity and bond sectors are in the high risk area. Companies that have deteriorating balance sheets and income statements have done the best in this recent bear market rally. In a similar fashion high yield junk bonds are doing equally as well with credit spreads continuing to narrow between high and low quality debt. This indicates that analysts and investors are expecting a robust economy to develop in the future. In fact looking at credit spreads and P/E multiples you can say that investors are not only anticipating a recovery, they are in fact expecting a boom. Even Mr. Greenspan is predicting 4.5 to 4.75% economic growth next year.
Those who remain obstinately bullish in this market may want to look at the charts of the 10-year note and 30-year bond below. As rates rise as they have recently, it means that future earnings will be discounted at a higher interest rate, making those earnings less valuable in today's dollars. Rising rates will at some point begin to compete with equities.
The plunge in the bond market today also weighed in on stocks. At the close of trading today the 10-year note lost 1 point bringing its yield up to 4.17. This puts the 10-year note yield back to where it was on January 9th of this year erasing all of this year's gain. The 30-year bond lost two points sending its yield soaring to 5.08%. If rates keep rising like this the stock market could be headed for problems along with the dollar. A lot of money has been bet on a strong U.S. economic recovery and a major recovery in corporate profits. If that doesn't materialize then, "Houston, we have a problem." That problem is going to be the value of the dollar and any other financial asset held here in the U.S.
One of today's bright spots was gold and silver bullion along with precious metal equities. Gold for August delivery closed up $3.70 for the day to finish at $351. The price of gold has held up rather well during this latest bear market rally in stocks. The fate of gold is ultimately tied to the fate of the dollar and other fiat currencies, which are depreciating only at a slower pace against a basket of key commodities.
Volume was weak given the decline in equity values. That could be bullish since it shows that there are no major signs yet in selling pressure. Volume on the NYSE was only 1.2 billion shares and only 1.4 billion on the Nasdaq. Market breadth was negative by a 24-8 margin on the NYSE which has a lot of financial issues. Losers beat out winners by a 21-11 margin on the Nasdaq. The VIX closed up .76 to 22.12 while the VXN dropped .34 to 33.07.
Graphic Source: Economagic & StockCharts
© 2003 James Puplava