by James J Puplava CFP, President & CEO, PFS Group. June 18, 2004
The markets don't look right to me. They appear to be out of order. Uncertainty is everywhere. Geopolitical risks abound from Central Asia and the Middle East to the American ballot box. Financial risks have never been greater with asset bubbles consistently inflating, fed by an avalanche of debt. Speculation is rampant with banks and hedge funds borrowing short and investing and lending long as well as households borrowing short and investing long in real estate. Despite record amounts of consumer, business, and government debt, financial markets remain complacent to the threat of higher interest rates.
An economy and stock market that is this levered is far more vulnerable to small movements in interest rates �even if they are measured. On the economic front, America's twin deficits keep expanding as our nation goes deeper in debt. Yet, the dollar has been in a rally mode since the beginning of the year. Inflation is also on the rise and is visible everywhere you look, but gold and silver prices have been falling.
What we have here is financial alchemy and I can't help but believe this is going to end badly. There is simply too much risk and uncertainty. What astounds me is the fact that investors seem oblivious to it all.
Source: US Census Bureau, June 14, 2004
On Monday of this week the Commerce Department reported that the April trade deficit was the worst on record coming in at $48.3 billion, an annual rate of $575 billion or nearly 5% of GDP. The decline in the dollar over the last two years has done very little to stem the U.S. trade imbalance.
According to recent figures, America is importing and paying more for its oil. The average cost of oil in April was $31 a barrel. The trade deficit figures should be even worse next month as energy prices continued to rise to record levels in May.
But the growing trade deficit wasn't entirely due to oil prices. Imports of everything from autos and electronics to furniture were also up. Automobile and auto parts imports rose to a record $19 billion, while Americans shelled out $31.7 billion for consumer goods. How is job growth in this country supposed to improve when more of our consumption goes towards the purchase of foreign made goods?
Economists argue that our rising trade deficit is due to our extraordinary economic growth in comparison with the rest of the world. Our GDP is expected to grow by over 4% this year. In contrast to our robust economic growth, French economic growth was revised downward to 0.50% for this year. Yet, America's trade deficit has darker side. It reflects a lack of national saving that needs to be supplemented by importing foreign capital.
The U.S. Is Not Alone With Deficits
Other nations that are running large budget and trade deficits are seeing the price of their bonds drop in value along with their currencies. For example, Brazil and Turkey are two countries that have run into difficulty recently. Both countries have suffered the sharpest increases in interest rates among emerging countries this year.
Brazil, which is running a $21 billion budget deficit, needs to come up with $33 billion to cover maturing bonds in 2004 in addition to financing this year's deficit. Turkey's budget deficit this year will approach $31 billion. It will also need to pay the equivalent of $110 billion to domestic bondholders in 2004. Turkey will also need to pay $2.1 billion in U.S.-denominated bonds and $500 million in yen-denominated bonds by the end of the year. Both countries are experiencing rising interest rates and a falling currency.
With a Little Help From Our Friends
By contrast, the U.S. has experienced a rising currency even as our budget and trade deficits worsen. This is due to currency intervention by Japan and China and other central banks. On Monday, June 13th, the day the April trade deficit numbers were released, the dollar rose against the Japanese yen. The Fed reports that foreign central bank holdings of Treasuries at the Fed have risen by $293 billion in the last twelve months. They are up only $7.4 billion in the latest week ending on June 9th.
Why has the dollar risen instead of falling as would be the case if the markets weren't altered?
Plain and simple: the value of the dollar has been held up by Asian currency policy. Asian central banks, in particular Japan and China, have been willing to endlessly buy dollars. So in effect, interest rates and the value of the greenback rest on the whims of Asian central bankers.
What will happen to interest rates here in the U.S.? What will happen to mortgage rates, to the value of real estate and to our stock market, which now rest in the hands of Japan and China more than it does the U.S. Fed? If foreign central banks stop buying or, even worse, start selling, our currency falls and interest rates rise. It is now a question of not "if" but "when" the dollar nexus unravels. No nation, not even the U.S., can run $500-$600 billion twin budget and trade deficits into perpetuity. At some point foreigners will say "No more!"
The Carry Trade - The Search for Yield
What will precipitate this unraveling is yet unknown. It could be another rogue wave in the financial markets or a geopolitical event. I suspect this time it will be financial in nature.
According to a recent BIS (Bank for International Settlements) report, derivatives traded on global exchanges rose at the fastest pace in three years during the first quarter of this year. The value of derivative contracts on stocks, interest rates, commodities, and currencies increased by 31% during Q1 of this year, rising to a record $272 trillion. Not since the first quarter of 2001 when derivative contracts surged 55% have we seen this much of an increase.
According to the BIS report, a robust appetite for risk underpinned equity and credit markets. Additional revelations of corporate malfeasance failed to put a dent in investors' appetites for risk. Equity and debt prices in emerging markets outperformed most markets. Implied volatility of options on U.S. equity indexes fell to record lows, while credit spreads narrowed on emerging and high yield debt.
Source: BIS Quarterly Report, June 2004, p.10.
During this speculative quarter not only did yields fall on risky debt, but in addition troubled economies of Brazil, Turkey, Venezuela and other emerging market borrowers continued to amass large amounts of new debt, more than any other quarter since 1996. Incredibly, despite increased risks, yields fell. To a large degree, this reflected the effects of the carry trade with institutions and hedge funds moving out of cash in search for yield.
That was March. Since then, things have changed. The first round of the unraveling of the carry trade took place in April and May. As it appeared that the Fed was going to tighten, the carry trade began to unwind. Shown below are charts of emerging market debt, junk bond spreads, the treasury market and the gold market. All four markets got hit hard. Emerging market debt fell by 15%, junk bonds fell by almost 10%, 10-year Treasury yields rose more than 119 basis points, and the gold stocks (HUI) fell by 29%. The major equity indices went from gains to losses. This was only round one.
As the markets began to unravel during this first stage of the tightening process, Federal Open Market Committee (FOMC) officials, or more appropriately the Federal Open Mouth Committee, went into high gear, feeding the markets soothing words such as "measured" and "slow." [See]
The damage above was all done without the Fed firing a single shot. Imagine what would happen if they were to get real serious about inflation. Fed officials were able to rescue the markets by reassuring market players that they would take their time in raising interest rates. This was supposed to assuage the market participants, and especially the carry trade, that they would have plenty of time to unwind their positions. The last thing the Fed wanted was another repeat of 1994, 1997, or 1998.
The markets have become even more geared since those turbulent days. In addition the Fed had plenty of bullets to fight a crisis with the federal funds rate at much higher levels than where it stands today. At the end of 1994, the federal funds rate stood at 5.50%. It was 5.50% at the end of 1997 and 4.75% at the end of 1998. All three years were crisis years. When the Fed raised interest rates in 1994, it nearly collapsed the financial markets creating the peso crisis and a crisis in derivatives with Orange County, Gibson Greeting Cards and other derivative players. Institutions simply didn't understand the risks they were taking. I am not sure they understand those risks today.
The point that needs to be understood is that the U.S. economy and the financial system is far more leveraged than where it was nearly a decade ago. Globally, derivatives have grown to a mammoth $272 trillion. In the U.S. the notional value of derivatives in insured commercial bank portfolios grew to $71.1 trillion. Of this amount, $61.9 trillion was interest rate related. Bank derivative portfolios have grown exponentially since 1994. We've seen derivatives grow from less than $17 trillion in 1994 to today's $71.1 trillion. Incredibly, bank derivatives have grown at a compound rate of over 17% over the last 9 years.
Unlike previous years, today's players are more interconnected. Most trades are placed with a handful of banks and brokerage firms. Everyone believes that they have hedged their risks. In actuality, the risk has just been passed around from bank to bank and brokerage firm to brokerage firm. Everything works out as long as no major player goes under. If that happens, the whole system implodes like dominoes stacked up one against the other. You may think that you are hedged, but your hedge is only as good as the financial solvency of your counterparty.
So far during the first phase of the unraveling, there have been no real casualties. Markets have adjusted to future rate expectations with the bond market doing most of the Fed's job. As shown in the 10-Year T-Note and 30-Year Bond charts, interest rates have risen significantly.
Massaging The Numbers Won't Make It Better
However, as much as rates have risen, they have much further to go. Inflation indexes indicate that the true rate of inflation is probably approaching 8-10%. The CPI and PPI numbers are statistically massaged to remove the major impact of inflationary increases. Instead of measuring the cost of housing, the CPI Index uses a rent equivalent number which is much lower than the true inflationary costs of housing. Other statistical measures, such as quality adjustments, temper or remove price increases so that inflation rates seem reasonable. Even with these adjustments, there is no hiding the fact that inflation is on the rise. May import prices for the United States were up 1.6% in May. While a good majority of this increase was due to a spike in oil prices, other commodity prices rose as well. Wage costs are rising, health care benefits are moving up at high single-digit rates and food costs have nearly doubled.
The May CPI index jumped 0.6%, which was the largest increase since January 2001. Higher food and energy costs accounted for the bulk of the increase. Year-over-year core CPI is up 1.7% and rising quickly this year. Including food and energy, which everyone needs, the CPI index is now rising at an annual rate between 7 to 8% a year. In the meantime, for the second time this year, the Bureau of Labor Statistics has delayed the release of the PPI, the second measure of inflation. The Bureau is having "technical difficulties" coming up with a number. One can only guess by the jump in raw material prices that the PPI number has risen considerably. The new improvement measures the Bureau is considering can suspiciously be seen as an attempt to suppress a sudden surge in the index. Given the fact that commodity prices are up this year, one would expect the PPI numbers to also be up. There is tremendous pressure to keep the numbers suppressed. Higher inflation numbers mean higher interest rates, higher COLA adjustments on pensions, and a major adjustment of market multiples. Higher inflation rates and higher interest rates pose a major risk not only to the financial markets, but also to the economy. It is important to maintain the illusion that inflation rates are low, especially for the bond markets, which are the traditional vigilantes of inflation. Regardless of what is said by Wall Street and Washington officials, inflation is on the rise and has worked its way down Wall Street to Main Street.
During the 80's inflation was transferred from the economy to the financial sector. Inflation accelerated during the 90's as the money supply ballooned. Debt levels went through the roof. However, the bulk of this money and credit went into our financial markets giving us double-digit growth in the major indexes year after year. Inflation never showed up on Main Street because excess demand was made up by cheap Asian imports.
The burgeoning trade deficit, a Nasdaq at 5048, and P/E multiples of 100 to 1,000 on tech and Internet stocks was a reflection of this inflation. Consider the fact that since January 1995 M3 money supply has grown by $4.8 trillion, a growth rate of over 8 percent per annum.
What has changed in this new millennium is that money growth has accelerated as a result of the bursting of a stock market bubble, a recession, and the attacks of 9-11.
In addition to the growth of money and credit, U.S. companies and consumers now compete with Asian companies and consumers for raw materials and consumer goods. Asian economic growth now competes with U.S. economic growth. The result is that inflation has made its way over on to Main Street.
Stagflation Rears Its Ugly Head
We are now in a new environment somewhat similar to the 1970s when the money supply soared as central banks expanded money and credit to accommodate the impact of higher energy prices. The result was stagflation. Isn't that where we are today? Rising energy prices, higher rates of inflation, anemic job growth, and stagnating wages all point to a stagflation environment.
Given the current budget and trade deficits of the U.S., inflation is likely to accelerate in the months and years ahead. The reason is simple: money and credit growth.
Watch What I Say... Not What I do
Forget what the Fed says and watch what it does. As shown below, the money supply is growing rapidly again. In addition the Fed has begun to monetize U.S. Treasury debt as shown in the table below.
With Asian central banks pulling back on their purchases, the Fed may have no choice but to start monetizing our debt. The government deficit will be over $500 billion this year and the trade deficit is tracking at an annual rate of $575 billion. Where will all of this money come from? If the government tries to get it from taxes, there will be a tax revolt in this country the likes we have not seen since the founding of this country. Taxes are going to go up no matter who is elected president. Kerry will raise tax rates the most, which will be the final death knell on the economy. Regardless of what tax rates our leaders impose, they won't be high enough to cover the government's voracious appetite for spending. (Each candidate is proposing massive new spending programs.) Taxes will not be able to cover the government's bill. Government simply spends more than it takes in. So what they don't take in taxes will be made up by printing more money. This will further accelerate inflation.
|Fed Securities Held Outright: 683,066 Bln|
|Recent Fed Securities Bought:|
|May 05, 2004||+ 2,199||billion|
|May 12, 2004||+ 88||million|
|May 19, 2004||+ 1,748||billion|
|May 26, 2004||+ 453||million|
|June 02, 2004||+ 1,441||billion|
|June 09, 2004||+ 1,598||billion|
|Source: Federal Reserve Data Bank|
Some question whether the money supply numbers are real, since the Fed seasonally adjusts these figures. Recently the Fed adjusted the money supply data all the way back to 1998. As with all U.S. economic statistics, one never knows what one is getting. All of our economic numbers are seasonally adjusted. The GDP numbers are artificially inflated through hedonic indexing and adjusted inflation numbers. The unemployment and jobs report is inflated by the "net birth/death model" and the inflation indexes are manipulated through quality adjustments and exclusions of items that are rising in cost. If there are any doubters as to the degree of money growth, all one has to do is view the debt graphs below of total debt outstanding, bank credit, corporate debt, and mortgage debt.
Source: Michael Hodges, Grandfather Economic Report
Source: A.Gary Schilling
Source: Doug Noland, Prudent Bear
If the money supply hasn't been growing as fast as the figures indicate, then where did all of this credit come from? Or consider these facts: financial sector debt more than doubled since 1997 from $5,532 billion to $11,402 billion, total indebtedness grew by $15 trillion to $35 trillion from 1997 to 2003, and it is now $37 trillion. As for that pillar of the global economy, the American consumer, he is up to his eyeballs in debt having borrowed $775.7 billion in 2002 and $879.9 billion in 2003 by way of mortgages, home equity loans and credit cards. Consumer debt is now estimated at over $2 trillion dollars.
Unraveling: Then and Now
What you have today is an economy that is entirely run on credit. Even a small rise in interest rates can do irreparable harm. Think back to 1999-2000. The Fed began raising interest rates at its June 30th meeting in 1999. It raised the federal funds rate from 4.75% to 5%. Thereafter, it continued to raise rates in quarter point increments, taking the federal funds rate up to 6.5% by May 16, 2001. It raised rates gradually and in small increments. But it was able to raise interest rates by only 1.75%. The rise in interest rates gave us a 75% decline in the Nasdaq, a recession, the worst job growth and the largest pullback in business investment in nearly half a century.
Companies, consumers, the government at all levels, the financial markets, and our entire economy are far more leveraged today than we were in 1991 or even 2000. A rise in interest rates of as much as 1, 2, 3 or 4% (as many analysts and economists are indicating) would collapse our economy and financial markets. What is sustaining the U.S. economy, our financial markets, and the American consumer is ever increasing amounts of debt and the asset bubbles that underpin that debt. Homeowner equity has fallen steadily from 85% in 1945 to 55% in 2003. Even that figure is distorted by the amount of homes that are free and clear held by an older generation. Corporate debt remains high at close to 75% of GDP and the government's own debt is now over $7 trillion.
The Consequence of Rising Interest Rates
If the Fed raises interest rates as high as many in the financial community suggest, they will lead us into the next Great Depression. I doubt whether the next president, whoever that turns out to be, or an American Congress would look favorably at collapsing real estate prices, a collapsing stock market, another banking crisis, a sinking economy, and unemployment rates of over 10%. There would be a voter backlash of biblical proportions. The economy is simply too weak and dependent on easy and cheap credit. Deprive that economy of credit and the whole financial edifice collapses. Unlike 2000, the financial system, in particular the banking system, is dependent on inflated real estate prices as collateral for all of those mortgage loans made to consumers. (Mortgage assets represent almost 60% of banks' earning assets.) The financial sector appears healthy only as long as real estate prices hold up. Household balance sheets are stretched to the limit with less disposal income and debt levels at record highs.
Hedge Funds & The Risk of Derivatives
Besides a crisis in the economy that will come about through rising interest rates, there is also the looming crisis in the financial markets. The meltdown in emerging debt is now spreading to the junk bond market. Interest rates on high-yield bonds are rising as the hot money bails out. There are now more than 7,000 hedge funds that play a major role in terms of global capital flows. These funds tend to follow the leader as they move into the same sectors. There is very little diversity in hedge fund strategies. Most funds follow the same strategy in the same way that mutual fund managers do. Everyone is doing the same thing. These funds manage about $860 billion in investor capital. That figure is considerably larger when you consider that many funds are leveraged 20:1. When rates are low, hedge funds can make a lot of money by borrowing short-term and investing long. However when rates rise, regulators start saying their prayers. No one wants to see another LTCM. And yet just as most funds employ the same investment strategies, they also use the same risk models. These models are supposded to minimize the risk according to Nassim Taleb, author of Fooled by Randomness. Taleb points out that the trouble with these models is that they are all backward looking. Since most funds use the same models, they move money in and out of sectors at the same time. They may be hedged, but who are they hedged with? Banks used to hedge their loan books with derivatives. Now they sell that insurance to hedge funds and other market players. The fallacy of banks selling insurance to others as Taleb points out is akin to "...buying insurance on the Titanic from someone on the Titanic."
The growing use of derivatives is one major factor that hovers over the financial markets. It is capable of accelerating any downward move in asset prices. When everyone is on the same side of the boat and they bought their life insurance from a group sitting on the other side of the boat, I'm not sure who survives when the boat capsizes.
Global Stress Points
Right now there are stress points that are visible globally. It can be seen in emerging market debt, the high-yield market, the U.S. Treasury market, and stock markets around the globe. The markets are on edge and rightly so. Every time the Fed embarks on a rate rising cycle, something or somebody blows up in the financial markets.
The Greenspan Fed is known for creating casualties as a result of its easy money reversals. Remember the stock market crash in 1987, the recession in 1991, the peso and derivative crisis in '94, Asia in 1997, LTCM in '98, the stock market collapse in 2000-2002, and the recession in 2001? Whenever the Greenspan Fed reverses policies as a result of major credit expansion, there has been no easy way out. Something major and bad usually follows.
No other Fed chairman has expanded the money supply as fast and furious as Mr. Greenspan. M3 under his chairmanship has expanded from $3.6 trillion to today's $9.2 trillion, a rate far above and beyond GDP growth. That expansion of money and credit has created bubbles all over the world. It doesn't matter what asset class you are looking at, whether it is stocks and bonds of emerging and developed economies, currencies, real estate or commodities. His reputation has been built on creating asset bubbles. His legacy may be the bursting of those asset bubbles and the depression that follows.
What must keep Mr. Greenspan up late at night is what he now sees in financial markets around the globe as he contemplates raising interest rates. This is a game that will not end well and it is beginning to dawn on the investment community.
In the emerging markets, the price of bonds has fallen sharply the world over. There are fears that a rise in U.S. interest rates will cause a withdrawal of capital from markets around the globe fed by money in search of a return. Most of that money has been borrowed as part of the carry trade. Borrowed money multiplies losses and causes enforced liquidation. It is one reason bond markets have fallen precipitously recently. There is particular concern in the foreign debt markets. Since most bonds are denominated in dollars, a rise in American bond yields sharply impacts the bond prices of emerging market debt. The risk is measured by credit spreads as shown in the graphs below. Last year the big money in bonds was made in falling credit spreads. Unfortunately this year, that is where the biggest losses have occurred.
Alarm bells are already staring to go off at the IMF and World Bank as well as the Asian Development Bank (ADB). In its annual outlook report, the ADB suggested that a failure to loosen fixed exchange rates and manage offshore reserves could lead to another financial crisis. Hot money inflows, bad loans in the banking sector, and regulatory shortcomings make the region ripe for another crisis. Banks throughout the region are weighted down by hundreds of billions of nonperforming loans in China, Japan, South Korea and the Philippines.
In Korea economist Chung Un-chan, president of the state-owned Seoul National University, gave a speech highlighting upcoming problems. "Household debts have almost doubled to 463 trillion won last year from 247 trillion won in 1997. The snowballing debts combined with continual economic slowdown could give rise to a second financial crisis."
Alarm Bells Are Ringing
If alarm bells are starting to go off in emerging markets, they are also starting to ring here in the U.S. Higher oil prices and an insatiable appetite for foreign goods is driving U.S. trade deficit higher. With the U.S. importing more expensive oil, our trade deficit will be heading higher in the months ahead. A 30% drop in the dollar since 2001 has failed to put a dent in our trade imbalance. This means the U.S. will need to attract a prodigious amount of foreign capital to help fund its twin deficits. Without that foreign capital, the dollar heads lower. The only way to attract more capital is to raise interest rates. However the higher interest rate rise, Greenspan and Co. risk bursting America's multiple bubbles in mortgages, real estate, bonds, and equities.
The whole country is involved in a borrowing and speculative orgy the likes of which have not been seen since the 17th century. Banks, brokers, hedge funds, and homeowners are all taking advantage of low short-term rates and the steep yield curve to speculate in everything from junk bonds, emerging debt, to residential housing. The bond and stock markets are highly levered as shown left. The bond market charts shown earlier are just a sampling of things to come when the carry trade is completely unwound.
PPI Rise Signals Change Ahead
We're still in the early innings of this new ball game and inflation is once again heating up. On Thursday this week, the government reported that the May wholesale prices rose by 0.8%, the biggest jump since March 2003. Food prices were up 1.5%, energy prices rose 1.6%, and gasoline prices climbed 5.7%. The PPI usually forecasts consumer prices six months ahead. The consecutive increases in PPI indicate that there is plenty of inflation in the pipeline, so inflation rates will head higher in the months ahead. It also signals that producers are having success in passing on higher costs to consumers.
The financial markets are now forecasting that the federal funds rate will rise to 2.25% by year-end. That would imply a quarter of a point hike at every Fed meeting from now until the end of the year. There is an election coming up and it is doubtful the Fed would raise rates the month before the election. This would mean that half a point rate hikes would come afterwards.
However, despite higher inflation rates, I'm convinced that the Fed will remain further and further behind the yield curve. The U.S. markets are too levered to take drastic measures. Half a point or even a full point rate hike would collapse the markets and the economy. There is simply more risk today in our economy than five years ago when the Fed last began to raise interest rates. If seven quarter point rate hikes (1.75%) between June 1999 and May 2000 collapsed the Nasdaq bubble and led the economy into recession, just imagine what similar rate hikes would do today. We've been adding an average of $2 trillion in new debt a year since 2000. This means there is $8 to $10 trillion of additional debt that has been added to our economy since the last rate raising cycle in 1999. With massive consumer, business, and government debt, even small movements in interest rates have a magnified effect. (Review the bond charts at the beginning of this essay.) That is why our yield curve remains steep in comparison to other countries such as the United Kingdom, which have taken steps in rein in credit and inflation.
Homeowners Face Risk with Higher Rates
Despite compelling evidence of inflation, the markets remain complacent. If financial markets are complacent, consumers and homeowners are oblivious to the risks of rising rates. Over 50% of all new mortgages are adjustable. Moreover, while the refinancing boom has collapsed, households have switched over to home equity loans. Home equity volume climbed 51% at J.P. Morgan in the first quarter of 2004. Wells Fargo and National City report that their home equity business set new records in March and April.  Home equity loans are expected to hit a record $370 billion this year. Like adjustable rate mortgages, home equity loans are tied to the prime rate and typically adjust monthly. Because rates adjust monthly on home equity loans, borrowers will see their payments rise as soon as the Fed raises rates. This could mean higher payments after each Fed meeting.
The risk to homeowners is immense, but this hasn't stopped the banks from enticing unsuspecting homeowners from taking on the risk of additional credit. Some lenders are going aggressively after this business by offering rates one-quarter to one-half a point below prime. In order to entice borrowers who fret over rate increases, some lenders like Wells Fargo are rolling out new home-equity products that fix interest rates for 3, 5, and 7 years.
The Fed's High-Wire Act
As the Fed starts raising interest rates beginning with this month, it will be carrying on a high wire balancing act with the financial markets. It can't raise rates too aggressively as the forward rates in the market are implying. If it moves too swiftly or raises rates too much, it will collapse all of the asset bubbles it has helped to inflate. Mortgage and credit could dry up causing the housing market to collapse and along with housing the consumption bubble. If it moves too slowly, it could disappoint the bond markets, which would lose all of its inflation fighting credibility. The bond markets want to believe that the Fed is earnestly concerned over rising inflation. This represents a lack of knowledge by the bond markets. The Fed by its very nature is an inflation creating institution. The ability to create unlimited amounts of money and credit is the power to create inflation. The rise in the money supply, the increase in debt monetization and recent open market operations of the Fed all point to higher rates of inflation.
I believe Mr. Greenspan when he says that the pace of increases "...is very likely to be measured over the quarters ahead." The Fed has no choice but to take a measured approach or else it will be looking at a collapsing market, bankruptcies, and depression if it moves otherwise. What I don't believe is that the Fed will get aggressive if inflation rates move higher. What do you call PPI and CPI that are rising at monthly rates of 0.6% and 0.8% respectively? What we are more likely to see are simultaneously operations by the Fed's Open Market (Open Mouth) Committee. Open Market operations will be measured, while Open Mouth operations will be aggressive. The Fed will try to appease the bond markets through tough talk. They will try to appease Washington through measured moves.
So far the bond market seems to be appeased judging by this week's reaction to Greenspan's tough talk to a London monetary conference. In a videoconference to bankers, the Fed Chairman ticked off a laundry list of concerns from high energy prices (something the Fed can do nothing about other than to kill off the economy in order to reduce demand) to climbing wages and accelerating core CPI. The bond market experienced its biggest one-day rally in over a month, gold prices took a hit, and stock prices rose.
Not everyone is buying into the Fed's tough talk. Pimco's chief investment officer, Bill Gross, who helps to manage the world's biggest bond fund, isn't buying the Fed's inflation concern. Pimco is planning to stay ahead of the inflation game by keeping the majority of the money it manages out of the U.S. Pimco's overseas investments would be higher according to Gross, if it weren't for pension fund requirements that place limits on how much can be invested abroad.
Pimco's movement overseas is a strategy to protect its investors from a falling dollar and inflation at home. You are now starting to see institutions move money overseas and into hard assets. They are looking for a hedge against a falling dollar, inflation, and another bear market in paper assets. Pimco and Oppenheimer have started a commodity-related mutual fund. Other institutions are moving directly into commodities by buying them outright and storing them in warehouses. Steven Leuthold of Weeden & Company has amassed large holdings of physical silver, palladium, copper, aluminum and other metals in warehouses across the country.  The recent drop in commodity prices hasn't bothered Leuthold who used the recent drop in commodity prices to load up on metals with his own money. He believes that commodities are in the midst of a long-term bull market, the biggest in more than 25 years.
The rise in commodities isn't entirely due to China. Capacity shortages as a result of underinvestment, a growing world population, rising inflation rates, and the vulnerability of paper assets like stocks and bonds are going to make hard assets more valuable. The Big and Smart money has already begun to move out of paper and into tangibles. Institutions that own paper like Pimco are moving more of that paper overseas. There is bright a future for commodities that could last well beyond this decade. It is a simple supply and demand imbalance. We haven't built a new refinery in this country since 1984. Environmental and geopolitical concerns have restricted new drilling for oil, natural gas or mining for base and precious metals. In addition commodity producers from big oil to large mining companies have learned from the past it doesn't pay to increase capacity when it brings lower prices. Lower prices threaten the industry's ability to survive, so it has consolidated. Consolidation doesn't add to capacity, it simply concentrates it in larger hands.
The world's economies and financial markets are awash with debt, especially the U.S. and Japan. Everyone is playing the carry trade made possible by the lowest interest rates in half a century. Banks are borrowing short and lending long. Hedge funds are still leveraged with short-term money while investment portfolios are long. Homeowners have borrowed short-term and invested long-term in their homes. The Fed will begin a rate raising cycle that may not last long if the economy rolls over, the market collapses, or if the U.S. gets hit by another terrorist attack. Because the U.S. economy and our financial markets have become so leveraged, the Fed will have no choice but to go slow. This means that the U.S. economy will experience negative real interest rates for a long time to come. That translates into higher rates of inflation. Our total debt now stands at $37 trillion. Our unfunded liabilities (pensions, Social Security, and Medicare) are now approaching $55 trillion. There is simply too much debt that will have to be inflated away. Whole swaths of the U.S. economy have been reflated by easy access to credit. The U.S. economy may no longer be a manufacturing powerhouse, but it is a powerhouse in its ability to manufacture credit.
Companies, consumers, and investors are going to have to cope with higher inflation rates. This also implies collapsing values for anything associated with credit from autos and luxury goods to real estate. While there remains many similarities of today's markets to the 1970s, there are also differences. One is that the U.S. imports more energy than it did during the 1970s. We are also heading towards peak oil production. The higher oil prices of the 70's were a geopolitical concern. Today they are geological as well as geopolitical. There is less aboveground stockpiles of commodities. Our energy and commodity infrastructure, the basis of a modern industrial society has been ignored and allowed to go into disrepair. New energy and alternative energy sources will take time to find and develop. That is why commodity prices will only head higher in the years ahead. It is why Pimco has started a commodity fund. It is why investors such as Steve Leuthold is buying commodities and storing them in warehouses. It is also why the smart money has been moving into gold, silver, commodities and foreign currencies and hard assets. The Fed is behind the yield curve and so is Wall Street. It is time to get real as in owning real assets. The time is now before the stampede begins or the unraveling unfolds.
 Bloomberg, "Brazil, Turkey vulnerable to rising interest rates, BIS says," June 14, 2004.
 BIS Quarterly Report, June 2004.
 Richebächer, Kurt, Richebächer Letter, June 2004, May 2004.
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