by Alasdair Macleod, GoldMoney:
Falling equity markets this week are likely to signal the onset of a bear market, responding to a combination of the coronavirus spreading beyond China and persistent indications of a developing recession.
This has provoked a flight into US Treasuries, with the ten-year yield falling to an all-time low of 1.31%. This will prove to be a mistake, given US price inflation which on independent estimates is running close to ten per cent, exposing US Treasuries as badly overpriced.
After this short-term response, much higher US Treasury yields are inevitable. Foreigners, who possess more dollars and dollar investments than the entire US GDP will almost certainly sell, driving bond yields up and the dollar down, leaving the Fed the only real buyer of US Treasuries.
This article goes through the sequence of events likely to destroy value in US financial assets and the dollar as well. And what goes for the US goes for all other fiat-currencies and their financial markets.
In my last article I pointed out that the cumulative effect of central bank intervention has led to bond prices that have come badly adrift from reality. Taking a more realistic estimate of the dollar’s purchasing power than that implied in goal-sought CPI numbers, plus an estimated amount for the time preference involved, ten-year US Treasuries should yield closer to 10% to maturity, not the 1.31% implied today. If a ten-year bond has a coupon such that it is currently priced at par, the price should halve.
Those who put our monetary misfortunes down to the coronavirus have missed the point. Yes, it will be fatal, both economically and unfortunately for some of us as individuals as well. It is early days in what is definitely becoming a pandemic, that is to say an epidemic that is not restricted to national boundaries. Not only China, but other nations as well are going into a state of lock-down. Hopes that things will return to normal in the second half of this year are obviously based on a belief that there is nothing else wrong in the global economy.
This is where those who actually understand money and the credit cycle part from the economic establishment, which continuously demonstrates its cluelessness. Note these indisputable facts:
1. Economic destabilisation arises from a cycle of bank credit expansion always followed by a credit crisis. It does not arise from business, but from time to time the willingness of banks to expand credit out of thin air, creating a temporary period of economic optimism which does not last.
2. The expansion of the global money quantity since 2008 has been unprecedented, not only numerically, but in proportion to the size of underlying economies. If nothing else, logic suggests the bust that follows will be proportionately destructive.
3. While their relative magnitudes to each other were different ninety years ago, a combination of trade tariffs and the top of the credit cycle mirrors the conditions that led to the Wall Street crash between 1929 and 1932. That should be warning enough that even without a coronavirus pandemic the world is on the edge of not just a recession, but a vicious slump.
The most important difference between the Wall Street crash and the depression that followed is found in the money. In those days, both the US and UK currencies were on a gold standard, which meant that collapsing commodity prices through the dollar and sterling were effectively being measured against gold. Other factors, such as the rapid mechanisation of farming and the productivity that followed exacerbated the situation for farmers worldwide, until the UK abandoned gold in 1932 and the dollar was devalued the in 1934. In short, the link with gold meant that leading currencies were not undermined by the depression.
Nevertheless, economists in the 1930s blamed the depression on gold, and governments have sought to remove it from the monetary system. Since 1971 there has been no residual link between gold and the dollar and therefore all other state-issued currencies. The quantity of money in circulation has been free to be expanded by central banks, the only limit being the consequential limitation of price inflation. That has now been conquered by statistical method.
From their actions following the Lehman crisis it is clear central banks now feel no constraint on the expansion of the money quantity as a policy tool. The Fed, the ECB and the Bank of Japan are already expanding base money before the crisis stage of the credit cycle has materialised, which should alert us to the catastrophic failure of monetary policy. Keynes’s concept of reviving animal spirits with a kick-start of inflation has morphed into a continual and accelerating monetary inflation over the whole cycle.
Collectively, in the post-war years we all bought into monetary inflation by shifting investment allocation progressively from bonds into equities to protect long term savings. But since the interest rate spike in the early 1980s, bond yields have generally declined to the point where in dollars, euros and yen they yield less than their values of time preference. In the two latter cases investors are now even paying for the privilege of lending money to their governments.
The abolition of meaningful yields has been achieved through a combination of statistical suppression of price inflation and monetary expansion. But this is just the start of it. Imagine for a moment a collapse today akin to the 1929-32 Wall Street crash, followed by an economic slump on a 1930s scale. Freed from apparent restrictions on the expansion of money and having a mandate to do whatever it takes, combined with demands for the financing of soaring government budget deficits the expansion of money will go into hyperdrive – everywhere at the same time.
Not only do we have that problem, but we now have a viral pandemic that has all but shut down the largest manufacturing economy in the world, disrupting the overwhelming majority of supply chains elsewhere. And that assumes the coronavirus is contained to China and that early signs of it turning into a global pandemic turn out to be false. But the signs are that it is becoming a pandemic on the eve of Wall Street crash Mark II, bringing forward and amplifying the economic destruction that always follows a period of credit expansion. The effect of the virus threatens to turn an economic slump, perhaps a once in a century event, into an outright production and consumption collapse.
What lies before us will be radically different from the past. Understanding money and the effects of changes in it as a circulating medium have rarely been more important. This article outlines the effects of what lies ahead, likely to commence in a collapse of financial asset values and the purchasing power of currencies.
The Fed will lose control
The Fed’s monetary policy has been all about exercising control over markets, ostensibly targeting a rate of price inflation at 2% and maximum employment consistent with it. This power is continually abused in the name of neo-Keynesian economics, and monetary debasement has become a permanent feature of US Government financing since 2001. Consequently, US Government debt is now larger than GDP and financing it at heavily suppressed rates absorbs almost 40% of a trillion-dollar deficit.
The policy controllers at the Fed can least afford an out of control financial system to reflect realistic bond prices. With the Bureau of Labour Statistics having successfully tamed the inflation numbers, the Fed has managed to keep the lie alive about monetary inflation not being reflected in a declining purchasing power for the dollar and therefore higher bond yields. The Fed is not alone in this, but in a dollar reserve monetary system other central banks and their currencies are just bit players and a critique of US monetary and economic policies is sufficient for an understanding of what lies ahead.
The crucial question is over the likelihood that having distorted markets to the point where government debt is now substantially overpriced, can the authorities maintain the illusion?