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INTERVENTION VS. MAIDEN FLIGHT

Several observations are worth noting about the current so-called recovery and the required actions to keep it sustained. Monetary expansion by the Federal Reserve, extended credit for consumption, and bond market liquidity have all been tremendous in magnitude. Federal government tax rebates, and other tax benefits had been equally vast last year. Foreign capital supply needs have been staggering in volume, steady at $1.5 billion per day. Their central banks are now expected to keep us propped, which is seen as positive, with no sense of anything awry. Bond carry trade has been critical in putting speculative forces to work, probably the greatest juggernaut of false power in our economic machinery and production of spendable wealth. The consequence of over-reliance upon bond speculation is that great risk has been created in spring-loaded low interest rates. Mortgage agencies have provided primary pools for new mortgages, for refinances, and for home equity extractions. Large banks and brokerage houses have shown outsized earnings in recent quarters, from a bumper crop in their bond speculation, combined with liquidity-driven stock rally gains. The US Economy depends heavily on consumption, and spending draws on all of the above-cited sources. Residential real estate is the foundation of the inflated economy, which is put at risk if rising rates or declining income leads to stalled or falling housing values.

The current US Economic recovery arrived late. Typically, a recovery ensues 12 to 18 months after stimulus of a large scale, whether from fiscal (government spending) or monetary (credit extension) origins. And we saw both types in large doses, implemented over almost three years. The Federal Reserve has engineered an unprecedented monetary expansion, amounting to a 37% increase in the money supply since the year 2000. Actual numbers record an increase from $6.6 trillion to just over $9.04 trillion, as of 4/5/2004. We are dependent on the monetary presses; they cannot stop. These are truly staggering figures to contemplate, never encountered in our brief modern history. In the years 2001 and 2002 we saw virtually nothing in economic growth to show for enormous money growth, as new money offset burned capital from bankruptcies, defaults, and writedowns. Some credit card debt was surely retired, from direct payments and from home equity extractions. Evidence is difficult to retrieve, since on a net basis revolving debt levels have spiraled ever higher.

AN ECONOMY DEPENDENT ON COLLUSION

The Greenspan Fed has finally broadened its view when prowling for price inflation signals. For months, they focused foolishly upon the faulty CPI index, where many critical items are ignored, and dynamic scoring sidesteps cleverly the rising components. They finally admit to rising prices for commodities, energy, intermediate goods (like steel), even scrap items, in reaction to the alarm bells rung by the both the Consumers and Producers Price Indexes. So far they have ignored the import price increases registered. Bond vigilantes are raising dust in their fast ride over the horizon. They had been notably absent since 2001, when accommodation began. No longer. Foreign central banks will not abandon the buttresses behind the bond dikes. The Bank of Japan seems overwhelmed, and might be standing down in their mindless support. The system will limp along without continuation of bond bubbles. The mainstay of intervention "IV" injections might more appropriately stand for "intravenous." Take them away, and policy makers had better be correct that the recovery can sustain itself. Herein lies the risk. Distort the data and hope the crippled, distorted, bloated beast will fly without tethered supports. Public confidence in its airworthiness might be unjustified. If the story of growth and progress is misrepresented, then great risks arise for sliding back into recession.

The USGovt has been the other active participant in the stimulus scheme. One year ago, tax refunds, tax rebates, child credits, and new depreciation schedules were important. Those have phased out or ended. We seem to have moved away from expecting the government to hand out money, to drop it by helicopters, so that citizens can spend it and meet the bill payment obligations. The financial markets have embraced a more mature mindset founded on optimism, whereby the economy can grow and provide income opportunities. We seem to look less to governmental parental hand to mouth actions. The public may not be as confident that intervention supports can be set aside, having suffered or witnessed job losses. The political, banking, and Wall Street leaders may harbor more confidence than is warranted, when they expect the system to sustain itself and operate effectively. We will see, but evidence of continued and growing imbalances (e.g. trade gap, consumer debt, nil savings, job outsourcing) makes the prospect unlikely.

Raymond Saulnier is not a household name. He served as economic advisor to Eisenhower. His words of wisdom in 1975 apply today: “Expansionary policies designed to promote recovery or to accelerate growth are often carried to excess and result not only in an outbreak of inflation but in structural imbalances that sooner or later make recession a virtual certainty.” American economists do not understand this. A man walking with impaired balance falls over. Instead, economists reason that more stimulus will bring about even stronger recovery and growth. They believe that Japan struggled for a decade, despite huge stimulus, because they did not stimulate enough. Excess abounds even in the economic thought process.

Asian central banks are caught in the full squeeze of a "Catch-22.” Over the years they have purchased roughly 45% of our US Treasury debt issuance. In the first three months of 2004, the USGovt finance needs came to $177 billion. The Japanese purchased $142B of that debt, which is 80% of the total. March and April are very much not the norm. March requires that Japanese foreign-held cash must be returned home, and repatriated. So the yen currency has halted its winter uprising. April demands that American citizens pay federal income taxes. So the US Treasury has been flush with cash, thereby reducing continued funding requirements. The USDollar has benefited. In May, unfavorable currency flows get back to normal.

THE TRUE ENGINE HAS BOND GEARS

The US real economy shrinks. Its financial economy grows. Bond speculation is critical to generate money. It includes many specific financial instruments for the purpose of creating profits and generating money without any production of physical products. In a casino, one has the choice of blackjack, craps, poker, roulette and more. In the bond market, one has the menu of the yield carry trade, corporate spreads, mortgage spreads, interest rate swaps, futures contracts, options hors d’oeuvres, and more. Bond speculation is the ingenious outgrowth of our inflation and debt structures. While the United States likes to boast that innovation, technological discovery, creative destruction, and true entrepreneurial activity keep our economy chock full of vitality, nothing compares to the sheer size and power of our financial engineering and its ability to spew new and redistributed money into the system. Inflation is its primary power plant. Leverage is its primary tool. Wall Street is its primary factory. Gambling is its primary game. The gray pinstriped suit is its primary uniform.

Bond speculation has been the central policy in the early stages of the US Economic recovery. The purpose is to create and distribute money into the system in a groundswell. The Federal Reserve cannot simply print money and deposit it like so many newspaper bundles across the financial doorsteps. The USGovt might be able to make helicopter drops to households via tax rebates, but the Fed needs financial waterways and devices along its tributaries for the selective distribution of money into the system. Flow is steered by locks and switches toward the smartest gamblers as well as the best connected to the ruling elite. The military industrial complex took criticism in the 1980 decade for its cozy relationships. In the present decade, attention should be more directed at the banker brokerage treasury complex. The Fed rigs the game for bond speculators, tipping them off early, bringing them to the table first, even dealing to them from the bottom of the deck. A new student to the game requires years to gain full exposure to its inner workings. The only sweat produced from such work comes from leaning over computer screens, poring over the Vegas lines, and fretting over the outcome of bets.

Few seem to comprehend the enormous complexity of the yield carry trade. Its many components work in complex interwoven machinery, as deep as it is broad. Simple bank operations allow loan officers to borrow at the discount rate, and lend to customers at higher rates for cars, home mortgages, or commercial loans small and large. Financial engineering takes it all to a grand level, with the usage of leverage via futures contracts. The greatest open interest (total number of active contracts) is associated with bond futures contracts. They underpin the Treasury yield carry trade, which borrows 1% money and invests in 4-5% bond securities. They underpin the corporate spread instruments, which invest on the differential between higher long-term (since riskier) corporate yields and Treasury yields. They underpin the mortgage spread instruments, which invest on the differential between higher long-term (since riskier) mortgage bond yields and Treasury yields. They underpin hedge book risk management programs for the Govt Sponsored Enterprises such as Fanny Mae, Freddy Mac, and the Federal Housing agencies. They underpin currency arbitrage involving the USDollar.

Corporations get into the act in yet another clever manner. Interest rate swap contracts allow company XYZ with a below-average credit rating to pay a vig, a fixed fee, to a company like General Electric, which boasts a stellar credit rating. In return, GE (or another such firm) would borrow at their available low short-term rate, on behalf of the client firm, and counteract the client’s long-term debt. XYZ sees their ongoing long-term borrowing costs reduced, sees a lift to quarterly earnings, but bears a risk. If and when short-term interest rates rise, XYZ will see a sudden and painful rise in the service cost of their debt load. If one believes this is an isolated exotic practice, think again. Since 2001, when Fed Funds ushered in 1% short-term rates, the swap trade became brisk, popular, and widespread. Participating firms saw a nice temporary improvement to earnings. Years later, thousands of companies stand to see earnings erosion if the Fed tightens on rates. Interest rate swaps are everywhere fastened in balance sheets, ready to tear wounds. A wider risk exists, since diverse financial structures have ratcheted tightly to lower rates. A reversal in rates will do damage.

In 1994 and 1995, when the Federal Reserve last reversed course, and tightened monetary policy, tremendous havoc reigned over the bond and stock markets. It is loosely reported that $250 billion was sloshing around in various forms of bond speculation at the time. We as a nation have matured, or else grown more wedded to the casino game, eschewing the old fashioned methods of creating wealth. Refer to build it, mine it, grow it, or fish it. We now print it, and apply leverage to the printing press. We celebrate our financial engineering and its output, mislabeled as wealth. Now the derivative pyramid is reported to contain $750 billion in bond speculation. If one third as much money on the casino bond tables caused such disruption ten years ago, imagine the upcoming disruption when the Fed reverses course and tightens in a new cycle. Could bond accidents be the final legacy of Robert Rubin, the chief architect of the carry trade designed for bonds, the dollar, and gold???  He initiated gold sales for USTBond support, and so far has a patient Mother Nature who knows revenge well.

If round after round of mortgage refinances were so successful, and the nation’s households benefited from equity extractions so smoothly, why stop the presses?  Because the Fed now believes our economy can sustain its fledgling growth. If the USGovt has indeed distorted the viability and balance of an economic recovery, then great risk lies ahead. The Fed is essentially allowing a Frankenstein aircraft to attempt to fly on its own, unassisted by supports. It could crash to the ground from insufficient income fuel or excessive debt in the baggage compartment. It could fail to fly straight from its financial sector imbalances, or blow up in midair from the devastating unwinding of bond speculation. The Fed might delay the maiden flight of this bloated, imbalanced, and under-fueled contraption. It might delay further with yet more intervention, by perpetuating the current accommodative low Fed Funds target rate. This is an election year.

THE CHARTS SPELL TROUBLE AHEAD

So far Asia has poured countless billions into the hopper each month, and been satisfied to walk away with mere pieces of paper, mainly Treasury bonds, corporate bonds, and mortgage agency bonds. If rates rise out of control, Asian reserves will be decimated. Is Asia dressed for the role of bagholder? Probably not. The extent of Asian philanthropy is soon to be tested. As China comes of age, they will need the United States less as a customer base. The entire US Economy depends on man-made low rates. Few notice a contradiction that debt requirements are staggering, yet interest rates to attract the capital are low. The spirit of last summer's bond revolt seems now long forgotten. Tremendous money supply growth, monster twin deficits, and low interest rates cannot co-exist for much longer. Large imbalances bid for a mammoth spontaneous combustion from deep within the bowels of our financial markets, as large opposing forces create a dangerous potential.

Alan Greenspan has made a back-peddle of 180 degrees in his recent statements, yet few challenge his leadership, judgment, or credibility. We are a nation of math and economics illiterates. The chairman seems confused, arrogant, and perhaps desperate, quite the mix. He advised homebuyers to utilize adjustable mortgages just a month ago, the final phase of a long process of attacking sacred cows. In the three-month process of attacking sacred cows, he must have developed calluses from patting himself on the back so often. Now he tells to expect higher interest rates. He believes deflation is no longer a threat (translation: inflation has taken root), pricing power is returning, and growth seems sustainable. One day after he warns of eventual interest rate hikes before Congress, he implies that rates might be kept fixed until job growth improves.

The bond vigilantes have revisited the bond pits. The perception of an actual recovery with legs might have called the Fed’s poker hand against the chairman’s will. Powerful deflationary forces are still evident in continued bankruptcies and job loss. Powerful inflationary forces are newly evident in materials, energy, shipping, which aggravate production and household costs. Volatility has arrived to the US Treasury market in force. These factors are interpreted as confirmation of economic recovery. They might instead be earthquake tremors from the bond market and turbulent winds ahead, signaling the poor chances that the overhauled US Economic recovery aircraft will remain airborne.

Note two inverted Head & Shoulders patterns. One is large with an upward tilted neckline and extends over 18 months, shown with black lines. A second is less evident in a more near-term, showing its early stages in orange lines, as identified by Richard Russell. The shoulders are not so well defined. The large pattern indicates higher interest rates are coming, imminently and eventually, possibly up to 5.5% or higher. Any move upward in rates will likely occur after a bounce off the blue 50-day moving average, now at 4.1% on what would be the smaller right shoulder. Certain stock sector indexes are indicating higher interest rates. The banking index and the RMS real estate index have each turned down. Political reality dictates that housing not go into reverse, that home equity remains extractable, that stocks stay on course. Higher interest rates would not only derail the economy, but President Bush’s re-election. If Greenspan wants to kill the second terms of both Bushes, then the Fed will hike soon and hike often.

We have technical evidence of late stages to the USDollar bounce, namely touching its 50-day moving average, and bumping against the upper rail of its DXY downtrend channel on a logarithmic scale. Also, gold has touched its 200MA. When technical events such as these occur, they prompt renewed questions on whether fundamentals have repaired themselves in turn. They have not, as none of the US$ main factors have seen remedy. Jim Turk of Gold Money points out in "The Buck Stops Here" the following:

* The federal debt is growing by more than 10% per annum

* Inflationary pressures continue to mount

* Shortages of materials (warning sign of rising inflation) are becoming more numerous

* Crude oil is continuing its climb toward $40 per barrel

* The US trade deficit continues at or near record levels and on and on and on.

© 2004 James Turk, www.GoldMoney.com 

Intervention might need to be permanent, or else the entire system could completely break down. Distortions, leverage, and dependence are so grand. There are no mulligans in this game. Intravenous lines perhaps should stay put. Once the vast coils unwind, our banking leaders might indeed lose control. Amplify the volatility and damage from a decade ago, then extrapolate by a factor of three in a highly nonlinear framework, and stand clear. In past economic recoveries, imbalances were addressed in the form of correcting inventory excesses. Fed monetary stimulus succeeded, after pent-up demand was built during delays in spending. In no way have recent events established such a healthy foundation. Kurt Richebächer says, “[Greenspan] glorifies asset bubbles as sources of wealth creation that allow and facilitate higher and higher consumer borrowing and spending.” He concludes, “priming the pump only works when the pump is in good working order.” It clearly is not.

Futures contracts and options are the tried & true inflationary tools of elite civil servants standing guard in sentry duty over the colossal coiled bond contraptions. Taking hands off, and entrusting this economy’s maiden flight to the laws of monetary physics will be truly interesting for both observers and participants. Confidence that smooth winds flow in the wake of an unwinding bond market seems badly misplaced. Ironically, gold has indirectly been hurt with early inflationary evidence. Higher rates have lifted the USDollar in a long-term bounce. If the 10-yr TNote yield surpasses 5.5%, it is my opinion that we pass through HELLGATE and lose control. The result might be chaos within the “bond dollar gold triangle,” where disorder may have begun. Unable to admit their errors, G-7 ministers are once again complaining about currency volatility. If and when events turn sour, we have a handy list of scapegoats to blame. The list starts with China, OPEC, and FOREX currency traders. Few can discern that leveraged monetary inflation as a policy for over a decade is to blame.

NEWS TIDBITS

All Nippon Airways announced a $6 billion order for 50 new Boeing 7E7 aircraft, to be delivered by 2008. Aventis has accepted a $65 billion offer to merge with rival French drugmaker Sanofi-Synthelabo, placing them as the third largest pharma. Big deals attract attention, but usually are evidence of silliness, overpayment, and imprudent usage of capital. New York-based OSI Pharmaceutical rose 140% after announcing successful Tarceva Phase III trials for non-small cell lung cancer treatment. The results pushed higher US biotech leader Genentech, their US partner. KMart revised and extended a working arrangement with Martha Stewart, which will not include 8-by-8 cell decoration. CS First Boston and Morgan Stanley were picked to lead the much-anticipated Google IPO. July Fed Funds futures contract indicates just under a 50% chance of a June rate hike, as consensus builds for an August hike. March new housing shot up 8.9% to 1.228 million units annualized, an all-time high. Among affluent investors, 50% regard S&P as bearing peak value, and 2/3-rds do not expect employment to improve by year-end. More backward but self-serving Wall Street economist assessments are flowing. The pitch “rates follow profits, not the other way around” certainly sounds good, despite the universal inflation.

Death count steadily rises in the Iraqi conquest, bringing increased denial of parallels to Viet Nam. The key differences are religious civil war and the presence of massive oil reserves, which render the situation an order of magnitude more dangerous. Al Qaeda terrorist wing Zarqawi claimed credit for an attempt to blow up a key Iraqi oil facility in the port of Basra, through which flows 85% of Iraqi oil export. Up to now, only the northeastern Kurdish territories had been targeted. Gasoline prices rose in April to an average $1.83 per gallon.

QB Eli Manning was picked #1 in the NFL draft, then was traded to the NYGiants for QB Rivers plus three draft selections. Two NFL draft records to note:  7 wide receivers picked in the first round, and 6 UMiami players picked in the first round. The draft drew New York City attention away from baseball, where two sub-500 teams are located. The Red Sox swept three games in the Bronx against the overpaid Yankees, as the BoSox bullpen extends its scoreless skein to over 24 innings. Is A-Rod something like Re-Rod, a steel product, overpriced and not supporting all that much without additional mass?

TODAY’S MARKET

Dow Jones Industrials wrapped up at 10,444 (-28), S&P at 1135 (-5), Nasdaq at 2037 (-13). TENS yield 4.43% (-2 bpt). Currencies closed with Euro at 118.6 (+0.4) on stronger consumer confidence news, JYen at  92.13 (+0.41), Can$ at 73.97 (+0.58). Metals finished with gold at 496.6 (+0.5), silver at 6.18 (unch), copper at 124.4 (+0.2). Energy ended with crude oil at 37.60 (unch), natural gas at 5.76 (+0.19), unleaded gasoline at 118.2 (+1.9). Prices are at major futures contracts.

Jim Willie CB

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