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[Correction on 6/14 essay: With their recent joint venture, Taseko Mines is on track to reopen the Gibraltar mine in the near future, as well as to benefit from an AMEX listing. There is no requirement to raise $500 million as was stated. My apologies. ~ JW]
The current financial mess requires, nay, demands a solution. An economic recovery in the usual sense is totally out of the question, since higher interest rates will kill off both the financial sector and the real economy. Each in its structural makeup has grown far too dependent upon easy credit terms, weighed horribly down by debt. The solution needs an engine, a mechanism to recycle debt waste products, and some harsh compromises. Mark Rostenko offers a brief but incisive opinion, that bubbles are everywhere, including in the economy in his May article “Let the Market Do the Talking.” The Federal Reserve has begun its hyper-liquidity endgame, probably sanctioned by the Dept of Treasury, but certainly not publicized by Wall Street nor even noticed by Main Street. As the differential strengthens between the low-pressure real economy and the high-pressure financial economy, something must give the PERFECT STORM its power. Jim Puplava has outlined its structural makeup for over two years now. He rightly argues that the exploding money supply and declining USDollar will be forces behind the storm. Here, my intention is to describe some of the hypothesized inner workings of that storm and its powerful engineering machinery. The financial engineering, about which the USA boasts, will be put to use on a grand scale. The process has begun in calendar year 2004.
The Federal Reserve must continue in its accommodation, with a heavy foot fixed on the accelerator pedal. Money supply growth is reported to be $400 billion, a 10% annualized growth rate, over the first four months of 2004. May has seen no slowdown, with another $160B in its first half. Where goes the money? A new modus operandi has shown itself. Debt is being monetized on a grand scale, at over twice the previous pace, which used to run at $548 million per week in Treasurys. Increases to securities held outright have risen by staggering numbers, like up $1.44 billion on the week of June 2, +$1.60B on the week of June 9, and +$1.91B on the week of June 16. Open market Fed injections are equally huge, breaking upward over trend. This is evidence of the Fed “going it alone” without big contributions by the Bank of Japan. Data is much more difficult to obtain for conversion of Fanny Mae and other GSE agency debt. Expect the trend to worsen. Magnus Ekervik makes an excellent argument in his article “Where is the Horror?” on SafeHaven. He makes inference that mortgage debt is being converted through Fed monetization. He draws in several warnings and strong hints by Fed Governor Poole on systemic economic risk. Rumors slosh around as to the motive for such heavy liquidity infusions. In order of relevant importance, here are my ranked reasons for the heavy monetary growth:
Providing relief to lost leveraged money from carry trade reversals is top on the list for where new money went, then bailout of the bloated Fanny Mae books. One must wonder if cozy deals with major Manhattan banks cost the Treasury dearly, with secret derivative book bailouts, all of course in the national interest. JPMorgan holds the largest derivative book in the entire world, something like 80 to 85% of all bond derivatives. Their books are not disclosed even to the SEC, let alone the public, even though they likely receive federal assistance. The majority of outstanding futures contracts lie in USTBonds. Interest rates went up bigtime. Carry trade participants were damaged. Mortgage bond leverage inflicted damage. Nowhere were either Fanny Mae or JPMorgan in the news. One must wonder if rescues took place which show up nowhere except in the final phase dirty laundry of money supply figures, as excrement from Wall Street warehouses into the East River. THE ANATOMY OF A TRAP The USDollar decline is powered by economic forces, by financial forces, by banking forces, all of which are gathering momentum. The natural mechanisms, designed to restore economic health, have been supplanted by man-made devices that destroy wealth through monetary growth and encroach upon the real economy. As the real economy shows stress, as the financial sector frets over higher rates, the solution will be seen to print money even faster, and to eradicate official debt (Treasury and Mortgage Agency) via monetization, using freshly minted dollars. The risk from higher interest rates will be transferred to the USDollar. While the real economy heads more firmly into a trap, its liquidity will be accelerated.
The forces within a liquidity trap are many and varied, indicative of economic decay. Causal factors are many, although surely not obvious. Low interest rates keep the economy at a slow pace, which requires false money to be injected in replacement to the real money offered as a yield on savings. Debt default and debt repayment reduce the money supply. Banks are more reluctant to lend money. Banks, low in reserves from a slow economy and troubled loan portfolios, receive insufficient interest rates to justify their shouldered risk. Insurance companies also receive low returns on bond holdings. Excess production capacity acts as an overhang, reducing capex outlays, as much equipment is either obsolete or tied to overpriced labor. Outsourced Indian service jobs inhibit domestic income sources. Chinese imports suppress pricing power across the entire economy. All of these forces contribute to the reduction in economic activity. The most misunderstood among them is low interest rates. Since twice as much interest income is earned versus interest payments paid out, low rates act as a severe damper in the current environment. Try telling mortgage holders hoping to refinance, corporations wanting to recycle debt, stock brokerage houses & investors expecting growth, or politicians seeking votes. Universal opposition is encountered. Sadly, the liquidity trap is not well understood any more than inflation, but only in the real economy. To oppose the extreme slow velocity forces, the US Economy has grown dependent on false wealth from the financial machinery. Symptoms of the liquidity trap act like circulating weights drawn down the drain in to a virtual black hole. Job losses are running high, reducing income. Household debt reduces consumer spending. Corporate debt reduces hiring and capex spending. Rising energy costs hurt corporations in shipping costs, mfg process costs, and household costs. Higher production costs for almost every conceivable raw material and intermediate product squeeze corporate earnings. Insurance costs crimp budgets across the economy, whose premiums are made high from poor income on bond portfolios. State, city, and local fiscal distress has greatly inhibited local spending. Factors overseas add to the forces. All these damping factors create a swirl to reinforce the trap dynamics. Strangely, few seem to notice that the fundamentally important real economy is caught in a liquidity trap right now. Easy finance terms cannot be withdrawn. THE DEBT RECYCLE STRUCTURE The magnitude of Asian trade surpluses with the USA is larger than anything ever seen in the history of human commerce. An excess of $200B of Asian surplus eventually finds its way into their central banks, in order to circumvent the conversion process by individual companies and banks. The govt-led banks take it off their hands. A mass conversion would have a detrimental effect on the local currency values that their entire economies depend upon. No end appears in sight for outsized surpluses, since the Bank of Japan and Beijing leaders will not easily forfeit their price advantages. The Japanese yen has gained some minor ground in USDollar terms, but nothing like what Europe has endured. Asian Central Banks must invest much of the $200 billion per year offloaded from exporting firms in such a way as to receive a return on their investment. They have few alternatives beyond the US credit market. The search for investment opportunities takes them full circle back to their export customers. It is ironic that the gigantic trade imbalance creates a gaping hole in debt that only the beneficiaries of that imbalance can fill with obscenely large surpluses. They can invest in US airline debt, or US high-tech debt, or US telecom debt, or German telecom debt, or Mexican telecom debt, or Brazilian govt debt, or twice over the world’s mining industry, or perhaps a sizeable slice of Swiss pharmaceuticals, or even attempt a hostile takeover of General Electric or Cisco Systems itself. We are talking about very big money here, whose direction must pay heed to political backlash. The bidding effect would sharply drive up the price of any pursued securities outside the large US credit markets, to the point of rendering the investment impractical and unwise. The alternatives outside USTBonds and GSE agency debt are limited, which helps to perpetuate America’s trade imbalance through support of low interest rates. Call it what you will, but we are seeing a tragic bloodletting take place as the USA passively drains its financial vitality. A massive transfusion has been installed, whereby Asia is gradually purchasing debt collateralized by our entire economy. For those who regard such a comment as hyperbole, take note that Asians now own US Treasury debt and GSE agency debt equal to more than 20% of the annual US GDP. That figure is rising rapidly. The trade gap alone grows at $1M per minute. Richard Duncan’s now famous book, The Dollar Crisis, provides great detail on Asia’s procession toward ownership of American assets.
The Federal Reserve sits at the center of the Hyper-Liquidity Engine. It either sponsors the sale of new debt, or removes existing debt through monetization from the balance sheets of the USGovt or Govt Sponsored Enterprises like Fanny Mae, nothing more than electronic printing press operations. Since this machinery has gone amok, existing debt must be monetized. Acting as financial sewage, derivatives like bond futures, which have grown like uncontrollable cancer, must be sanitized via more monetization. If not above board in open market actions, then on an increasing basis we will see evidence of vast new money supply, new data on securities held, new data on permanent injections. It is my belief that an acceleration of the hidden monetization process has emerged. In order to protect the integrity of bond markets from sanitized efforts, such activity must be kept from public view. HYPER-LIQUIDITY TRAP SOLUTION For the last three years, the Federal Reserve has justified artificially low interest rates, flimsy reasons which the economically untrained masses and experts eagerly gobble up. Investors, speculators, and consumers seem blindly unaware of the risk. The real economy might be breathing some life, perhaps temporarily, but that life depends on ultra low rates. The financial economy might seem strong, perhaps temporarily, but that robustness depends on ultra low rates. It probably is in the midst of a grand stall before the downturn. Each measure used by the Fed presents a signpost for monetary policy toward disaster. No economy can continue forever to extend consumer debt, mortgage finance, and feed the bond, banking, and carry trade industries indefinitely. In the next phase, the USGovt ministries and agencies will secretly fund credit, and redeem bonds, on a level never seen before in our national history. The process has already begun. The degree of current leveraged speculation is so great that a return to health is out of the question. Our national economy has been tarnished, damaged, and dislocated far too much under the Greenspan Fed. There is no turning back. If the Fed permits more benign neglect to the real economy, it will do so at the expense of bond market integrity, even in the face of price inflation pockets. This might occur since inflationary effects are felt on the production and household side, which dampens economic activity. In other words, the type of price inflation we have seen lately is economically deflationary to the real economy in which we live. Higher food and energy costs slow down the spending process. This is part of the reason why gold has performed so poorly in recent months. The traction requires that wages grow and pricing power is restored, missing factors. Instead, it is my contention that the Fed has no end game, and is thus coerced into keeping alive the bond game or face economic death. The bond bubbles must NOT be ventilated and released, since the only source of dynamism in wealth production comes from the financial sector. Real wealth production through building, growing, mining in a true production sense is minimal with our once great but now crippled economy. It is my contention that the US Economy will back into an interest rate trap, by focusing on the weakness of the real economy, while allowing continued extravagance with monetary expansion in outright subsidies to the financial sector. The Fed might interrupt any semblance of economic growth by capping interest rates, and impose more commodity inflation via USDollar debasement. The scale involved for money growth has not been witnessed since the Weimar Republic in the 1920 decade. The process has already begun. Japan has provided the United States an example of a grand systemic failure. The Fed has publicly stated that the Bank of Japan did not flood their economy will enough liquidity, i.e. inflated money supply. But the BOJ did just that, flood their system. The Fed has criticized the Bank of Japan for encouraging both stock and real estate bubbles. But the Fed has done exactly the same, and has even boasted of doing so. Wealth generation is its specific boast, pointing to the housing sector. Japan had no Fanny Mae centrifuge apparatus. The Japanese bond market became mired and stuck in the proverbial “trap” wherein bond yields remained stubbornly in the 1% range, sometimes even lower. Their govt enforced the tight trap door by enacted regulations that direct govt worker pensions into the Japanese Govt Bonds (“jags”). In doing so, they averted the damage of bond yield reversal. However, the Japanese employed very little bond speculation from carry trade (including mortgage debt) and its powerful leverage. They also have much less consumer debt. They suffered a 50% housing decline, which the US leaders will fight to prevent. We compare poorly to Japan, despite our arrogant claims to the contrary. Japan never suffered from lack of liquidity, and neither will the USA. Our outcome will be as distorted as our population is obese. In almost every respect, Japan has advantages. They continued to overbuild their real economy after bubbles broke. The USA overbuilt its financial sector chronically, and continued to export its real economy after bubbles broke. The real risk lies with the US Economy, whose financial sector engineering has built such leveraged machinery as to threaten the entire system. The Federal Reserve will most likely keep interest rates low for as long as possible. A mere 25 bpt hike at the June 30-th meeting could be a meaningless bone to toss the bond market. It would satisfy those bond vigilantes who urge more responsible monetary actions. But it would do little to halt the rise in cheap money permeating the system. The US speculative community, which surely includes homeowners eager to purchase overpriced homes, and to extract cash equity from overvalued homes, have piled up $1.04 trillion in debt during calendar year 2003. Events of the last two months have convinced me that a substantive rise in the USDollar can kill the US Economy. More importantly, it means a certain smother to the financial sector, bound to the great bond speculation game. The financial markets are a bubble, but so is the entire US Economy a bubble. Fundamentally, a USDollar rise would choke off the rise in export commerce which is vital to reduce the burgeoning trade gap. We face a herculean challenge to reduce imports without having to cut off the arms & legs of the US Economy, which is structured toward retail sales. I doubt it can be done. The only true solution requires huge bankruptcies, the return of the mfg base to the USA, a 50% decline in the USDollar, harsh govt program cutbacks (e.g. Social Security, Medicare), and the dismantlement of the US Military machine. The only likely piece to that recipe to come to reality might be the 50% US$ corrective adjustment. However, it will not be done constructively, but rather as part of a desperate hidden policy to fight a crisis whose grip will grow more powerful. It is my contention that the USDollar will be fully sacrificed in order to keep a cap on long-term interest rates. As evidence continues to arrive on multiple fronts of price inflation, we are sure to see greater bond market volatility, but perhaps not sharply higher long-term yields. The Fed will be doing brisk business of printing phony money to purchase 10-yr Trez Notes in open market actions, along with mortgage debt from the Fanny Mae failure. Vigilantes will be relentless, as always, to force up the 10-yr TNote yield in lockstep with the erosion to capital which price inflation entails. However, real economy deterioration will keep the vigilantes at bay, as rates periodically react downward. The Fed can and will monetize the TENS, keep a lid on mortgage rates, and prevent leakage of damage from the financial sector to the tangible reality of households, to housing prices. Their strategy to protect from rising interest rates will force the USDollar below critical support, again and again, starting with the important DXY=85 line, which corresponds to the Japanese yen at 95-96, and the euro at 128-129. REAL ECONOMY PUT AT SEVERE RISK The Fed will be in a fight for its life, to prevent mortgage rates to rise. They will be forced to continue the monetization of mortgage bonds. They will be forced to continue the monetization of federal debt, so as to avoid crowding out the corporate bond market. Since the Fed regards the general industrial base at a severe disadvantage from a still overvalued USDollar, they will add to even more supply in order to bring the US$ down until jobs return and outsourcing ends. This unavoidable policy is sure to slow the US Economy from several causes:
The Fed will take the road with less immediate risk. They will attempt to avoid higher rates. Liquidity will accelerate, as it has in the initial months of this year. That trend should continue, quietly at first, then to a greater extent as the markets catch on to their strategy, which is to SACRIFICE THE DOLLAR, and to SALVAGE BONDS. Traders will jump on dollar carry trades to hurt the US$ decline. The Federal Reserve and Dept of Treasury will transfer risk from interest rates to the currency. In doing so, the Fed will offer a giant assist to the financial sector, to whom the Fed is deeply beholden. They will amplify the risk put to the real economy, which must deal with higher commodity prices, energy prices, food prices, scrap prices, and intermediate goods prices like steel. For the last two years, the financial sector has thrived, but at the direct expense of the real economy. THE ONLY CONCESSION HAS BEEN TO HOUSEHOLDS, in the form of higher property values. However, equity extraction is a trap and evidence of liquidation. Expect this trend phenomenon to worsen, badly worsen, like with reverse mortgages. Rather than revive the real economy, the consequent inflationary effect of the falling USDollar will further stress the real economy. The financial sector will be supported, since it resides closer to the power center of the nation. The only way for the stock indexes not to break down, and the bond market not to break down, is for staggering monetary expansion, debt monetization, and interference with the free markets. The strategy will succeed until foreigners have had enough of bond losses, made worse by currency translations which override any minor gains. The Federal Reserve no longer has the Bank of Japan and the People’s Bank of China to do their dirty work and overnight bidding. The Fed will be forced to go it alone, to enable a grand USDollar decline, with a directive NOT to crush the bond market with higher interest rates. A weaker US Economy than reported will expose the plan as pure folly. The real economy slowdown might be much worse than anyone anticipates. For 30 years we have exported inflation, and now it returns home, directly or indirectly. The best indicator on the health of the real economy is the yield curve. As the Fed grudgingly hikes rates, watch to see whether long-term rates rise in step. If LT rates do rise, danger exists for unwound carry trades to take them unexpectedly high from a convex response built from speculation. If LT rates do not rise, it could be from Fed backroom actions which put the US Economy at even greater risk down the road, from a USDollar crisis. In the absence of product pricing power, and absence of wage growth, rising oil prices tied to terrorist actions are most likely to slow the US Economy. In the past, higher oil prices have been inflationary. In this current distorted and dislocated environment, higher oil prices might be economically deflationary. The fate of gold and bonds is uncertain. NEWS TIDBITS Wachovia offered $14.3 billion to acquire SouthTrust, which would strengthen their southeast business and clear expansion into Texas. Simon Properties offered to acquire upscale Chelsea Properties for $3.5 billion, which includes $1.3B in debt and preferred stock. Jean Marie Messier has been indicted by French officials for fraud in the management of Vivendi. The Supreme Court ruled that HMO’s cannot be sued for failure to pay for doctor recommended treatment. Two Qwest executives have come to agreement, which settles SEC prosecution. Connecticut governor Rowland resigned, in the face of impeachment and a federal corruption probe. The Saudi Al Qaeda mastermind Abdel Aziz al Muqrin was reportedly killed in Riyahd. The fuse may be lit for retaliatory assassinations of middle level Saudi royals. The lack of American understanding of Saudi civil disarray, national deterioration, royal corruption, decline in per capita income, widespread poverty, wealth confiscation, division within the royal family, connection with fundamentalist groups, and tight links to US military industrial political complex is truly alarming. An Iraqi judge has ruled that the Abu Ghraib prison is not be destroyed, but must be preserved as a crime scene, despite the President Bush call for its demolition. Iraq has brought one of two Basra pipelines online, and has restored one million barrels per day. Iran holds three British sea vessels, for crossing into its waters. South African Retief Goosen overtook Phil Mickelson with late green putts, to win the US Open golf tournament in Shinnecock Hills on Long Island. Junior Griffey hit home run #500 to join an exclusive club of 20 other players in baseball, whose currently active members include Bonds, Sosa, and Palmiero. LA Dodger relief pitcher Eric Gagné logged his 81st consecutive save to beat the ugly NY Yankees, and gives credit to not washing his salt-stained hat in over two years. TODAY'S
MARKET Jim Willie CB
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THE
FED’S HYPER-LIQUIDITY ENDGAME
