Jim Puplava: Joining me next on the program is Felix Zulauf; he is president of Zulauf Asset Management. Felix, I want to go back to something you said in the beginning of the year in a roundtable interview. You offered the opinion that there are two worlds that we live in; say the industrial world and the emerging world. Inside of the industrial world, it is living on the fiction that it can afford its current lifestyle by going further into debt. Have recent deficits in the US surprised you in that the bond markets have been slow to revolt?
Felix Zulauf: In a way yes, but there are good reasons for that and the good reasons are that the global capital flow system is not working according to a free market letting happen. It is because central banks on the other side of the US dollar where those capital flows flow to out of the US dollar because monitored policy is too easy here and weakens the dollar and nobody wants the dollar as an investment currency anymore and money flows away. Would actually then strengthen other currencies and those recipients of those dollars they do not like their currencies to be strengthened to the degree free capital flows would do it and therefore they intervene. They recycle a big part, not all but a big part of the money back into US treasury paper and that is why the whole system continues further and that is why the US Bond Market, the Treasury Bond Market has held up much better. On top of that, you have the Central Bank buying huge quantities of treasury paper and there are so called almost despite the large deficit a certain technical shortage of treasury paper for the time being. Of course this is not the very stable situation, it is sustained for the time being, unstable situation and is highly inflationary at the end but it can break down anytime and when it does, then we enter a bear market and not just for equities but also for commodities.
Jim Puplava: Now because the private sector is still in a process of de-leveraging, it is allowed government such as ours to leverage up. Lately Felix inflationary signs are beginning to surface for example regional fed surveys on the day that you and I are speaking we have the Texas manufacturing outlook, the prices paid component has been going up and recently we are starting to see a pickup in the PPI and CPI. How long before this presents a problem for the Fed and the financial markets.
Felix Zulauf: Well first of all going back to what I said before is the inflationary pickup would have shown up much more quickly and in much more decisive way if the other central banks would have let their currencies depreciate to the degree free capital flows would have done so. That would have stopped the US central banks from pursuing its ill guided policy much sooner. Now I think inflation is picking up and we are talking about consumer price inflation. I mean there are many types of inflation around but talking about consumer price inflation and producer price inflation, those prices are picking up and I think they will surprise on the upside in the US during the second part of this year. I do expect CPI to reach 4% or slightly above that probably and doing that it should really stop the Fed from the current policy. It should really lead to some change of monetary policy, that will be very decisive for capital markets and commodity markets, and those are currency markets in the world.
Jim Puplava: By holding on to their currency peg and I am referring to countries like China, US inflation is being transmitted to many emerging markets such as China. China has been in the process of raising bank reserves and raising interest rates to combat inflation. Is there a risk Felix that they over do it and what might that mean to the developing world, especially the US?
Felix Zulauf: Well it is true that they are tightening credit in a way by hiking up reserve for ratio requirements but this is only one factor. Other factors still point to very easy monetary policy in China and so this is only taking away what they give on the other hand and it is still a relatively easy monetary environment in China, and you can see that by the enterprises in China still going up. When you have an economy that is a closed economy to a very large degree because capital cannot freely flow out of its system, and you have inflation rates that probably 10% in reality and you have prime lending rates at maybe 6.5% and you have deposit rate for savers at 2%. That means you have very low deep negative real interest rates, that is an incentive to invest in all sorts of assets, and as long as that is the case you know, the reserve ratio requirement has to go up a lot higher until it really slows down the Chinese economy into a recession. I think we are marching in that direction but we are far from the point where it would trigger a recession. What the Chinese are trying to do is they are trying to moderate economic growth and thereby controlling inflation bringing it down to a somewhat lower level so that the cyclical expansion of the economy can continue and the job creation can continue etc, and that is what they are shooting for. They may be successful for the time being but the end of the day is this business cycle expansion in China will go to excesses that some of the excesses are very clearly around and you can see it with ghost towns and mail investments in several part of the economy etc. But it will only continue to run for another, I do not know, two or three years until something, probably an exogenous shock or a decisive change of monetary policy somewhere else triggers the recession. I think we are on the way to it, but it will take another two to three years until we get there.
Jim Puplava: I want to move onto Europe where we have the problems with the pig countries, the Euro is a monetary currency without a political union. How does the issue of the pig death issues get resolved and does the Euro hold together or do the Pigs break off or do we get for example two different currencies say, any thoughts on that?
Felix Zulauf: Well if I knew, I think the two currencies are out of the question that is unrealistic. You cannot create for political reasons, you cannot create two clear classes of currencies, a good currency and a bad currency, and you cannot do that. Economical rationale is trying to force a breakup by pushing interest rates higher and pushing some economies eventually out of the currency union. Political forces however they want to keep the currency together. They are moving and pushing in the other direction and for good reasons you know, European history has been a very bloody one and European integration is an important factor for European countries. They do not want to fall back to WWI or WWII and those things and therefore you will have a tug of war between two forces and I think it will go on for a number of more years. In the meantime, you have a situation where the markets are trying to force a decision and unfortunately, Germany has the big saying and the German government because they have been the threat to the rest of Europe, WWI and WWII and their own history. You know, they do not want to break the Euro apart, and therefore they will at the end of the day, they will always cave in and it will be up to the German people, not the German politicians. The German people to revolt against the fiscal union and the Germans paying eventually for their southern neighbors. I think it will be dragging on epic drama for a number of more years. In the meantime you will see that the current policy track by the European central bank that wants to go the way of the old German Bundesbank namely to put currency stability first and economic management by monetary policy last, that will not work. Because the Euro can only hold together in the long run if the European monetary policy goes the way the US monetary policy goes. Namely to make the Euro as structurally the currency and of course the Germans do not want that and therefore you have a lot of issues. I believe that the next in line will probably not be Spain, but I think the next stock in Europe will come out of Italy. The Italian public debt situation is a lot worse than Spain; Spain’s public debt situation at the present time is okay. The problem there is the private debt situation. It is a little bit like Ireland before the government assumed the debt of all the banks and assumed the banking system guaranteed etc etc. but I think the world is focused on Spain, which will eventually fall in my view, but I think before that you will probably see Italy. We have a banking system in Italy that is losing deposits and they have problems to refund the banking system, and you know; only two or three large banks can directly go to the ECB to get very low, cheap refinancing. The other banks they cannot do that, they have to go to the free market and the Euro monetary situation is very tight, liquidity is very tight because the European central bank is steering a different policy from the US. Therefore what these banks are doing, they go to the Dole Market, they refund in dollars, translate those dollars into euros which make the Euro a strong currency or it appears as though in the currency markets and that is how they breach the currency situation. This is a highly unsustainable situation because it forces the Euro further up and in face of the whole weak peripheral economies and they are weak. They are the weakest in the whole industrialized world, they are being forced down because they cannot export anything anymore. So I think you will soon see, this summer or so, you will see a problem in the Italian market and that will be the next shock in Europe, and those shocks then force the ECB to change direction and eventually they will end up with an easy monetary policy.
Jim Puplava: I want to move back to the United States and if we look back historically Felix and you talked about this in your Barons’ Interview, in the 60s and 70s over a period of time, we had inflation building up in the economy in the financial system. That process was reversed under Volker who kept interest rates high over a period of time until he rung large inflation out of the system. It seems like we are gradually reversing that process first with Greenspan and now with Bernanke and it would appear that ultimately this leads to the debasement of the dollar which we have seen fall. It appears this process has already begun, in your opinion where are these polices leading the US and what happens to the dollar and especially its reserve status?
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