The Fed is currently shooting for a target rate of inflation. Solid consecutive jobs reports will be a key indicator, but we need to focus in on what will drive the inflation and jobs reports.
Velocity of Money
The biggest problem with the Fed hitting its current target rate of inflation is that there is no velocity of money. In other words, the Fed can print gigantic piles of cash and leave them on every street corner, but if no one is spending those dollars in the economy, the money is just sitting there static, i.e., it isn’t going anywhere and there is no “velocity of money.” This velocity of money is a basic requirement for the Fed to gets its increased target rate of inflation, which it believes is the key metric by which it can assure all is good and well in the world. Sadly for the Fed, the velocity of money just keeps dropping. This is sad for us, too, because it means endless QE and all the risks that come with that.
Another way of understanding velocity of money is to think of it as the rate of spending. Interestingly, spending in the US is directly tied to how good or bad people feel about their finances. More specifically, it's tied to how they feel about their home increasing in value thereby adding positive equity to their net worth or if their home is upside-down on the mortgage making their financial statement look like a train wreck. The US housing market and its ancillary industries such as new home construction make up as much as 1/6 of the entire US economy.
In order to create this increased value of homes, there has to be increased buying of homes. In order for there to be increased buying of homes, there has to be (continued) low interest rates for mortgages.
Home mortgage interest rates key off the US 10-year treasury rate. If bonds sell off, rates skyrocket, and so does the cost of mortgages.
Bingo - there is your smoking gun. The Fed is currently the majority buyer of US Treasuries to the tune of almost 80% of the entire amount of new paper issued. If the Fed stops buying, it will create a black hole of no demand for Treasuries. This will destroy bond prices, interest rates will skyrocket, and home purchasing will crater. All just when the Fed desperately needs a recovery in the housing market to fuel jobs and velocity of money to create the inflation target it is trying to hit.
Ben Bernanke's recent mere talk of tapering sent the bond markets into a nosedive, driving heavy selling of Treasuries, and proves that the Fed cannot cut off the supply line of easy cash or it will never get the jobs creation and velocity of money it needs to hit its target metrics. Mr. Bernanke must have been horrified watching the bond market reaction to his recent speech mentioning possible tapering in 2014.
So do you want to know when the Fed can stop buying its own Treasuries? Watch for much more positive data in housing and for velocity of money.
The second problem contributing to low velocity of money is that the gigantic piles of cash the banks are accumulating from all this Fed punchbowl is just sitting. There is currently a massive snowpack of money on the balance sheets of banks that is not moving out into the economy; it's an avalanche of inflation waiting to happen. Every month the Fed is adding another Billion in new snow to this precariously bloated pile. The following chart shows “Excess Reserves” of depository institutions (banks) holding money in surplus of what is required for their reserve positions.
The amount of money simply sitting there on bank balance sheets doing absolutely nothing has skyrocketed from almost zero to close to .9 Trillion in just three years.
The thing that keeps nagging at me is what happens when that gigantic snowpack of money shifts and starts to move? Is this going to be an avalanche? Do we see inflation rates of 8%, 10%, 25% or 100%? This may be a perfect structural set up for hyperinflation.
The Primary Driving Influence in Financial Markets Today
Put down the Quantitative Easing and step away from the punchbowl, slowly, sir.
According to my good friend Ronald Stoeferle of Incrementum, prior to the beginning of QE1, the historic correlation between the balance sheet of the Federal Reserve and the S&P Index was 20%. Since 2009 the correlation has increased to 86%.
This is a frightening concept. The reality is that the markets seem to have become so displaced from fact, and so dependent on the feel-good injection of funny money from the Fed, that market participants can no longer tell right from wrong, good from bad. Stock valuations have less to do so much with corporate profits, but more with what comes out of Bernanke’s mouth. Decisions to sell real assets such as gold and chase the magically levitating equities markets have become so compelling that some investors are simply unable to resist. By the way, this was precisely the stock market behavior and activity of Germany's central bank prior to the Weimar hyperinflation. What good is a stock valued at 100 times what it was when you bought it if the dollar it is measured in has 1/1000 the buying power?
For some, this is going to end badly.
One might wonder if Japan’s Prime Minister and his great “Abenomics” experiment is just the guinea pig for a future Fed QE program that is three times the current size. What if the Fed was using Japan as a test bed, much like Cyprus has been used as the test bed for a “bail-in confiscation of depositors' assets” for the rest of the world? Shinzo Abe’s most recent “Third Arrow” in his program has been to pledge to print money until incomes are rising at 3% annually! The image of a samurai warrior with a grave expression on his face furiously pushing on a wet noodle comes to mind. History may look back at these actions and compare them with every other action politicians have implemented in various societies through time in an attempt to force the markets to do what they want them to do, ultimately causing far more damage than if they simply allowed markets to correct.
Between the USA and Japan alone, central banks are printing at an unprecedented rate of 160 Billion USD per month. Warning label: The extent of the current purchase program by the Fed and its time horizon has no limits.
This has never happened before in the history of the world. It’s kind of like we are all (and I mean all) on an Apollo 130 flight to Mars piloted by Ben Bernanke with the entire population of the world relying on the Fed's ability, the cunning new science of paper money to not fail, and our currencies to not go into a hyperinflation. Otherwise, we are all going to die a miserable frozen death out in the middle of space millions of miles from home. I don’t like it when someone else is driving my spaceship, and I suspect many of you don’t either.
Parting Shots and Gold
AFE Treasury Director Simon Heapes likes to tell the story of how ancient Parthian Asian horse lords devastated seven Roman Legions through the use of an interesting tactic and incredible skill with bows. Mounted archers would advance towards the enemy formation in a column, then split in two parts and peel away from the enemy towards the right and left rear respectively. As they peeled off, they would fire their arrow (backwards, on horseback as it were) into the enemy formation. This is where we get the term “parting shot.”
According to the CFTC CoT report as of Tuesday July 18th, the total number of shorts contracts in gold by market speculators reached a titanic 160,000, the equivalent of 497.7 metric tons. This is a record number, and it is also a huge indicator of negative market sentiment. History has shown that when the market reaches such a massive concentration to one side of sentiment, a violent correction is due, and it is also a prerequisite of the next major upleg. When this gold market corrects, and correct it will, we are going to see some explosive movements.
