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From Opium Wars to Currency Wars

August 19, 2019

In 1842 the Qing dynasty surrendered Hong Kong to the British Empire following the First Opium War. Then, in 1898, the British pledged to cede it back to China after 100 years had passed. Excluding the period of Japanese occupation during the Second World War, Hong Kong remained under British rule until its peaceful handover to the Chinese in 1997. This transition was structured by the Sino–British Joint Declaration, which guaranteed Hong Kong would remain a capitalist economy and have its own currency and separate legal system until the year 2047. This rubric was known as “One Country Two Systems.”

Regrettably, the current conflict between Hong Kong and the mainland was inevitable because the people of Hong Kong have a long history of thinking of themselves as a part of a western-style democracy—one that has been prospering for 177 years–and would never easily relinquish their freedoms. The salient question now is will China send the People’s Liberation Army into Hong Kong to quell protestors that were originally incensed about a “fugitives bill.” This bill would allow Hong Kong citizens to be extradited to China. President Trump has already indicated that he is behind President Xi. And, with American/Sino relations at a low point, the time may be ripe for China to expedite the complete annexation of Hong Kong both territorially and systemically.

Until very recently, Hong Kong has enjoyed its quasi-independence from mainland China, growing economically both as a manufacturing hub and one of the financial capitals of the world. But, unhappiness with the proposed extradition bill has led to civil unrest. Hong Kong’s chief executive, Carrie Lam, agreed to suspend the bill but not remove it entirely. That has simply reminded the people of their eventual fate.  The truth is it was never going to be possible for the 7.4 million free citizens of Hong Kong to change the way that the communist autocratic regime controls 1.4 billion mainland Chinese.

Gordan Chang author of “The Coming Collapse of China,” believes revolution is on the horizon for China; starting with Hong Kong. And these seeds of revolution have already begun. On Monday, August 5th, defying Beijing, seven districts in Hong Kong participated in a general strike, leading to the cancellation of hundreds of flights and the eventual shut down of the main airport. A quarter of the entire population of Hong Kong has now taken to the streets.

The civil unrest in China has also started to impact the value of its currency–the yuan broke below the important level of 7 yuan to the dollar.

China’s central bank suggested that the depreciation was in response to Mr. Trump’s decision to extend punitive tariffs to the entire value of China’s exports. However, China is not manipulating its currency lower as Trump would suggest. Rather, China is desperately trying to keep it from crashing.

Hayman Capital’s Kyle Bass believes that if the Chinese yuan were to trade freely, it could be looking at as much as a 30% – 40% devaluation. The Chinese government is working hard to prevent a free-fall currency collapse. And it’s unclear if the 7-yuan breach was a test to see if markets would allow the yuan to devalue slightly without experiencing massive capital flight out of China.

Because China now has both a fiscal and current account deficit, it is in desperate need of US dollars for trade and debt repayments.

And the truth is large Chinese commercial banks have become even more dependent on dollar-denominated debt. The Bank of China’s annual report showed the total amount of dollar debt stood at 2.21 trillion yuan ($314 billion) at the end of 2018, up 12% on the year. However, as dollar debt has increased, dollar assets remained unchanged at 1.67 trillion yuan, bringing the dollar-debt to dollar-asset gap up 81% to 536.5 billion yuan.

However, despite China’s woes, many market pundits believe that China’s over $3 trillion in foreign currency reserves leaves both China and its currency out of danger. But those pundits may be surprised to know that it’s not just China skeptics that question the potency of China’s foreign reserves. According to the IMF, China’s reserves have been below the recommended levels since 2017. Despite its substantial foreign reserves, which have surged by 430% from 2004 to 2015, money supply and short-term debt have increased even faster; growing 860% and 780% respectively, over the same period.

China’s total debt has skyrocketed to $40 trillion (over 300% of GDP), from around just $2 trillion back in 2000. Not surprisingly, the amount of bad loans has increased alongside the pace of state-directed unproductive debt. Official data shows that the amount of non-performing commercial loans (NPLs) has recently reached 2.16 trillion yuan—a 16-year high. This number is still a very low percentage of total loans outstanding, but that is because the government ameliorates the default process by papering over most of those NPLs. The PBOC may be forced to soon print 10’s of trillions of yuan to bail out its faltering banking system, which would send the value of its currency plunging from its current precarious position.

If the pace of yuan decline were to continue, it would force China’s major trading partners to devalue along with the yuan–or risk an export-led recession. Thus, putting a tremendous strain on the ability of these countries to carry their tremendous amount of dollar=based debt.

The trade war is increasing the difficulty of keeping the Chinese economy and currency levitated.  According to the Nikkei Asian review, more than 50 multinationals from Apple to Nintendo to Dell are working on relocating their manufacturing bases out of China to escape the punitive tariffs placed by the United States. With the large outflow of economic activity, China is going to have a harder time feigning its illusory 6% growth rate.

Any Pentonomics follower knows I have maintained for some time that China’s economy is built on an enormous debt bubble that will one day burst. Europe, Japan, and the US share much the same fate. This will have hugely negative ramifications for the global economy. China looks like it is now a gentle gust of wind from having its entire house of cards blow.

The Red nation is now having to fight three wars simultaneously; a trade with the United States; amalgamating the freedom-loving citizens of Hong Kong into the communist dictatorship of the mainland; and, a currency crisis that would destabilize the eastern bloc nations and take the developed western world down with it.

Investors need to factor in the natural progression of the dynamics between China, Hong Kong, and the free world. That is; from Opium wars to currency wars, to military wars. China has labeled the protestors as terrorists that must be severely punished “without leniency, without mercy.” This war might not be confined to China and its territories much longer. The political, economic, and military tensions between China and the West are intensifying rapidly.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

An Ounce of Prevention is NOT Worth a Quarter Point of Cure

August 5, 2019

With Inflation hovering around 2% and the level of unemployment at historic lows, the Fed is fully attaining its prescribed dual mandate of full employment and stable prices (now defined as 2% inflation rate). Given this, one would think Jerome Powell was enjoying his summer, vacationing, taking long walks on the beach or lounging by the pool delighting in his success as Fed Chair.

But ironically, Fed officials saw the need to panic into a quarter-point rate cut on and also decided to end QT on July 31st. Why you ask?  Fed officials appear to be channeling Benjamin Franklin’s wisdom that “an ounce of prevention is worth a pound of cure.” Jerome Powell has been twitter bullied by Trump to “make the fed great again” –so he’s now playing offense.

In fact, former Minneapolis Federal Reserve President Narayana Kocherlakota went as far to say that he believes it will be at least 3-5 years of an easy monetary policy before the fed can even consider raising rates again. And our Fed isn’t the only central bank looking to add both defensive and offensive stimulus. The People’s Bank of China has eased lending conditions. And Australia, India, New Zealand, and Russia have recently injected fresh stimulus into their economies.

Of course, there is also the European Central Bank (ECB) President Mario Draghi, who is poised to spring into action in September, despite a current deposit rate of -0.4%. Draghi actually believes that negative interest rates equate to borrowing costs that are still too high and that making them even more negative is the panacea for EU and its insolvent banking system.

The Eurozone economy is circling the drain, and Draghi noted recently that, “This outlook is getting worse and worse… in manufacturing, especially, and it’s getting worse and worse in those countries where manufacturing is very important.” Analysts are predicting that GDP in the Eurozone for the second quarter flatlined at about .2% and they are forecasting the third quarter will come in about the same.

All this bad news is taking its toll, as German businesses are said to be the most pessimistic in a decade. The second-quarter figures are set to show a contraction in Italy and possibly Germany with Spain and France looking only slightly better.

All this “worse and worse” news is leading the ECB to signal they are willing to do more and more of “whatever it takes.” Of course, it’s going to be interesting to see where these new measures leave Deutsche Bank–one of Europe’s most prominent banks– whose stock has plummeted 77% over the past few years on the back of negative interest rates.

Still, there is an expectation that before Draghi hands over the switches of this economic train wreck to the current IMF Director, Christine Lagarde, he will first put the euro printing presses into overdrive.

Mr. Draghi, who leaves office in October, has never once raised interest rates throughout his eight-year tenure. His successor is believed to be even more dovish. She’s scheduled to start on Nov. 1, the same day as a no-deal Brexit occurs, which could lead to increased market turmoil.

But will more negative interest rates resolve the imbalances in world economies and markets? If past performance is an indicator of future success, the answer is no!

Negative rates haven’t worked out that well for the Eurozone. Mario Draghi was able to end QE in December of 2018; but that illusion of heading towards normalcy has now been shattered, as the ECB prepares for a further balance sheet expansion.

The nation of Japan could never entertain any such delusions. It is more proof that endless QE and negative interest rates are not the salve for an economic malaise. The Bank of Japan (BOJ) never tried to get rates above 0% and could not even begin to taper its QE program. Japan has enjoyed negative rates since early 2016 going out a full ten years on its sovereign bonds. However, the real economy has completely stagnated. Japan’s GDP measured in dollars in 2016 was $4.92 trillion. At the end of 2018, it was $4.971 trillion…a gain of a measly 0.9%.

There is a stark warning for those who use Japan as an example of an economy that can exist just fine on low rates, high debt levels, and no growth for a long period of time without any profound consequences to its economy. What they fail to grasp is that Japan’s stock and real estate market collapsed in 1989, and the Nikkei Dow is still down 50% from those levels reached three decades ago. Hence, the Japanification of the globe may well be fully underway, but a crash in asset prices is an integral part of that condition. Therefore, a debt-disabled, low-growth, negative-rate world can indeed exist for a very long time. But the US market will not trade at 150% of GDP if it becomes well accepted by investors that economic growth has permanently entered into a state of profound illness.

The real damaging effect of all this money printing is the inequity it is breeding in the United States and around the world. Central banks have been printing money to keep assets prices in a permanent bubble. But this asset price inflation has created a huge wealth gap that continues to broaden.

Think about real estate in some of our big cities–the owners of real estate in the boroughs of Manhattan and Brooklyn have seen the price of real estate triple the rate of inflation over the past 10 years, according to The Douglas Elliman Market report. Meanwhile, rents in Manhattan have exploded on average of 55% during this time; while wages have stagnated.

 

It is becoming apparent that ever-easier monetary policies are approaching their limits—simply because the developed world’s central banks have virtually run out of room to boost demand by reducing borrowing costs. The consequence of which is the confidence in central banks is eroding as fast as the middle class is approaching extinction.

Mr. Powell may think an ounce of prevention is worth a pound of cure. But, because of central banks’ proclivity to lean on artificially-low rates to boost asset prices and GDP for the past few decades, only a few ounces are now available–where a ton of easing is needed to keep the bubbles afloat.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

The Fed is Further Fueling the Bond Bubble

July 29, 2019

Let’s dive right into why lowering interest rates at this point in the cycle will not provide much of a boost to the faltering global economy and may not be much help to the stock market either. The simple truth is that asset prices are far too overvalued and debt levels far too onerous for a few rate cuts—for which Wall Street has already priced into the market–to make much of a difference. The European Central Bank (ECB), Bank of Japan (BOJ), and Fed don’t have room left any longer to play the same trick they have played since 1987. Namely, whenever there has been a hiccup in the stock market or the economy, they drop borrowing costs by at least 5%. But now there is zero room left in Europe and Japan, and just over 2% here in the US to reduce borrowing costs.

The proof can be found in the real estate market. By persistently forcing interest rates down, the Fed has engendered another bubble in home prices that has simply pushed them far above the affordability level for first-time buyers. Existing Home sales are down 2.2% from the year-ago period in June. Permits to build more homes, meanwhile, sank 6.1% month/month in June and were also about 7% lower compared to the same month last year. However, the 30-year fixed mortgage rate dropped to about 3.75% during the month of June, from a peak of 4.94% last November, according to data from mortgage finance agency Freddie Mac. This is proof that what the housing market needs to attract new buyers is much lower prices, not a few basis points lower in mortgage rates.

I want to share with you some disturbing data that was published by the highly respected personal finance company called Wallet Hub that doesn’t offer much hope for the immediate future regarding the affordability, or lack thereof, for first-time home buyers. Today, about one in nine individuals between the ages of 16 and 24 are neither working nor attending school. And, more than 70% of these young adults are ineligible to join the U.S. military because they fail academic, moral, or health qualifications.

Turning to the health of US corporations and the broader economy, a good barometer can be found in the railroad industrial giant CSX. The company reported earnings recently that missed on both the top and bottom line. And here’s what the CEO had to say about the condition of the economy:

“Both global and U.S. economic conditions have been unusual this year, to say the least, and have impacted our volumes. You see it every week in our reported carloads,” Chief Executive James Foote said on a conference call following the earnings report. “The present economic backdrop is one of the most puzzling I have experienced in my career.” Mr. Foote’s career in the railroad industry is over 40 years. The stock plummeted 12% on the news in one day.

While the data on Retail Sales was a bit better than some of the gloom coming from corporate earnings reports for Q2, GDP growth still dropped from 3.1% in Q1, to just 2.1% this quarter.

Regrettably, the data on global GDP growth is much worse. Auto sales in the European Union (EU) dropped by 7.9% in June from the same month a year ago. And exports from Singapore fell for the 4th month in a row and were down an astonishing 17.3% in June from the same month in 2018. The nation’s exports of electronics plummeted by 31.9% year/year. Germany’s manufacturing sector worsened in July with goods producer performance falling to its lowest level in seven years.

I want to highlight some comments made in a recent interview by one of the Fed’s chief lovers of counterfeiting, Charles Evans, President of the Chicago Fed. It is crucial to understand to what degree these central planners are hell-bent on destroying the middle class in favor of Wall Street. Mr. Evans was very clear that having an inflation rate that is even a few basis points below its asinine 2% target must be “rectified” as soon as possible and for a very long time. In other words, some members of the FOMC believe inflation must be forced well above 2% for many years to make up for the years the Core PCE Index spent below 2%. Core PCE Inflation is the Fed’s preferred metric for measuring inflation and is by far the lowest measure concocted by the government. Nevertheless, because this measurement of inflation is a measly three tenths below target, the FOMC may be panicking towards the zero-bound level once again.

The world’s central bankers have redefined stable prices as a 2% annual rate of inflation. Mr. Evans now says, “We need to go above 2% at some point or else I’m worried that [investors will think] that 2% certainly looked like a ceiling didn’t it” In other words, the Fed thinks it is imperative to empirically demonstrate to everyone that it can bring inflation above 2% “with confidence”.

The truth behind why the Fed is so concerned about maintaining a 2% inflation target is that it knows banks’ assets are in a bubble and the financialization of the economy requires that the central bank keep asset prices from ever correcting. This is because the bubbles are so big that an innocuous burst is no longer possible. Even a small decline in asset prices could quickly spiral into a crash and take the entire economy down with it.

Despite the perennial “better than expected” game Wall Street loves to play, year over year earnings growth has been pitiful. BASF, FAST, TXT, NFLX, CSX and CAT are just some of the tape bombs that we have seen. In some cases, their shares plunged by double digits just seconds after the new release. CAT dropped by 5% after missing on earnings and revenue and lowered guidance. There have been a plethora of industrials and transportation companies whose terrible earnings show how weak the global economy has become. Indeed, not all earnings have been bad and most, as they always do, have beat lowered expectations. But the truth is that global growth is slowing—the IMF recently lowered its growth forecast again; this time to the lowest level since 2009. For now, it may be the case that Wall Street doesn’t care because the Fed is expected to cut rates and force more people to chase in an unhedged fashion further into this dangerous bubble.

But it will take a massive stimulus package from the Fed, ECB, BOJ, and PBOC to push the economy from disinflation to stagflation, which may levitate asset prices a bit longer. The sad truth is that such fiscal and monetary madness is definitely on its way at some point. We’ll learn more about this on July 31st after the FOMC’s rate decision. Perhaps a 50-bps rate cut and the end of the Quantitative Tightening (QT) would do the trick. But that will just severely weaken the foundation for the market and economy, just as it intensifies the inflation central banks have been so aggressively trying to construct.

The problem with the global economy does not stem from borrowing costs that are too high. In fact, interest rates are already at an all-time low. Therefore, lowering interest rates cannot at all fix the economy. It will just create more imbalances and further undermine what’s left of the middle class.  And eventually, ensure the coming interest rates shock will obliterate the stock bubble that has been built on free money.

What the World Doesn’t Need Now is Lower Rates

July 22, 2019

The Q2 earnings season is upon us and the risks to the rally that started after the worst December on record at the close of last year is in serious jeopardy. We received a glimpse of this with some of the current companies that have reported. For example, to understand how dangerous this earnings reporting season can be, take a look at what one of the largest US multinational firms had to say recently after it reported earnings. The Minnesota-based Fastenal, which is the largest fastener distributor in North America, reported worse-than-expected second-quarter earnings and revenue. Shares of Fastenal promptly tanked more than 4%. But what the management said about the quarter was very interesting. The company said in its press release that its strategy to raise prices to offset tariffs placed to date on products sourced from China were not sufficient to also counter general inflation in the marketplace.

In fact, companies that collect more than half their sales outside the U.S. are expected to see a 9.3% slump in second-quarter earnings, according to FactSet estimates. This quarter’s earnings overall are expected to drop by 2.3%–making it the second quarter in a row of declining EPS growth.

What I find most interesting is that we have a capital spending slowdown, a global manufacturing recession, global GDP grinding downward, US Q2 growth falling to about 1.5% from the 3% level seen last year, and an S&P 500 earnings recession. All of this is happening in the context of asset prices that are at all-time high valuations and are clinging precariously to a worldwide fixed income bubble that is destined to go supernova and obliterate asset prices.

I’ve gone on record indicating that the daggers for the bubble on Wall Street and the global bond market are inflation and recession. A recession would blow up the $5.4 Trillion worth of BBB, Junk and Collateralized Loan markets; And rising rates of inflation would leave the entire fixed-income spectrum in tatters.

But what happens if you get both occurring at the same time? What if we see the return of stagflation? What if rates undergo a massive spike due to global central bank insanity and their inability to ever come even close to normalizing interest rates; and then you also have a recession that causes multiple trillions of dollars’ worth of bonds to default? The answer is, yields would soar like a surface to air missile from the currently insane level of low rates that could only make sense in the twilight zone.

How insanely-low are interest rates you ask? There are now Junk bonds in Europe that have a negative yield, Austria recently issued a one-hundred-year bond with a yield of just 1.2%, And, almost every single country in Northern Europe and the nation of Japan have sovereign bonds with a negative yield– some of which going out ten years in duration!

Therefore, because rates have been forced down by central banks to such an insane level, a gradual normalization that is fairly innocuous for markets is virtually impossible to occur. What is more probable is a violent interest rate shock like we have never before seen; especially if we end up in an environment of stagflation that causes yields to jump by 100s of bps very quickly and destroys the global equity markets with catastrophic expediency. Speaking about the insanity of low yields, the Treasury Department recently stated the deficit grew 23% from October 2018 through June, for a total Fiscal ’19 Deficit of $747 billion with one quarter of the year still left. Annual deficits near $1 trillion are happening outside of a recession. During an economic contraction, deficits should surge towards $2.5-$3 trillion.

The global bond market suffers from a plethora of insolvent corporations and sovereigns that are issuing debt with yields that offer less than zero percent. The day of reckoning may not be imminent, but you must be fully prepared for its eventuality. It is possible to profit from it, but if you don’t anticipate its occurrence, the economic consequences will be severe.

But central banks and governments are unconcerned about these asset bubbles. Incredibly, they are printing and borrow more money. To this end, we should all be aware that the Fed no longer has a dual mandate consisting of stable prices and full employment. The Fed’s primary concern is to try and levitate asset bubbles. After all, Trump says this is the best economy ever and even members of the FOMC assent that underlying growth is very strong. The unemployment rate is at a record low, and the CPI for all items less food and energy rose 2.1 percent over the last 12 months. So, core inflation is over the Fed’s asinine target, and the jobs market is very strong at this time; initial unemployment claims are at a 50-year low.

Why then would Powell indicate during his latest testimony before congress that a rate-cutting cycle will begin later this month?  The truth is the economy is very fragile precisely because it has become 100% dependent upon perpetual asset bubbles. Powell became aware of this when stocks plunged in Q4 of last year and the Junk Bond market completely shut down. The truth is that Powell, and his merry band of counterfeiters, have become absolutely petrified about a recession because they know that it will implode the entire corporate bond market…turning an average run of the mill recession into a depression in short order.

Therefore, he will now run to the printing press at the slightest hint of a downturn. But the chances are high that a 25-basis point rate cut won’t be enough to bail out the global economy.  Nor will several more like it do the trick. It should take 100s of bps and a return to QE to push prices higher.

Are we supposed to believe that central banks are going to make this all ok by easing monetary policy further from here? After all, they have already forced $13 trillion worth of sovereign debt below zero, and the European Central Bank and the Bank of Japan already have negative rates and have been at that level for years. And the Fed only has 225bps of rate cuts available, when it usually has needed 500bps or more.

Perhaps central bankers can manage to force a few more drinks down the hatch in order to delay the inevitable hangover. But that just makes the eventual collapse all the more severe.

 

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

Will Fed Easing Turn Out Like ’95 or ‘07?

July 15, 2019

 You should completely understand that the market is dangerously overvalued and that global economic growth has slowed to a crawl along with S&P 500 earnings. However, you must also be wondering when the massive overhang of unprecedented debt levels, artificial market manipulations, and the anemic economy will finally shock Wall Street to a brutal reality.

Artificially-low bond yields are prolonging the life of this terminally-ill market. In fact, record-low borrowing costs have been the lynchpin for perpetuating the illusion. Therefore, what will finally pull the plug on this market’s life support system is spiking corporate bond yields, which will manifest from the bursting of the $5.4 trillion BBB, Junk bond and leveraged loan markets. And, for that to occur, you will first need an outright US recession and/or a bonafide inflation scare.

We already have a manufacturing recession abroad and a contraction in the US, as illustrated in the new orders data from the June the ISM report. Wall Street is now starting to understand that there will be virtually zero earnings growth for the S&P 500 for the entirety of 2019. However, what is holding up the high-yield market and, consequently, equity prices now is the view that the Fed’s new rate cutting path will allow this ersatz economy a bit of a reprieve by taking interest rates back to zero and thus suppressing junk-bond yields as well.

The answer to the question regarding when stock prices will crash back toward a fair valuation hinges upon whether or not the Fed’s return trip back to free money will be enough to levitate asset prices and the economy a bit longer. Therefore, you must determine if Jerome Powell’s quick retreat on monetary policy will be like the rate cutting exercise that occurred in 1995, or will it be more like the 2001 and 2007 FFR cutting cycle, which turned out to be far too late to save stocks.

Those three economic cycles all experienced a flat or inverted yield curve with rapidly decelerating economic growth; similar to what we find today. But unlike the relatively innocuous period of ’95, the ’01 & ’07 cycles proved that the rate cuts implemented were not nearly enough to avert a brutal stock market collapse.

Let’s look at a bit of history. After first having raised the Fed Fund Rate (FFR) by 300 bps leading up to the middle of the 1990s, the Fed then began cutting rates by February of 1995. It ended its three 25 bps rate cutting cycle by January 1996. The total amount of 75 bps of rate reductions were enough to not only steepen the yield curve and propel the economy out of its two-quarter growth recession but also launched the S&P 500 on an epoch five-year run of 140% by the year 2000. Of course, Wall Street would love for you to believe that Jerome Powell’s new-found dovishness will lead to a similar result.

In sharp contrast to what occurred nearly a quarter century ago, the Fed’s last two attempts to pull the economy out of a nose-dive ended in disaster.

The Fed began to raise interest rates in June of 1999 in an effort to put a damp cloth on the red-hot NASDAQ bubble. By May of 2000, it had undergone a total of 175 bps worth of rate hikes. Mr. Greenspan then began to lower rates in January of 2001 and finally ended his rate cutting cycle in June of 2003 after he reduced the FFR by a whopping 550 bps. Nevertheless, those rate cuts were not enough to save equity prices.  By the fall of 2002, Greenspan had already lowered the FFR by a total of 525 bps, but that didn’t stop the NASDAQ from losing 78% of its value by that time and for investors to see $5 trillion worth of their assets obliterated.

It was a similar situation regarding what occurred during the Great Recession. Chairs Greenspan and Bernanke collaborated to raise the FFR by 425 bps from June of 2003 thru June of 2006. Ben Bernanke then began cutting rates in September of 2007 with an oversized 50 bps reduction right off the bat. He then, in a rather aggressive manner, took rates to virtually zero percent by December of 2008. In other words, he slashed rates to a record low level and by a total of 525 bps, and it only took him one year and three months to do it! However, even that wasn’t enough to keep the stock and housing bubbles from crashing. By March of 2009, the Dow Jones had shed 54% of its value, and home prices plunged by 33%  on a national basis.

Again, this begs the crucial and salient question: will the hoped-for rate cutting cycle, which Jerome Powell indicated at his testimony before Congress on July 10th will probably begin on July 31st, be enough to keep the record equity bubble from imploding? Of course, nobody knows for sure, but there is a strategy to help us accurately model the answer.

First off, the rate cutting cycle in the mid-nineties was abetted by the massive productivity boom engendered by the advent of the internet. There is no such productivity phenomenon of commensurate capacity evident today. In addition, China was on the cusp of bringing 200 million of its population into the middle class by taking on $38 trillion in new debt. The building of that giant pile of debt was responsible for creating 1/3rd of global growth and cannot be duplicated again. Indeed, global growth today is careening towards the flat line rather than being on the cusp of a major expansion.

Not only this but the debt burden in 1995 pales in comparison to that of 2008 and 2019. Total Public and Private US debt as a percent of GDP was just 260% in 1995. However, by the year 2008, it had surged to 390% of GDP, and that figure still stands at 365% today. That is over 100 percentage points higher than it was in ’95.

Another comparison to view is the amount of overvaluation in the stock market between periods. In 1995 the total market cap of equities to GDP was around 70%. But by 2000, it shot up to 148% of GDP. That figure was 110% at the end of 2007 and has now climbed all the way back to 146% today.  The bottom line is the economy is much more fragile today than it was in 1995.

But perhaps even more important than the overvaluation of equities and the massive debt burden the economy must endure is the fact that the Fed could only raise the FFR to 2.25% before stocks began to falter during this last hiking cycle. Therefore, it can only cut rates nine times before returning to the zero-bound range. In each of the previous three rate-cutting cycles, the Fed had plenty of dry powder. In fact, in ’95 it had 600 bps, in 2000 it had 650 bps, and in 2008 it had 525 bps of rate cuts available to deploy.

Also, when looking at the effective number of rate hikes the Fed has engaged in during this latest tightening cycle, you get approximately the equivalent of 625 bps of hiking since 2014. This would include the wind-down of $85 billion in QE, 225 bps of nominal FFR hikes, and the $700 billion QT program – which for the first time in U.S. history saw a tremendous amount of base money destroyed. That amount of monetary tightening is absolutely extraordinary.

The unavoidable conclusion is that the efforts from Mr. Powell will not be nearly enough to thwart the market from its well-deserved day of reckoning.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Baoshang Bank Could Be China’s Indybank

June 17, 2019

For the first time in nearly 30 years, the Chinese central bank and the Banking Regulatory Commission announced it would take control of one of its banks. The troubled Mongolia-based Baoshang Bank had assets of 576 billion yuan ($84 billion), and its seizure is indicative of the deteriorating health of small-scale banks, mostly in rural areas and in smaller cities, as China’s economy slows.

The turmoil surrounding its conservatorship has led interbank lending rates to spike, forcing the Bank of China to inject billions of yuan to quell the fear of systemic contagion. For years China’s regional banks have used shadow-financing to obfuscate their exposure to precarious borrowers. While China has made an effort to rein in shadow-banking activity, this is the first time in decades that regulators have assumed control of a bank in this way. In 2015 and 2016, they recapitalized lenders and merged stronger banks with weaker ones, but these restructuring efforts were disorganized, inadequate, and didn’t address the main issue at hand…insolvency.

According to data compiled by Bloomberg, for the first four months of the year, companies defaulted on 39.2 billion yuan ($5.8 billion) of domestic bonds. This is 3.4 times the total for the same period during 2018.

With the solvency issues plaguing the smaller banks and the rise in defaults, it is becoming evident that funding needs for China’s major commercial banks are becoming intractable for Beijing. The PBOC is running low on the U.S. dollars it needs for activities both at home and abroad. In 2013, China’s four largest commercial banks had around $125 billion more worth of dollar assets than liabilities. But today they owe more dollars to creditors and customers than are owed to them.

Making things even worse for the Chinese banking system is that its problems extend beyond mainland China; there is a looming banking crisis in Hong Kong as well.

Hong Kong pegs its currency to the US dollar and therefore has been overaccommodative with their monetary policy since 2008. This has led to a massive bubble in real estate. Hayman Capital’s Kyle Bass believes Hong Kong is reminiscent of Iceland, Ireland, and Cyprus, whose banking systems imploded during the European banking crisis. The commonality was that each country had allowed their banking sectors to grow to almost 1,000% of GDP, leaving them vulnerable to the smallest economic hiccup. Bass believes that Hong Kong is in a similar situation with its banking system sitting as one of the most levered in the world at approximately “850% of GDP (with 280% of GDP being lent directly into mainland China)”.

Mainland China would be directly on the hook for Hong Kong’s failure as the two largest banks in that nation (Standard Chartered and HSBC) were once filled with British depositors, but now have mostly Chinese obligations.

China’s government has operated its economy much like a Ponzi scheme. It has been stimulating growth by printing money and issuing debt since the year 2000. This is much the same throughout the developed world. But this practice has been on steroids in since 2009. For example, M2 money supply in has skyrocketed by over 133 trillion Chinese Yuan, nearly $20 trillion during that timeframe. But during that same period, China’s annual GDP grew by approximately only $8.4 trillion—proving much of that debt issuance was of the non-productive variety. Therefore, it takes an ever-increasing supply of new money and debt to grow its economy and continue the economic charade.

China is in the midst of one of the largest financial bubbles in modern history. The ratio of banking assets to GDP is much higher than the US at the top of the housing bubble and higher than the EU right before its sovereign debt crisis in 2012.

Still, there are many in the market who believe that with the impressive $3.2 trillion pile of foreign exchange (FX) reserves held by China, nothing can go wrong. Those people should note that that figure was $4.0 trillion not long ago and is currently declining at a rate of $100 billion per month.

Kyle Bass notes that China needs $2.7 trillion of required minimum reserves just to keep trade functioning properly. Thus, making that FX safety cushion a lot narrower.

China is just now experiencing cracks in its banking system that will test their newly established deposit insurance system, making a run on the banks a real possibility. For the Chinese government to save the banks, it may have to destroy their currency in the process. As it stands right now, the yuan is getting close to breaking the all-important 7 per dollar key psychological level. If this level is indeed breached, you may see a massive flight of capital out of the Chinese yuan.

Therefore, the government is forced to continuously issue a massive amount of new currency and debt to keep the economic mirage in place. Yet, at the same time, must find a way to keep its currency afloat. This is the Achilles heel of China’s communist command and control economic model, and it is negatively affecting the yuan’s purchasing power. Consumer prices in May increased by the most in 15 months, while food inflation spiked 7.7% year over year.

Will the conservatorship of Baoshang bank be the event that finally unravels their banking system’s Potemkin Chinese Wall of solvency?  That still is not clear. But with each new iteration of stimulus, the yuan weakens–even against other currency manipulators like the Fed and ECB.

Very few investors thought back in July of 2008 that Indybank was the canary in the coal mine, which gave an advanced warning regarding the insolvency of much of the US financial system. At the time of the bank’s failure, FDIC Chair Sheila Bair assured markets not to worry and that its failure was well within the range of what they could handle. Fed Chair, Ben Bernanke, also gave assurances that the incipient subprime mortgage crisis was completely contained. It wouldn’t be until later that year when investors realized the full extent of the banking crisis that led to the conservatorship of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers, the takeover of Washington Mutual in September of 2008–and, soon thereafter, the near collapse of the entire global economy.

Given that China’s total debt has quadrupled in the past twelve years, a feat that is absolutely unapparelled in history, it wouldn’t be surprising if the collapse of Baoshang Bank forebodes the same fate for China’s economy as Indybank did for the United States.

Fed Running Out of Time and Conventional Weapons

June 10, 2019

The buy and hold mantra from Wall Street Carnival Barkers should have died decades ago. After all, just buying stocks has gotten you absolutely crushed in China for more than a decade. And in Japan, you have been buried under an avalanche of losses for the last three decades. And even in the good old USA, you wouldn’t want to just own stocks if the economy was about to enter another deflationary recession/depression like 2008. Likewise, you wouldn’t want to own any bonds at all in a high-inflation environment as we had during the ’70s.

The truth is that the mainstream financial media is, for the most part, clueless and our Fed is blatantly feckless.

The Fed has gone from claiming in late 2018 that it would hike rates another four times, to now saying that it is open to actually start cutting rates very soon.

My friend John Rubino who runs the show at DollarCollapse.com recently noted: “bad debts are everywhere, from emerging market dollar-denominated bonds to Italian sovereign debt, Chinese shadow banks, US subprime auto loans, and US student loans. All are teetering on the edge.” I would add that the banking system of Europe is insolvent—look no further than Deutsche Bank with its massive derivatives book, which is the 15th largest bank in the world and 4th biggest in Europe. Its stock was trading at $150 pre-crisis, but it has now crashed to a record low $6.90 today. If this bank fails, look for it to take down multiple banks around the globe.

The US is in bad shape, and there is little doubt about it, but the nucleus of the next crisis does not have to emanate from America. I find it incredible that so many people ignore the “melting down nuclear reactors” around the world. China’s factory data shows that the nation’s manufacturing sector is now contracting. China’s National Bureau of Statistics released official manufacturing PMI for the month of May, which fell to 49.4 from 50.1 in April. South Korean GDP shrank in Q1 by 0.4%. In case you were not aware, South Korea and copper prices both have PhDs in the global economy. Copper for its use in construction and Korea for its production of semiconductors. Both are highly sensitive to economic activity, and both are crashing.

Here is one example as to why the Fed is so deathly afraid of a recession. Wisdom Tree and Factset did a study on Zombie companies. They are defined as those with current trailing 12-month interest expenses that exceed the average of the past three years of earnings before interest and taxes. That number is now just under 23%, which is much higher than the 13% rate that what was evident in 2007 just prior to the Great Recession.

To put this in perspective, nearly 1/4 of firms in the Russell 2000 don’t even make enough money to service their debt much less pay back the debt. As economic growth begins to slow sharply, interest rates on high yield debt will start to rise, and zombie companies will get shut out of the credit market. If they cannot service the debt, they go bankrupt and close the doors. As these companies lay off their workforce, the economy will slow further, and that will push junk bond yields higher. This will cause more companies to go belly up and increase the unemployment rolls creating a death spiral of debt defaults, rising unemployment and crashing junk bond prices (soaring yields). A recession/depression would be virtually guaranteed given the record amount of corporate debt– there’s $5.4T worth BBB, junk & leveraged loans outstanding compared to $1.5 trillion sub-prime mortgages in 2007.

This means the EPS on the S&P 500 may not be anywhere close to the ridiculous $186 projected for 2020. Don’t forget; S&P 500 earnings dropped by over 80% in the last recession. Crashing EPS will most definitely pop the equity bubble, and stock prices should fall more than 50%. There will also be a rising strain on government transfer payments (welfare, unemployment, food stamps), which will cause deficits to explode well north of $2 trillion per annum.

Now let’s discuss the yield curve. Yes, it does matter, and no, it’s not different this time. The spread that most matters in the world of the yield curve is the 10year minus Fed funds. This is because of something called negative carry. The current spread between the 10year and Fed Funds Rate is minus 30bps. If shadow banks were to borrow money overnight to invest in longer-duration assets, they would be losing money on each trade. Hence, they stop borrowing; causing money supply growth to dry up quickly. At that point, banks’ profits and the economy contract at a faster pace. In reality, it doesn’t matter why the curve inverts; the effect is the same. So don’t believe the perma-bulls when they tell you the curve has inverted for technical reasons and therefore it is different this time. It matters a lot– especially to the Fed.

The Fed funds futures market is now pricing in 3-4 rate cuts over the next 12 months. It is the market that tells the Fed when it is time to cut rates because of the inverted yield curve. The Fed’s comparable minuscule intellectual capacity has no possible ability to compete with the market’s collective wisdom about where the economy is heading. That’s why we don’t need a central bank at all, especially one that has inserted itself into markets to such a degree that it has now supplanted them entirely.

The salient question is will the coming rate cut(s) be enough to pull the US out of its march towards recession and does it also save China, Japan, Korea and the rest of the maimed global economies around the globe? And, does it also rescue the European banking system as well? The answer is no. What the global economy really needs to perpetuate the growth illusion is a resolution to all the trade wars, along with rate cuts and another massive QE to re-inflate faltering asset prices.

In conclusion, here is a recent a quote from Fed chair Powell, offering more evidence that the Fed– and every other central bank on the planet–are simply slaves to the stock market and headed firmly down the path towards creating a condition of global stagflation:

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future Effective Lower Bound (ELB) spells, which we hope will be rare.”

“ELB” spells are central bank speak for when rates are brought down to zero percent and stay there for a decade they will need to not openly go back into QE, but then even find new ways to get a massive amount of money directly into the hands of consumers.

Therefore, the Fed will be forced to once again try to bail out the economy and stock market later this year. However, it only has 225 bps of easing left before the ELB is reached. It is most probable that the Fed is already too late and also does not have enough conventional weapons to stave off a depression in markets and the economy. That is why before too long, we will have to deal with the unconventional weapons of Universal Basic Income, Helicopter Money, and Negative Nominal Interest Rates.

The chances of this leading to a viable solution to markets and the economy is less than the level of where the Fed Funds Rate will end up..which looks destined to be headed somewhere south of zero.

 

A Brief History of Financial Entropy

May 17, 2019

The global economy began an experiment with fiscal and monetary alchemy when it exited the gold standard almost 50 years ago.

In 1971 the USD completely separated from the last vestiges of its tether to gold. In effect, it released the worldwide monetary system from any limitations of base money growth, as it was no longer pegged to the increase in the mine supply of gold. This is because the USD was once linked to gold and the rest of the developed world linked their currencies to the dollar. This was the case ever since The Bretton Woods agreement of 1944.

Therefore, when the U.S. severed the link to gold, the world entered into its doomed experiment with global fiat currencies and began its journey down the road to financial entropy.

A Bit of History

Paul Volcker (Fed Chair from August 1979 thru August 1987) had vanquished the inflation caused by the loose monetary policies of the Johnson and Carter Administrations by the early ’80s. But once again, the recidivism of the Fed led to rising inflation by the middle of the decade. By the first half of 1987 stock markets had been soaring, rising an astonishing 44% by late August. But by mid-October, the federal government disclosed a larger-than-expected trade deficit leading the dollar to fall further in value and markets to unravel.  By the end of trading on Friday, October 16th the Dow Jones Industrial Average (DJIA) sank 4.6%.  On the following Monday morning, investors in the US awoke to stock markets in and around Asia in free fall. This led the DJIA to crash at the opening bell, eventually plunging 508 points, which amounted to a brutal 22.6% one-day decline. Fed Chairman Alan Greenspan was quick to assure markets his Fed would serve as a source of liquidity and that he would print enough money to support the financial system. He thus encouraged financial institutions not just to remain calm but buy shares with abandon with the full sanction of the central bank.

For the first time since its inception in 1913, the Fed wasn’t just coming to the rescue of an individual bank, or even trying to tinker around the edges of stimulating economic growth; Alan Greenspan made it clear that the Fed was now in the business of directly supporting the stock market. The DJIA gained back 288 points in just two trading sessions. Back in 1987, the entire market value of equities made up just 66% of the economy. And Household Net Worth as a percent of GDP was 370%

The late 1990s ushered in new market worries such as the “Asian Contagion.” From 1985 to 1996, Thailand’s economy grew at over 9% per year. But by 1997, it became clear that much of that growth had been predicated on years of rampant credit growth that yielded an abundance of bad loans. There was also a tremendous amount of foreign borrowing of dollar-based loans and other foreign currencies that exposed the Thai economy to exchange rate risks that had been masked by longstanding currency pegs. When those pegs proved unsustainable and were forced to be broken, firms were unable to pay their foreign-denominated debt–leading many into insolvency. This collapse spread like wildfire throughout Asia and caused the IMF to offer a bailout of over $20 billion.

On the heels of the Asian crisis, Russia becomes an issue. Its weak economy, deficits, and reliance on short-term financing caused the outbreak of a severe sovereign debt crisis. In August of 1998, the Russian government shocked markets when it announced it would devalue the ruble and no longer honor its debts; financial chaos ensued. Many governments and financial institutions found themselves on the wrong side of this trade, but none more so than the highly leveraged hedge fund called Long Term Capital Management, which lost $4.6 billion in short order. Fearing a systemic financial meltdown, the Fed once again came to the rescue of markets organizing a bailout by a consortium of 14 financial firms. Of course, all underwritten by the international fiat printing press.

All of that government-sanctioned counterfeiting exacerbated the NASDAQ bubble of 2000, which soon after burst causing tech stocks to lose 78% of their value by the fall of 2002. At the peak of this bubble, the total market cap of equities as a percentage of the economy was no longer 66%, but had grown to 148% of GDP! And, Household Net Worth surged to 450% of GDP.

In the wake of the dot-com collapse, the Fed took interest rates to one percent and left them there for one year—between June 2003 June thru 2004. This engendered the real estate bubble and Great Recession of 2007 thru 2009. Just before the collapse, Household New Worth climbed to a then-record of nearly 490% of GDP.

The Fed’s response to that worst crisis since the Great Depression was to cut interest rates from 5.25% in 2007, to virtually 0% by the end of 2008; and kept them pegged there for nearly nine years. It also purchased $3.7 trillion worth of banks’ assets to push those same assets back into another bubble. This latest iteration of central bank mania has placed the economy in the position of enduring three great bubbles concurrently for the first time in history (real estate, equities, and bonds). Consequently, not only are stocks valuations back towards 1.5 times the economy but home prices are overvalued by about 35%; along with bond prices that are so distorted that governments are getting paid to borrow money. This current bubble has caused Household Net Worth as a percent of GDP to skyrocket to a record 535%!

From Order to Chaos

The salient issue is that each crisis was ameliorated by printing more money and pushing borrowing costs significantly lower than where the free market would have demanded. Rising rates would normally have cut off access to the cheap credit that keeps non-viable businesses afloat. Recessions are healthy in that they purge the economy of its malinvestments. However, by its systemic practice of artificially suppressing interest rates with increasing distortions, central banks have created massive misallocations of capital that have produced unprecedented levels of debt and asset bubbles.

As a result of this, Household Net Worth as a percentage of GDP is now 50% higher than its historical average.

A significant component of Household Net Worth is stock valuations. As you can see from the chart below, we are now at altitudes only once before ascended during the thin air of the tech bubble.

Another important component of Household Net Worth is real estate values. Here we find that US home prices have far exceeded their bubble-highs set 13 years ago at the peak of the real estate bubble.

 

Add to this calculation the price of bonds, which includes $10 trillion worth of sovereign debt with a negative yield, and you get the trifecta of the everything bubble. It was previously unfathomable to have even one dollar’s worth of negative yielding debt prior to the Great Recession.

The major consequence of all this is that the valuation of assets has now become far bigger than the underlying economy and therefore can very easily bring the whole charade crashing down.

The amount of subprime mortgage debt before the Real Estate bubble collapsed was just shy of $1.5 trillion–its demise brought down the entire global economy. Compare that figure to the amount of “sub-prime” corporate debt, and you can understand the scope of just one of these asset price distortions. When you add the total of junk bonds and leveraged loans together, you come up with a figure of $2.8 trillion. Then, if you count the surging $2.6 trillion level of BBB debt, which is just one notch above junk, you come up with a figure of $5.4 trillion worth of extremely economically sensitive business debt. By the way, this does not imply that over leveraging can only be found in business debt; as of Q1 2019 there is a record $13.6 trillion of household debt outstanding, which is nearly one trillion dollars more than the previous peak in Q3 2008. Therefore, even a small contraction in GDP could quickly snowball into an avalanche of defaults and economic chaos.

The key point here is that when the total value of equities was roughly half of GDP like it was from the mid-’70s thru the mid-’90s; the economy was able to lead the stock market. But, when money printing pushes stocks to become 1.5x the value of the economy, it is stocks that then lead GDP. Likewise, when Household Net Worth was 370% of GDP, asset prices were more a function of economic growth. But with asset prices now at 535% of GDP, it is asset prices that pull the economy. Hence, keeping equities in a bubble is now mandatory because a fall in the market can easily bring down the economy and also any political leader that happens to be in charge. Donald Trump is keenly aware of this fact. But in truth, all those in power are cognizant to this fact as well. We saw an example of this in Q4 2018 when the junk bond market froze for 41 days without any new issuance, and stock prices entered into a bear market. The Fed quickly abandoned its rate hiking plans and promised to truncate its QT program.

But, of course, this bubble just doesn’t belong to the U.S. According to Kyle Bass, the banking system of Hong Kong has now exploded to become 8.5x the island nation’s GDP. Its neighbor, China, has a massive and unproductive $40 trillion worth of debt that has quadrupled since 2007. Japan’s economy would crash in epoch fashion if the Bank of Japan (BOJ) ever began to step away from its asset bubble support. The quadrillion yen Japanese government bond market (JGBs) would become insolvent without its primary buyer the BOJ—it now owns over 50% of the entire JGB market. The BOJ also already has possession of nearly 80% of the ETF market. Therefore, at the first hint that the Japanese government was to begin removing its bid for stocks it would most likely cause the NIKKEI Dow to plunge in a manner that makes its spectacular crash of 1989 look like a bull market.

In other words, the power that once existed within free markets has now been completely usurped by governments and central banks.  These abrogators of freedom have gone all-in with their price manipulations and are now forced to perpetually engage in debt monetization, or risk a global asset price meltdown that would almost certainly engender a depression worldwide. This is the truth as to why Wall Street cares very little about earnings and the economy and instead has become completely focused upon every word that proceedeth out of the mouth of a central banker.

The linking of money to gold was a spark of human genius, but it was also the avarice nature of mankind that eventually destroyed it. The inevitable and dire consequences of which are high.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

When Overvalued and Dangerous Markets Meet Stagflation

April 29, 2019

To put into perspective how overvalued and dangerous the US market has become; I often cite the figure of total market cap to GDP—currently 145% of the economy. How high is 145% of GDP? It is a full 30% higher than it was before the start of the Great Recession. The twin sister to this metric is the Household Net Worth to GDP Ratio. Household net worth as a percent of GDP is calculated by dividing the current bubbles in home prices and equities by the underlying economy, which has been artificially inflated by interest rates that have been pushed into the sub-basement of history. This metric is now an incredible 535% of GDP, which is a record high and 19% higher than the NASDAQ bubble of 2000. To put that figure in perspective, the good folks at Daily Reckoning have calculated that the historical average is 384%.

These valuation measurements are much more accurate than Wall Street’s favorite PE ratio valuation barometer because they cannot be easily manipulated by corporate share buybacks that have been facilitated by record-low borrowing costs. And, as hinted at already, the GDP denominator of today is much more tenuous because it has become more than ever predicated on the record amount of fiscal and monetary stimulus from the government.

This begs the question: why are asset prices at an all-time high when Japan and Europe are stuck at zero percent GDP growth, U.S. growth has been cut in half, and the growth rate of China is decelerating.  What caused these bubbles is no mystery: a decade’s worth of Zero Interest Rate Policy and Negative Interest Rate Policy worldwide that led to a massive pulling forward of consumption through a record level of new debt, which in turn was primarily used to purchase (a.k.a. inflate) asset prices.

Global Central Banks have become the captains on this heavily overcrowded and doomed ship that has a woefully insufficient number of lifeboats; where investors have been forced onboard chasing risk because traditional bank deposits offer little no return.

However, this daunting game can continue skipping along until one of two daggers present themselves to annihilate these bubbles. The two catalysts are; intractable inflation or a recession/depression. I include depression as a likely outcome in the next economic contraction because the level of economic distortions has never been more manifest.

So how will inflation prick this bubble and what level will most likely accomplish this? First, it is crucial to understand that central banks cannot accurately create a certain level of inflation. Central banks are undergoing a process of trying to inflate asset prices by eroding the confidence in fiat currencies, which is ultimately what inflation is all about. They do this by printing enough money to ensure nominal bond yields are below inflation.

Therefore, it is impossible for a handful of academics that sit on the Fed Open Market Committee to accurately pinpoint where the rate of inflation will end up, much less be able to maintain it at a certain level. This is especially true given their professed knowledge of inflation matches that of an amoeba with a low IQ. One possible outcome is that inflation eventually brings the Fed back into tightening mode. This would most assuredly occur if the core level of its preferred metric, core PCE price index, reaches above 2.5% in a sustainable fashion and then continues higher from there. And, even if the Fed did not react to this inflation by increasing the Fed Funds Rate, longer-duration yields would surely begin to spike to offset the increasing loss of purchasing power over time. The already-embattled auto and real estate markets would then crater just as the consumer is crushed under rising debt service payments on the record amount of household debt. In addition, the junk bond market would implode just as equity prices crash due to the increasing competition for cash–in other words, a replay of Q4 2018 that can’t be so easily cut short and mollified just by another Fed pause. It would take rate cuts and a return to QE to have a chance at arresting the next economic and market downturn.

The other dagger is an economic contraction; which, given how far asset values have grown above the underlying economy, is virtually guaranteed to be a long and brutal one. Surging government expenditures along with falling revenue will send trillion-dollar deficits soaring above $2 trillion in short order. Annual deficits will be accretive to the $22 trillion National Debt just as the GDP denominator in the Debt to GDP Ratio heads sharply lower—causing the already dangerous 105% National Debt to GDP Ratio to surge.

The bottom line is the bubbles will break just as they have in the past. But investors must first become afraid of not only losing their profits but their ability to retire. Falling GDP, and/or spiking interest rates will accomplish this. And, given the fact that both equities and bonds are in a bubble, there is a chance that bonds and equities will collapse in price together.

Today’s market is trading at a nominal record high and record high valuations. But these prices exist in the context of unprecedented economic distortions. To be specific; there is $10 trillion worth of sovereign debt with a negative yield, global debt has surged by $70 trillion—to $250 trillion–since 2008, central banks are stuck at the zero-bound interest rate range and have already permanently monetized $14 trillion worth of debt and have destroyed the free market and the middle class in the process.

Hence, the only prudent strategy at this time is to have a robust and proven model that will identify when the inflation or the growth slowdown has reached critical mass so you can protect and profit from the next air-pocket in equity prices. As a reminder, during the last two recessions, investors lost half of their wealth. February and October of last year proved beyond a doubt how fragile this market is, and that tenuous state is the direct consequence of its artificial construction.

Wise investors will think about these facts and use this strategy to avoid getting sucked into the markets biggest black hole in history.

Global Bond Bubble’s Ultimate Culmination

April 22, 2019

Historically speaking, a normal Fed tightening cycles consist of raising the Fed Funds Rate (FFR) by 350-425bps. It is at that point that the yield curve usually inverts–thus, disincentivizing future lending and closing down the credit conduit. At that point the Fed backs off from future rate hikes. Then, about a year later, a stock market meltdown begins; and six months after that a recession ensues. During this current cycle, the Fed Open Market Committee (FOMC) has raised rates by just 250bps before turning dovish. Therefore, Wall Street takes solace in the view that this time around the Fed stopped in time before it killed the business cycle.

However, that 250bps of hiking is before you factor in the end of Quantitative Easing (QE) and the current Quantitative Tightening Program (QT), which is still an ongoing process and won’t end until September. When you factor in the tightening that occurred when the Fed ended QE in October of 2014, which amounted to $85b per month of newly printed money at its peak and added a total of $3.7 trillion to the Fed’s balance sheet, the actual amount of tightening from ending QE is probably close to 300bps. And, the QT from the Fed will end up draining nearly $1 trillion from its balance sheet and reached $40-$50 billion per month at its peak. A reduction in the Fed’s balance sheet of anything close to $1 trillion is completely unprecedented and amounted to a tremendous drain on liquidity. Nobody knows exactly the amount of rate hikes this equates to, but it most likely added another 75bps of monetary tightening.

Société Générale calculates that the Shadow Fed’s Fund Rate dropped to three percent and, therefore, the amount of rate hikes to date have been 525-550bps. 300bps more than the stated FFR of 2.25-2.5%. But that is before you add in the Fed’s QT program. Therefore, when you add it all up, you get the equivalent of 600-625bps of rate hikes in this current tightening cycle—well above the high-end of the historical range where the business cycle turns towards recession.

My friend and Director of the National Economic Council, Larry Kudlow, recently stated that interest rates might not rise again in his lifetime. He is 71 years old, and I hope he lives for a very long time, but you get the point. Larry believes interest rates won’t rise for decades to come. Vice President Mike Pence said in an interview with CNBC that the Fed should cut interest rates by 50bps and agrees with President Trump about ending the QT program immediately. Pence also said this, “There’s no evidence of inflation in this economy.” Ok, Mr. VP, you don’t have to be Sherlock Holmes to discover the evidence. Home prices have jumped 48% in the past six years, all forms of insurance coverage have skyrocketed, and college tuition has been rising 8x faster than wages. But even if he took the time to view the manipulated government data on CPI and PPI, he’d see Consumer Prices are up 1.9% year/year, and Producer Prices have risen 2.2% year/year.

Nevertheless, President Trump is pushing for a return to QE, and he may find out that he has more friends on the Fed than he currently believes. Chicago Fed President, Charles Evans, had this pithy bit of wisdom regarding how he views his responsibility to protect the purchasing power of the dollar, “Inflation is weaker than I would like,” he said recently on a TV interview. As to why more inflation would help grow the economy, these lovers of counterfeiting can never clearly articulate.

With the FFR hovering at less than half its historical level, and the Fed’s balance sheet at $4 trillion, one would hope the government would think the last thing this economy needs is to cast more doubt on the faith in the US dollar’s purchasing power.  Inflation pushes the middle class further and faster along its inexorable path towards extinction. To add to this distorted view, our President recently tweeted that the Dow would be 5-10k points higher if the Fed had not engaged in QT. One also has to wonder how much more unhinged the President wants the stock market to become in relation to the underlying economy. After all, the total market cap of equities now stands at an incredible and dangerous 1.5 times GDP. The danger to the entire economy emanating from the inevitable crash from such lofty heights is growing exponentially.

Meanwhile, the debt dung pile in Chinese debt just got a whole lot deeper. Again, I don’t blame the great people of China but rather its government for this. The March total debt number was 80% higher than the year-ago figure, and the YTD debt increase was 40% higher than the year-ago period. Aggregate financing in the first quarter amounted to 8.18 trillion yuan (US$1.2 trillion), which was an increase of 2.34 trillion-yuan year/year. As to how Wall Street believes adding to China’s debt at this point can be a viable and sustainable plan is inconceivable. After all, China’s debt has already quadrupled in the past seven years. So, it is not as if Beijing has not tried this stimulus trick before. The government has indeed levered-up many times before in a big way and has produced a more unstable and unhealthy economy with each iteration.

Turning to the US, our March fiscal year to date deficit came in at $691 billion–that is for just the 1st half or the fiscal year. So, governments around the world have unbelievably and inconceivably taken fiscal and monetary madness a giant leap further and deeper into the depths of inescapable insolvency.

Is it any wonder why stock prices are rallying? There has been an absolute deluge of promises from global governments since the market collapse of Q4 2018 that there will be more free money on offer, even though they are fully aware that taking on more debt at this point guarantees the future will be beyond bleak.

For now, the economy walks a very thin line along the cliff’s edge. Unless you believe central banks can stay at the 0 bound interest rate range forever and never cause a reduction in a currency’s purchasing power, intractable inflation is inevitable. Once achieved, it will produce an interest rate surge from all-time lows that will engender an equally disastrous plunge in asset prices. Any fixed income instrument and equity that the government is not actively purchasing will crash in price. This is exactly what occurred in October of 1987, where the Dow lost 23% of its value in one day. But unfortunately, the carnage should be much worse than 1987 given the relative level of debt and overvaluation of equities that exists today.

The number and dollar amount of business defaults occurring as a result of such a meltdown should be unprecedented. There is a real danger the economy will contract into a depression given the record level of debt it is lugging along. The US carries total debt that is worth 350% of GDP, which is the same Pre-Great Recession level. This figure was 160% of GDP in 1980 and just over 200% in 1987. But this time around central banks have little, to no room, left to reduce borrowing costs and spur on new lending.

On the other hand, a recession could begin even before inflation runs intractable. The global economy is already slowing, and earnings growth has slowed to a negative level. If the amount of Fed tightening I estimated earlier is anywhere near correct, the business cycle should soon turn south following a stock market peak and crash that is only a few quarters away. The massive re-leveraging in China has served to hold off the carnage a bit longer, but Beijing now risks a crash in the yuan.

If you are investing in this market, it is necessary to try and eke out any gains left and do so using a data and math-driven model that is built to identify when to head for the nearest emergency exit well ahead of time to ensure you find one of the few lifeboats available. Then, you can sit back and use your cash to finally pick up the pieces of good companies with solid cash flow and dividends at a fair price. It’s the only sound plan around.