US Economy Is Toast

This morning, whilst scrolling through the charts, the chart below (courtesy Stockcharts.com) caught my eye and prompted two questions.

The questions were:

1. 'What would have caused the US Dollar to outperform falling bond yields since April?'
2. If the chart now bounces down from its 200 week MA, will this translate into a falling dollar or rising yields?

To put some perspective on this, the daily chart below shows the shorter term strength of the US Dollar relative to the 30 Year Bond Yield - and the bearish rising wedge formation should also be noted. It seems likely that the ratio of the $USD:$TYX is more likely to fall from here than to rise further.

The first question seems to have a rational answer in that what we have been watching - ie a rising ratio - may well have been nothing more than a technical reaction to the earlier steep collapse as shown on the weekly chart. The ratio fell from around 2.00 to around 1.60 (20%) in ten weeks. So, with all those currency and bond traders out there, it is possible that the bounce arose from nothing other than a 'normal' market reaction to relative moves that were overdone.

The long term chart on the 30 year yield is shown below (courtesy Decisionpoint.com)

The two lines AB and CD have been drawn in by joining the maximum number of contact points, viz 7 in the upper line and 6 in the lower line.

When read in conjunction with the shape of the PMO trendlines - note that the lower line has been rising as the rate of descent of the yield has been falling - it would appear that the yields do not seem to want to fall further.

From a technical perspective, another clue that the yield seems to want to change its historic direction, flows from the 'higher highs' in the PMO over the past few months, and the fact that the yield itself broke up above the 24 year AB trendline before falling back below it.

The 'safest' conclusion to be drawn here is that the yield seems unlikely to fall below 4% at the apex of the triangle formed by lines ABCD.

Of course, this begs the question as to whether yields will trend sideways from this point or reverse upwards. (One needs to bear in mind that this is a monthly chart dating back to 1948 and developments unfold slowly. This is not a 'traders' chart)

If we turn now to the long term chart of the US Dollar, another picture emerges

There can be no doubt that the US Dollar has recently broken down and is in what appears to be 'free fall'. It also appears that the 80 level may soon be challenged for the fifth time in 15 years, and the question arises: "Will the 80 level hold?"

There are many loud opinions being expressed that a US Dollar collapse is inevitable, based on:

• US Sovereign debt levels being unsustainable
• The 'worthless' forex holdings of trading partner Central Banks, in particular China which holds around one trillion of these dollars
• None other than Sir Alan telling the world to expect a diversification by Central Banks out of US Dollars

I am not going to argue with these opinions. What I am going to do is draw attention to three different thought paradigms, as follows:

1. Fiat currencies are the invention of Central Bankers and are inherently valueless
2. Gold is the 'currency of last resort' because it represents the ultimate store of value
3. Debt needs to be repaid or written off. It can't just hang around ad infinitum.

So what do we mean when we talk about 'thought paradigms'?

A though paradigm may be viewed as a set of rules which act as benchmarks relative to which any environmental development may be assessed.

By way of example, if one has a thought paradigm that the earth rotates around its own axis, then when darkness descends one's conclusion is not that that the world is about to end, but rather than night has arrived and, within a few hours, it will become light again. A thought paradigm is what allows us to make sense of our environment.

It is important to recognise that, if humanity is to evolve, thought paradigms cannot be permanent. By definition, these two concepts are mutually exclusive. It follows that a thought paradigm will be embraced up to the point where another paradigm needs to be defined to explain that which is unexplainable in terms of the current paradigm. That's why Einstein's Theory of Relativity made such an impact. It introduced a new paradigm which could explain that which Newtonian physics could not. That is also why String Theory is having such an impact. It seeks to explain that which cannot be explained by Einstein's theories.

One trouble with the human mind is that we have an ability to hold two conflicting thoughts in our minds at once and we also have an ability to lie to ourselves so that we can rationalise the simultaneous existence of these conflicting thoughts rather than modify our thought paradigms. We tend to want to not change our thought paradigms too easily. Such an act would force us to admit we were wrong, and that's tough on the ego.

By way of example: If any person was to argue that fiat currencies are inherently worthless, then how is possible for that same person to accept the 'rules of the game' and use fiat currency as legal tender? Either fiat currency is worthless or it is not. Those who absolutely believe that gold is the currency of last resort should not be able to accept the paradigm that fiat currencies have value. But if fiat currencies have no value, then why do we all have wallets and purses and other containers to carry these things around in? Thus the human mind is able to accept two conflicting thought paradigms in defiance of logic. Thus we are able to argue vociferously that gold is the only sensible currency whilst simultaneously pulling out a dollar bill to pay for a (small) pack of gum, as an example.

Of course, at the margin, one weak fiat currency - like the Brazilian Cruzero when it existed - may be rejected in favour of another stronger currency, such as the German Mark or the British Pound or the US Dollar. But we need to be honest with ourselves: Either the concept of fiat currencies is accepted or it is not. By definition, as these words are being committed to paper, fiat currency is accepted by roughly six billion people on this planet.

It is a fact - not my personal opinion - that (with some exceptions) every single US citizen accepts the concept of fiat currency. How do I know this? I know this because when you go into a supermarket to buy a loaf of bread you either tender a piece of paper with some dollar denomination on it, or you tender an EFTPOS card of some sort and the trader accepts what you offer. That is an absolute, irrefutable and not negotiable fact.

So, what we are all facing at the moment is a sort of fork in the road. Either:

1. The world's strongest currency from a historical point of view is going to go the way of the Brazilian Cruzero, or
2. The very future of the concept of Fiat currencies is at stake, or
3. Something else is going to happen to facilitate a smooth transition from the US Dollar to some other fiat currency or basket of currencies.

Will there be a seamless move away from US Dollars to (say) Euros, or will there be a painful move out of US Dollars, or will Fiat currencies in general become unacceptable as legal tender?

Now let's get practical for a moment.

If fiat currencies are facing their demise, the challenge will be, amongst other things: 'How do we re-educate some six billion people regarding the acceptability of an alternative currency?'

Gee, when you put it in those terms, well maybe we need to rethink our paradigm that gold is the currency of last resort. It might well have been in biblical times when the population of the entire planet was less than the population of New York City today, but to argue that the same paradigm applies today is to ignore the practicalities of the world in which we live.

So what's the alternative?

Well, maybe we can have a hybrid system. Maybe we can have paper currencies backed by gold.

Sure. There is no problem with that logic. If one US Dollar is, henceforth, to be defined as being worth (say) 1/750th of one ounce of gold then that will be just fine. But it needs to be recognised that this will require all the Central Banks of the world to change their thought paradigms.

The way they currently think (and have done since Central Banking was invented) is that the money supply that is pumped into the economy, leveraged by the multiplier effect of the commercial banks lending practices 'drives' the economy. When they want to accelerate economic activity they pump more money in, and when they want to slow things down they reduce the money supply (or maybe the rate of increase of the money supply).

In this context, if a US Dollar were to have a fixed value of 1/750th of one ounce of gold then the amount of money in circulation would be a function of the gold reserves in Fort Knox. If the US ran its economy at a deficit, the gold reserves would fall and the amount of money in circulation would then - by definition of the rules of the new game - also need to fall.

But, when money supply contracts, the value of commercial transactions contracts by a multiple because the banks are constrained in what they are allowed to lend relative to 'reserves'. In the USA at present, the minimum 'reserve to loan' ratio is 10%. If you take a dollar of cash out of the system, you take up to nine dollars of business transactions out of the system.

It also need to be understood that if the US lives beyond it means under such a (gold standard) scenario then it will experience the inevitable 'depression' consequences until the mountain of debt is repaid, because the economy will no longer be capable of being managed by the Central Banks who do this now by managing the money supply.

So the problem is not so much a function of what the Central Bank is doing, as it is a function of the propensity of consumers to want to buy now and pay later. Under a gold standard, consumers will need to be re-educated not to live beyond their means.

But if people were prepared to accept the concept that they need to live within their means then they would not borrow. The velocity of money would slow down and the economy would slow down - regardless of what the Central Banks did about the money supply.

Therefore, the problem is not 'fiat currency vs gold'. The problem is whether or not people choose to live within their means. The minute they start to live within their means, the velocity of money will slow and the economy will slow.

Unfortunately, this is all academic. From where I am sitting, the average US citizen is tapped out at this point in time in any event, and is no longer able to buy now and pay later. With a softening real estate market we have already arrived at 'later', and the standard of living in the USA is already starting to fall. We no longer have the luxury of even asking the question: 'Should we stick with fiat currencies or move to a gold standard?'.

The evidence of the fact that we have arrived at 'pay the piper' time is that the money supply is growing faster than the CPI growth rate. When you cut through the BS of 'hedonic' accounting - which seeks to have its bread buttered on both sides by factoring in efficiencies and ignoring such key items as energy costs - there is only one way that I can think of that money supply can grow faster than CPI, and that is if people are slowing down in their borrowing and consumption and the velocity of money is slowing. Money is being pumped into the economy but is not being on-lent at the same rate as before.

From a commercial banker's perspective, if they want to keep growing their profits, they will probably need to start focussing their attention on expanding their loan portfolios within economies where the propensity to borrow is higher. Hmmm. Is that why Citigroup has just bought a large bank in China?

Okay, that's the background. Let's now look at the gold price to see if the world seems predisposed to jettison fiat currencies altogether.

The above charts are fascinating to me in that whilst the Gold Price itself has risen to a higher high, the goldollar index has not.

On the other hand, gold has broken up relative to commodities in general, as can be seen from the chart below:

This raises the $64,000 question:

Is the gold price rising because investors are positioning to jettison fiat currencies, or is gold being re-rated relative to other commodities?

The beauty of that question is that it doesn't really matter what the answer is. The gold price in US Dollars seems to be rising both relative to other commodities and in absolute terms. We don't need to get cute. We just need to be able to tell up from down.

My own personal paradigm is that I cannot get my mind around how it will be possible to re-educate 6 billion people to accept anything other than paper currency, and so the Central Banking system is not facing its demise. Whether or not the world goes onto a gold 'backed' standard is, in my view, irrelevant.

The core issue is that consumers in the West in general and in the US in particular have been prepared to live beyond their means because banks have been prepared to lend to them to facilitate this.

In terms of my personal paradigm, the issue is not whether or not the world should embrace a gold standard. It doesn't matter! If that's the decision then let's get on with it. But we need to recognise that this will not solve anything. The issue is the propensity of banks to be prepared to lend money to people who are wanting to spend it on consumption and then be left with a debt hanging over their heads.

The problem revolves around the rules by which commercial banks operate. In turn, this should have been actively managed by the Central Banks in the interests of society as a whole. Unfortunately, because of the structure of the Federal Reserve - where private interests are ultimately calling the shots - the Commercial Banks are not being managed in the interests of society at large.

Unfortunately, the reason that this state of affairs was allowed to manifest and will continue until the pain becomes unbearable for consumers, is that the politicians who run the country are either spineless or do not understand the problems, or do not care. Either way, the problem boils down to 'people' and not the financial system.

So let's get practical again.

Question: Will the US Dollar 'collapse'?

Answer: It depends on your thought paradigm. If, like me, you see the problem as being related to commercial bank behaviour, then the only reason the US Dollar will collapse is if the entire fiat currency system collapses. If the fiat currency system collapses, and there is nothing practical to replace it because the problem is not caused by fiat currencies but by an absence of integrity, then the world economy will collapse and we will wallow around in an environment of black market barter. If, like me, you believe that the Central Banks and Governments of the world clearly understand the consequences of a collapse in the fiat currency system then you will accept that:

1. China will not just 'dump' dollars onto the world market. They will quietly switch their emphasis from dollars to (say) euros and continue to sit on their mountain of US Dollars which they will dribble into the market place
2. The US Consumer is 'toast' and the standard of living within the US will now spiral downwards for years to come until there is an intersection of living standards between the US and the Far Eastern countries (a loooong way to go)
3. The commercial bankers will be working like crazy to stimulate consumer demand within China and India so as to reduce the dependence of those two economies on demand from US consumers.

If, on the other hand, you think that 'market forces' will determine the US Dollar's level, then it will be inevitable that the US Dollar will collapse - but then you will also need to accept the likelihood that the world economy will fall flat on its face as confidence is lost in the very concept of fiat currencies (If it can happen to the US dollar today, then why not the Euro tomorrow).

Conclusions

• The world's central bankers and governments will do whatever they believe is necessary to prevent a collapse in the US Dollar.
• Standards of living within the USA have probably peaked and will spiral downwards for the foreseeable future.
• Commercial Banking focus of attention will be shifted to China and India - so as to protect their profitability.
• The consequence of this is that consumers in China and India will start getting more deeply into debt and, in the process, replace the US consumer as the 'drivers' of the world economy.
• Commodity prices, including the price of gold will remain in bull trends because there are roughly two billion people whose needs now need to be satisfied and funded by consumer debt.
• The (multinational) commercial banks will continue to make extraordinary large profits
• The US economy is 'toast' - which is evidenced in part by the recently announced fact that Ford Motor Company has mortgaged its entire business just to raise the working capital to keep going.

Question

Why would anyone invest in US Industrial equities under these circumstances, given that a 'reversion to the mean is likely to bring prices back within the rising channel? Even if this occurs as a result of years of sideways movement, there seems to be little hope of capital profits from US equities.