The Writing is on the Wall

This Market, including stocks, bonds, real estate and commodities have all been built on a massive amount of credit and "out of thin air" monetary creation. But unlike all previous massive printing press monetary inflations, this one has been based on a combination of huge amounts of easy credit combined with completely unrealistic low interest rates world wide: Beginning with ZERO interest rates in Japan to negative 4% ( 1% interest - 5% inflation) in the USA. Well my friends, unless you are deaf, dumb and blind, this game is over. "IT" has begun almost exactly as predicted with the trigger being the realization that there were no bids for the attempted sale of CMOs by the Bear Sterns Hedge Funds. The problem was NOT as stated; that they were junk bonds based on sub-prime mortgages, after all they were rated AAA. The real problem is that the world has reached its limit on how much debt can be absorbed. Suddenly, the whole world realized that the Emperor Had No Clothes and credit virtually dried up everywhere. What do sub-prime mortgages have to do with Private Equity Hedge Funds and Corporate Takeovers? NOTHING; except that all credit has virtually disappeared overnight.

HAS A BEAUTIFUL BUYING OPPORTUNITY BEEN CREATED?

We are being flooded with one expert after another coming on TV, all talking about how strong the Economy is and how low the P/Es are and on and on about how cheap the market is and how fantastic a buying opportunity it is. But they are all talking about the past and everyone of them has admitted that they are fully invested and so is everyone else. When it comes to the hedge funds, not only are they fully invested, but they are leveraged anywhere from 5 to 25 times. Do you remember the old Bob Newhart skit, who is there left to buy? They are all refusing to face the facts that "THE PARTY IS OVER"

"TO LOWER OR NOT TO LOWER: THAT IS THE QUESTION"

"Just cut interest rates" cries Wall St. and the media's talking heads, as they can continue on with their rosy pie in the sky forecast. "Just print more money" and let the party keep on rolling, merrily, merrily, merrily along in the new paradigm Goldilocks economy. From overpriced, overextended stocks and bonds to overpriced real estate that has gone up so much in the last few years that it has become unaffordable to the average worker at any reasonable interest rate: But all that is not called inflation, or is it? What will be the next bubble? Where else will all this new money, created out of thin air, go? NOT to consumer prices or salaries, why that would be inflationary!

People seem to forget that the continuous creation of money out of thin air does not create anything except higher prices which is, after all, the definition of inflation. Printing more Dollars does not create one more drop of oil or one more apple.

BERENANKE

They are right, Berenanke is not Greenspan. But he has inherited the public's Greenspan Inflationary Bubble Psychology and he is doing his best to try and slow the economy without creating a recession or worse, turning it into a crash and Depression. The last thing he wants to do is lower interest rates because then everyone in the world will know that the Emperor has no clothes. (The economy is in trouble.) Reminds me of another truism "You can lead a horse to water, but you can't make him drink"

INTEREST RATES ALONG WITH PROFIT

ARE THE TRAFFIC SIGNALS OF THE ECONOMY

In order to make and intelligent appraisal as to whether or not to lower interest rates, one must at least understand what interest rates are and how they work.

WHAT ARE INTEREST RATES?

#1 Interest rate is just another word for price. It is the price to borrow money and its price is supposed to be determined exactly the same way as the price of any other commodity, product or service - through the interaction of supply and demand.

#2 However, unlike every other product, commodity or service, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are manipulated (controlled) by the Fed. They do this by controlling the amount (supply) of money that is available in the banking system through their Open Market Operations (buying & selling Treasury Bonds in the open market) and by changing their deposits that they hold with their individual member banks, directly affecting their reserves and thus their ability to lend. They also increase the money supply the good old fashioned way, by printing it.

WHAT ARE THE FUNCTIONS OF INTEREST RATES?

# 1 Interest rates determine the propensity of people to either save or consume. When interest rates are manipulated (by the Fed), it influences the degree that people are willing to defer present consumption, i.e. save. If interest rates are manipulated too low, like they are now, people are no longer willing to save. When the interest rate becomes negative (the interest rate is lower than the inflation rate) people, since they are now being paid to go into debt, take on excessive debt as well as excessive risk because that is exactly what they are being paid to do. Conversely, when interest rates are high, such as in the early 80's, people were willing to forego current consumption in order to avail themselves of the ultra high interest rates and we ended up having high savings rates.

# 2 When interest rates are high, the demand for cash is extremely low. People can't wait to deposit every cent that they can spare so as to earn that high rate of interest. However when rates are low, the propensity to hold cash is very high because at a 1% or 2% interest there is not much to be forgone by keeping extra cash in their pockets.

# 3 The Velocity of money (how many times the money supply turns over during the year) and therefore the calculation of the money supply itself is greatly affected by the level of interest rates. When rates are outside the normal range, the FED cannot calculate the velocity until long after the fact and thus they lose track of what the money supply really is and its effect on the economy, leading to the interest rate conundrum.

# 4 Interest rates also determine which investments should or should not be made, according to the investment's expected rates of return. When interest rates are manipulated too low, a great many investments and risks are undertaken that should not have been, because these poor investments will fail at the first signs of weakness in the economy or be forced into bankruptcy with the eventual return to rising interest rates. This is the main underlying cause behind the business cycle. The imbalances (wasted resources) in the economy must be liquidated before the economy can stabilize enough so that the misused scarce resources become available for the next growth phase.

# 5 A neutral rate of interest is the rate that neither stimulates nor restricts the economy. Greenspan was and Bernanke is in a conundrum as to what that rate is or should be. Previously, that rate was thought to be 1.5% to 3% over the inflation rate. (According to the latest CPI report (5%) the Discount Rate should be at least 6.5%.) In the past, when the Fed did not manipulate the rates except at the extremes, the market was able to determine what that rate should be through the interactions of the Free Market. But today, with US savings nearly zero and the CPI and interest rates being highly manipulated, the Fed is unable to measure the Velocity of Money and with negative interest rates, the Fed does not have a clue as what the neutral rate should be.

# 6 The Discount Rate is the rate that the Fed charges banks who need to borrow money from the Fed to meet their reserve requirements. The FED was originally created to be "the Lender of Last Resort", avoiding bank runs and liquidity squeezes. The Discount Rate charged used to be a Punitive Rate; a rate that was somewhat above the Fed Funds Rates (the rate at which Banks lend to each other in order to meet their overnight reserve requirements). But today, the Discount Rate is above the Fed Funds rate, drastically lowering the banks' cost of money and reducing the amount of interest they are willing to pay for deposits, so that now massive amounts of money are being borrowed from the FED without having to worry about the excess demand increasing interest rates. This greatly increases the banks' ability to create money out of thin air; completely negating the supply/demand function in setting interest rates. This breakdown in the function of a free market has led to the creation of "The Carry Trade." In so doing, the Fed has completely lost control over the banks' and near banks' (FNM, FRE, GE, GMAC etc.) ability to create money and have therefore lost control over the money supply. This has led directly to the creation of the Stock and Bond Market Bubbles as well as the Real Estate Bubble that has, after 15 years, most probably topped out and is in the process of rolling over into a crash.

For a long time now, regardless of the ever increasing demand for loans and the seventeen ¼% Discount Rate increases, Long Term rates, because of the ongoing Carry Trades, refuse to go up and reflect the true conditions of the market.

Ever since Berenanke took over the reigns of the FED, while he continued raising the Discount rate, which is meant to reduce the supply of money and raise interest rates to a more logical level, at the same time he was increasing the reserves of the banking system, lowering the lending requirements and encouraging the making of sub-standard loans, greatly increasing the supply of loanable funds, more than compensating for the higher discount rate and sending confusing signals to the free market.

NOTE: For the last twenty years or so, the money supply has been growing at an average of 7% above the economy's growth rate. That, my friends, is the definition of inflation. Most of the excess cash has found its way into creating overvalued Stock, Bond and Real Estate Markets.

The Pivot Point

We are now at or close to the topping out point, which is the apex at which consumers cannot or will not take on any more debt and/or mortgages and corporations and banks are unwilling or unable to extend more credit, especially since the assets that they are lending against (homes, businesses, commodities) are all decreasing in price. We now seem to be hitting those topping points simultaneously in many areas: Jobs, housing, consumer spending, credit expansion and most notably, the Takeover and Buyout Craze that can no longer get cheap financing.

The poor investments of the must have-it-now generation are about to be unwound. We are where we are because Central Banks have printed ever expanding amounts of money to prevent the normal business cycles from working in an attempt to satisfy politicians seeking re-election. Remember "it's the economy stupid". But the only thing the Central Banks have accomplished is to delay the inevitable deflationary credit crunch, while making sure it will be a lot worse in the end. They have definitely NOT eliminated the business cycle.

There are many who think true deflation (decrease in money supply) cannot happen under a fiat money system. IT can but perhaps the point is moot. Money supply itself actually never contracted in Japan during the 1990's. Instead, it grew very slowly for a long time as bank credit contracted for more than nine consecutive years. Clearly there was a credit contraction, so how did the money supply still manage to grow? Fiscal deficits were ramped up to dizzying heights, island airports and roads to everywhere were built and the Bank of Japan monetized all of it. I don't think the Government and the FED could get away with that here in the USA especially since, unlike Japan, where they have a 40% savings rate, our savings rate is close to zero. In addition, Japan's Gov. Debt is owned by the Japanese, unlike the USA that owes the rest of the world more than $4 Trillion. A financial crisis that brings about massive debt repudiation would cause a massive shrinkage of the money supply (the true definition of deflation). Also, the velocity of money plummeted in Japan. The net effect of the credit contraction on prices was clearly "deflationary". Prices across a broad range of assets, goods and services fell. Indeed, practically everything fell in price except government bonds.

People were amazed at the alleged "Bond Bubble" as well as the Zero Interest Rate Policies of the BOJ. However, a 1% interest rate on a 10-year bond makes sense when prices are falling 2.5% annually. The real yield becomes 3.5% (1% interest rate + 2.5% deflation) which is obviously far higher than the 1% stated rate. Perhaps a practical way to think of deflation under a FIAT system is the destruction of credit/debt that exceeds the growth of the money supply.

Regardless of social, economic and political differences, I expect the USA to attempt to follow in the footsteps of Japan even though the circumstances are vastly different. Although a central bank might be able to sustain a certain amount of inflation by resorting to extreme measures such as "dropping money out of helicopters," it cannot stop the inevitable credit contraction, the beginning of which is now becoming evident. Nor will the FED bail out consumers either at their own or other creditor's expense. The Fed like the BOJ will stop short of destroying themselves and their power. At some point, most likely due to the Real Estate Bubble implosion, consumers will be unable to take on more debt and/or because banks will refuse to extend consumers additional credit as the value of their assets collateralizing their loans tumbles, consumer bankruptcies will soar as the various credit bubbles implode. Furthermore, in a world awash in overcapacity, there will be no need for corporations to borrow to make investments when they are already over capitalized. That is why the Bank of Japan failed to defeat deflation and that is why Bernanke will, in the end, fail as well.

One of the complaints against Japan in their long battle with deflation was its refusal to write off bad banking sector loans. The USA's "solution" to that problem in the past was to create ultra large interest rate spreads so that the banks can soak the borrowers, making abnormally high profits as they fight their way back to profitability. However, this time around we have an inverted yield curve and I am convinced that this will backfire on the banks in ways we have not yet even begun to dream of (nightmares). The problem by now should be obvious. Central Banks are attempting to do the impossible. Arguably the best thing that could happen would be for the Central Banks to abolish themselves. Since that is not about to happen, let us instead turn to more practical solutions. Instead of trying to achieve "price stability" which, as we noted is something that can neither be achieved nor measured, how about shooting for "money supply stability" instead? Central Banks Should Let the Market Set Interest Rates. Life would be so much simpler if Central Banks everywhere would stop trying to micromanage the CPI, currency and job growth, which are mutually exclusive objectives. They are plainly trying to achieve nirvana when nirvana cannot possibly be measured, let alone achieved. Nirvana like Shangri-La is only a pipe dream and not of this world. Like it or not, as long as we have Central Banks or Governments that influence both credit and the money supply, we will continue to have economic cycles no matter how much the Central Banks try to avoid or postpone them. All they have ever succeeded in doing was to make matters worse. It seems as if we have learned nothing from the Great Depression or from the more recent experience of Japan. I fear things will have to get a lot worse before they can eventually get better.

GOLD

The stage is being set for a rush to GOLD. But for the time being, the world's accent is on liquidity. Margin calls are flying all over the place and people are discovering that their investments that are generating most of the margin calls cannot be sold, therefore you sell what you can in an attempt to stay solvent.

People also mistakenly when forced to sell, sell their profits and hang onto their losses. Gold has liquidity and so you sell your Gold even though you don't want to. As I have been telling in every letter for over a year now, Gold was still working on completing its consolidation and that its maximum downside risk was $550, although I didn't foresee how or why it should drop that low. Now we know! If you have taken my advice all along, you should be sitting on a 50% Gold position and the rest in cash, having liquidated all of your other investments over the last three months. If you haven't been listening, we all may be lucky enough to see one last engineered rally that could even possibly make a new high but I would not bet too much on that.

WHAT TO DO NOW?

Continue to accumulate Gold on all further sell-offs. Check your charts on the Gold stocks for buy signals. WARNING: Have patience; wait for clear signals, your patience will be rewarded. Re-read the complete letter and always keep the big picture in mind at all times.

GOOD LUCK AND GOD BLESS

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767