It’s time once
again to watch the
anti-Bernanke music video produced by the kids at the Columbia
Business School. Its prediction has come true. “When the yield curve
flips, I’ll be watching you.”
rate has not gone down recently, but other rates have. Long-term
rates have declined, indicating that lenders are losing their fear
of price inflation. They have demanded an ever-lower inflation premium
for their money.
Why would a
rational investor on September 29 have lent money to the U.S. Treasury
for 30 years at 4.77% when he could have received 4.89% for buying
90-day T-bills? I offer two reasons:
- He thought
the 4.89% rate would not last. It would go lower than 4.77%.
- He thought
the 4.77% rate would not last. It would go lower. He locked in
4.77% for 30 years.
cause either rate to fall? A slowdown in the economy. What would
cause both rates to fall? A recession. This is why an inverted yield
curve has been a familiar statistical prelude to recession.
IS BLISS . . . TEMPORARILY
26, 2006, I published a report, “Ben Bernanke: Bubble Buster.” I
wrote it on September 25. On September 26, the Standard
& Poor’s 500 started moving up for the week.
There are investors
in stocks who will no doubt think, “North has his timing all wrong.
The day he published that the Federal Reserve is determined to pop
the real estate bubble, the stock market started going up.” It did,
although it slipped back at the end of the week.
who are bullish on the precious metals probably paid no attention
to the upward move of the stock market. They regard the move as
further proof that stock market investors are incurable bulls, refusing
to learn what should be an obvious lesson: The bull market in American
stocks has been over for six years. The S&P 500 peaked in 2000
at 1550. It is 200 points below that level. The more gold and silver
they own, the more likely they will interpret the index in this
At the same
time, most of these precious metals investors probably shrugged
off my other point, namely, that the FED’s stable money policy,
designed to pop the real estate bubble, will put downward pressure
on the entire economy, including the precious metals, which are
price inflation hedges, not recession hedges. They will think, “North
has his timing all wrong. The day he published that the Federal
Reserve is determined to pop the real estate bubble, the precious
metals markets started going up.” Both silver and gold did rise,
although both slid back at the end of the week. You
can see the charts for both metals here.
bulls will not compare the week’s performance with the precious
metals, which closely paralleled the stock market’s move. Precious
metals bulls will not compare the week’s performance with the stock
market’s move. They live in separate emotional universes.
What is my
point? This: Week-long moves in markets do not prove anyone’s theory.
It takes longer for events to sort out.
bulls normally think of the precious metals as alternatives to the
U.S. stock market. So, when both markets move up or down together
for a few days, and then reverse on the same day, precious metals
investors see this as random: noise. They do not abandon their metals
bullishness because of a few days of parallel action.
They are correct
to regard such parallel movements as noise — but only for a few
investment question is: Can the two markets — stocks and precious
metals — move down together for months? I think they can. I think
they will, short of a war in Iran or some terrorist act in a U.S.
bulls will, as always, resist any bearish analyses, just as they
have resisted since February and March of 2000, when I issued my
pair of warnings that the price/earnings ratio indicated a looming
fall in prices. My conclusion, based on Federal Reserve policy,
was just too painful to bear. It involved selling assets, which
requires a payment of capital gain taxes. Asset owners with a paper
profit like to pretend that they can defer the payment of capital
gains taxes until their death. In other words, they are lifetime
and faith is matched by precious metals bulls, who share the same
view regarding the payment of capital gains taxes. Their distaste
of capital gains taxes makes them operational perma-bulls.
I share this
distaste. I also prefer not to sell an asset that may fall for a
while but not stay down in the long run. But if the asset is leveraged,
then I bite the bullet. I do not hang on. I sell.
on margin are leveraged. Commodity futures contracts are leveraged.
Junior mining shares are as volatile as leveraged contracts.
IS A RISING MARKET UNLESS YOU’RE SHORT”
There is a
temptation that faces investors who happen to buy into a market
just before a major rise. They think, “I’m a genius. I can beat
The most recent
example of this mentality is the 32-year-old hot-shot who made two
billion dollars for hedge fund clients in the highly leveraged natural
gas futures market. Then, in just two weeks, he lost six and a half
billion dollars with his technique. Amaranth Partners, a hedge fund,
suffered the consequences.
1, Amaranth suspended redemptions by its clients. They are now locked
in. Their capital is no longer accessible to them. Redemption is
by grace — the grace of the directors. The directors giveth, and
the directors taketh away.
thought, “I’m a genius. I got into Amaranth Partners.” They are
all ex-geniuses this month.
Genius is a
This is the
largest single loss that any investor has ever produced. Yet this
hot-shot was a world-renowned genius earlier this year. You can
read a story in Canada’s National Post (March 28, 2006),
with this headline: “Calgary
trader, 32, among world’s best.” These sorts of stories are
usually referred to as “flak.”
his credit — he’ll need a lot of credit from now on — was apparently
not the source of the story. He refused to return the reporter’s
phone call. He is not returning reporters’ phone calls these days,
hot, you’re hot. When you’re not, you’re not.
We all like
to believe we are street smart. We like to believe that the impersonal
statistics of life are personally on our side. So, when we are on
the right side of a trade, we think our ship has come in.
Maybe it has.
But we may be in the bus terminal.
IN FED POLICY
If you are
hedging against long-term inflation, you must believe that the Federal
Reserve System is not going to resist Congress’s cries to “Do Something”
when the next recession hits. I am of this opinion, too.
that a recession will hit. Otherwise, Congress will not pay any
attention to the Federal Reserve System. Neither will most people,
They should be asking themselves these questions: “Has the Federal
Reserve Board reversed policy? Has it adopted a monetary policy
not seen since Paul Volcker’s era?”
of the Adjusted Monetary Base indicates that the FED has indeed
shifted its policy. Monetary policy is close to flat, and has been
since February. The other monetary charts reflect this change.
decided in October, 1979, to cease targeting interest rates and
begin targeting monetary growth rates. He decided to stabilize money
and let interest rates go wherever the market took them.
took them sky high — higher than they had been in modern U.S. history.
Volcker stuck to his guns. There were two recessions, 1980 and 1981.
Price inflation came down, just as the Board had believed it would.
rates are falling. Yet monetary policy is the same as in 1980.
different results. What is going on here?
POLICY, DIFFERENT RESULTS . . . BUT NOT FOR LONG
the country had been suffering from massive monetary inflation and
massive price inflation. Then, overnight, the FED switched policy.
Volcker announced this, but no one listened. They did not assess
what the price would be of wringing inflation out of the economy.
policies of the FED after 2000 were high, but then they began to
slow. The peak in the rate of growth for the Adjusted Monetary Base
came in the second quarter of 2002. Then it slowly declined. See
the chart, “Monetary
Base and Inflation Targets.”
The rate of
price inflation remained below 5% per annum throughout the entire
period. This is about a third of its peak in 1980.
So, as the
FED has stabilized money and has allowed the federal funds rate
to rise, the economy has not hit a brick wall. There has been no
recession. The FED’s policy-makers think this will continue. They
are now testing their theory.
has produced an inverted yield curve. Bernanke has dismissed this.
He says that this time, it’s different. Here
is his explanation, offered on March 20. It is not entirely
in English, but at least it is not in Greenspan’s central banker
expect that weakness to require policy easing in the medium term,
they will mark down their projected path of future spot interest
rates, lowering far-forward rates and causing the yield curve
to flatten or even to invert. Indeed, historically, the slope
of the yield curve has tended to decline significantly in advance
So, he is aware
of the economic past. He knows how reliable the inverted yield curve
has been as a recession forecaster. But he says this will not be
true this time.
What is the
relevance of this scenario for today? Although macroeconomic forecasting
is fraught with hazards, I would not interpret the currently very
flat yield curve as indicating a significant economic slowdown
to come, for several reasons. First, in previous episodes when
an inverted yield curve was followed by recession, the level of
interest rates was quite high, consistent with considerable financial
restraint. This time, both short- and long-term interest rates
— in nominal and real terms — are relatively low by historical
He is correct
about the level of rates. But he neglects the obvious: the increase
of the FedFunds rate from 1% to (now) 5.25%. This is the largest
percentage increase in any comparable period of time in American
financial history. The question remains: Why are short rates higher
than long rates? He has an answer:
I have already discussed, to the extent that the flattening or
inversion of the yield curve is the result of a smaller term premium,
the implications for future economic activity are positive rather
What does he
mean, “term premium”? He means supply in relation to demand.
economic outlook held constant, changes in the net demand for
long-term securities have their largest effect on the term premium.
In particular, if the demand for long-dated securities rises relative
to the supply, then investors will generally accept less compensation
to hold longer-term instruments — that is, the term premium will
As the guy
sings on the Bernanke music video: “Benny, Benny . . . PLEASE!”
First, as a
Ph.D.-holding economist, Bernanke has covered his tracks with the
academic economist’s favorite scenario: a frozen economy. He hypothesizes:
“With the economic outlook held constant. . . .” But economies are
never constant. Neither are economic outlooks.
He and the
Federal Open Market Committee have frozen the monetary base. It
looks as though they are trying to hold the housing market constant
and the economy constant and Congressional incumbents’ election
results constant. But freezing the money supply after a decade of
housing bubble is not going to keep the economic outlook constant.
has there been the recent supposed “rush” into 30-year T-bonds?
Why has “demand for long-dated securities” risen “relative to the
supply”? What evidence is there of such a rate-reducing disequilibrium
of supply and demand? None that I know about.
the yield curve is only one of the financial indicators that researchers
have found useful in predicting swings in economic activity. Other
indicators that have had empirical success in the past, including
corporate risk spreads, would seem to be consistent with continuing
solid economic growth. In that regard, the fact that actual and
implied volatilities of most financial prices remain subdued suggests
that market participants do not harbor significant reservations
about the economic outlook.
In the past,
the yield curve has served as the supreme distant early warning
of a recession. It appeared before other indicators revealed evidence
that produced “reservations about the economic outlook.”
market is slowing. This has been the number-one engine of economic
growth in the American economy for five years. But, like the old
engine in The Little Engine That Could, it is slowing down.
Who will bring all the toys and good things to eat to the children?
The Little Engine That Could? That’s the FED. It will have to inflate.
But when? That’s the investor’s dilemma.
be wise to acknowledge that the FED has switched policies under
Bernanke’s leadership. So far, the economy is holding up. So far,
stock market investors have remained bullish. So have precious metals
This fact should
give us pause. Why is the same perception of the economy driving
up the stock market and the precious metals market?
The two markets
are not the same. The precious metals market was hammered badly
last May and has not recovered much. The stock market is trudging
upward. The Dow Jones Industrial Average has slightly exceeded its
2000 peak, but the S&P 500 has not come close.
are now both moving into the wind. What wind? Stabilized money.
When years of monetary inflation end, the traditional result is
a recession. I have written about this in my minibook, Mises
on Money. See Chapter 5.
This time it
may be different. But I would not count on this if I were you.