by Gary North
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."
The FedFunds 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.
What would 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.
IGNORANCE IS BLISS . . . TEMPORARILY
On September 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.
Those people 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 way.
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.
Stock market 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.
Precious metals 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 days.
The important 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. city.
Stock market 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 perma-bulls.
Their tenacity 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.
Stocks purchased on margin are leveraged. Commodity futures contracts are leveraged. Junior mining shares are as volatile as leveraged contracts.
"GENIUS 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 market."
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.
On October 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.
The clients thought, "I'm a genius. I got into Amaranth Partners." They are all ex-geniuses this month.
Genius is a rising market.
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."
Hunter, to 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, either.
When you're 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.
A CHANGE 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.
This presumes that a recession will hit. Otherwise, Congress will not pay any attention to the Federal Reserve System. Neither will most people, including investors.
They should. 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?"
The chart 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.
Paul Volcker 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.
The market 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.
Today, interest rates are falling. Yet monetary policy is the same as in 1980.
Same policy, different results. What is going on here?
SAME POLICY, DIFFERENT RESULTS . . . BUT NOT FOR LONG
In 1979—80, 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.
The inflationary 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.
Their policy 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 Esperanto.
If investors 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 of recessions.
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 standards.
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:
Second, as 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 than negative.
What does he mean, "term premium"? He means supply in relation to demand.
With the 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 decline.
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.
Second, why 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.
Finally, 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."
The housing 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.
Investors would 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 investors.
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.
They 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.
October 5, 2006
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