Gary North's REALITY CHECK
Issue 411 January 7, 2005
GREENSPAN: "THE DEVIL MADE ME DO IT!"
One of my favorite Flip Wilson characters was Rev.
Leroy, the pastor of the Church of What's Happening Now. I
am not a fan of cross-dressing, so I was not a fan of
Wilson's Geraldine. But Geraldine's immortal line -- "The
Devil made me do it!" -- was always good for a laugh.
Combine Rev. Leroy and Geraldine, and you get Alan
Greenspan. I am tempted to call him Rev. Al, but Al
Sharpton has a lock on the title.
The Federal Reserve System is surely the economy's
Church of What's Happening Now. What is happening now is
not much. That's what has been happening for several
months.
The adjusted monetary base is the one monetary
component that the FED controls directly. When it buys or
sells Treasury debt, the statistic goes up or down,
respectively. This is high-powered money: the money that
serves as the legal reserve for the commercial banking
system. These days, the AMB is barely moving. In the most
recent reported week, it was moving down.
http://snipurl.com/8mc6
This is consistent with the FED's announced policy of
raising interest rates, which means short-term rates. The
American economy is expanding today, while the money
supply's legal monetary base is flat. The presumption is
that interest rates -- the price of borrowed money -- will
rise: more demand, fixed supply.
The other major monetary statistic that I watch
closely is MZM: money of zero maturity. I think it is
closest to true money: no waiting. It has been flat --
peak to peak -- for eight months, which is a considerable
period of time in the world of the FED.
http://snipurl.com/bsp8
What about consumer prices? There is no agreement
among forecasters and economists as to which official
consumer price index best reflects the condition of Joe
Average. I use the median CPI, which is published monthly
by the Federal Reserve Bank of Cleveland. The median CPI
is a weighted median of the CPI. As a price inflation
predictor, it does pretty well. November's increase was
0.1%, or 1.1% annualized. Year to year, the increase was
2.3%. (http://snipurl.com/bsp6)
So, from the point of view of statisticians, the FED
is achieving its stated goal of bringing down price
inflation. It is also acting consistently with its stated
goal of raising short-term interest rates.
But . . . the fall in the rate of price inflation
tends to reduce long-term rates, meaning bond and mortgage
rates. Why? Because a permanent reduction in the expected
rate of price inflation reduces the fear of lenders that
they must add a money depreciation factor into long-term
loans. Ludwig von Mises called this the inflation premium
of the free market's interest rate.
If lenders believe that today's rate of price
inflation -- low -- will be maintained for the duration of
the loan, they will be willing to lend money at a lower
rate of interest than they would if the rate of price
inflation were higher.
This reduction in the long-term interest rate can be
offset by a reduction in the demand for long-term loans.
If borrowers think they will have to pay off their debts
with money that is less likely to depreciate, they may be
less willing to take on new debt. Maybe they planned to
stick it to lenders good and hard by riding the wave of
price inflation and repaying the loans with funny money.
At present, we are seeing rising short-term rates and
stable long-term rates. Mortgage rates fell slightly in
the first week of January, and are slightly lower than they
were a year ago.
If the FED sticks to its present policy of stable
money, price inflation will become a declining factor in
the long-term credit markets. Long-rates will not rise as
fast as short rates will. This raises the specter of
recession.
THE INVERTED YIELD CURVE
When 90-day T-bills pay more interest than 30-year T-
bonds, we call this an inverted yield curve. Why inverted?
Because it's abnormal. Why abnormal? Because it is
normally riskier to tie up your money for 30 years than 90
days. So, the interest rate on long-term money is higher:
a default-factor premium.
For short-term rates to exceed long-term rates, there
has to be an intense demand for short-term loans. What
would cause this? This: fear of falling demand for goods
and services -- a fear so great that business borrowers
want to finish existing capital projects. They may be
facing falling revenue, or expect to, which pressures them
to shut down uncompleted projects. They resist shutting
them down, for obvious reasons: incomplete projects produce
no income, yet existing debt must be paid off, whether a
project is shut down or not. So, they want short-term
money to tide them over. Demand for short-term loans rises
in relation to demand for long-term loans, which frighten
borrowers who think recession is coming.
The inverted yield curve is the best predictor of
recession I know of. The Federal Reserve in 1996 published
a paper that reached the same conclusion. I used this
indicator to forecast Bush Sr.'s 1990 recession and Bush
Jr.'s 2001 recession.
Today in the United States, we do not face an inverted
yield curve. Britain does. Here are the observations of
John Mauldin, author of "Bulls Eye Investing" (Wiley,
2004). He used to be the manager of my newsletter,
"Remnant Review." I introduced him to the yield curve 15
years ago. John is something of a quant. He loves rows of
numbers. He monitors numbers. Here is what he has
discovered.
UK unemployment is an amazing 2.7%. I am sure
there are examples, but I cannot recall a major
economic country with such a low unemployment
rate. Inflation, although rising, is still under
2%. Wages rose by 4.4% in the three months
through October, the highest rise in several
years and more evidence of nascent inflation.
The housing market is doing quite well, thank
you. In what everyone calls a bubble, housing in
England still rose 12.5% year over year in
November, although only 0.2% in the last month.
Could it be slowing? UK household debt is 140%,
which is above US levels.
The Bank of England recently noted, "Any
sustained fall in [house] prices would reduce
homeowners' cushion of housing equity. This might
reduce their opportunity to re-mortgage to
consolidate other debts or to lower their monthly
payments. Financing difficulties would be
exacerbated if any fall in house prices were
accompanied by a wider economic slowdown."
(Marshall Auerbach at Prudent Bear). . . .
The Bank of England is in a hard spot. They have
been steadily raising rates to keep inflation in
check and to rein in the white-hot housing
bubble. Since the housing market is still doing
well, and inflation is rising, one would think
they should continue to raise rates. But with an
inverted yield curve and a very strong pound,
raising rates might not be wise, as that could
push the country into recession.
If I lived in England, I would be getting my
personal house in order. No long only stock
funds, switching to bonds and absolute return
type investments and funds. While the Fed study
on yield curves was based on US precedent, the
rule generally applies everywhere. Thus
precaution is the order of the day. . . .
I think England may be 6-9 months ahead of us in
the softening process. (http://snipurl.com/bsqk)
Mauldin calls the inverted yield curve in Britain the
canary in the coal mine. Miners used canaries to predict
gas leaks. The canaries would stop chirping, due to the
inconvenience of just having died.
I say, let the Brits perform this useful function.
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THE GOLD/DOLLAR/EURO RELATIONSHIP
Gold has been rising against the dollar at about the
same rate that the dollar has declined against the euro.
Gold has not risen in the euro price. This indicates that
the problem is the dollar, not a shortage of gold
internationally.
The dollar has rallied against the euro in recent
days. A number of contrarians predicted this, including
Dan Denning of "Strategic Investment" and Marc Faber of the
"Gloom, Doom, and Boom Report." Both remain bullish on
gold long-term, but both were convinced that the dollar had
been oversold in relation to the euro. Faber's report is
especially prescient, published on December 1.
Regular readers of this column know that my view
remains that the US economy is in deep trouble
and that the US dollar is a doomed currency,
which will over time lose all its value. However,
even within a downtrend there can be countertrend
rallies the same way there can be significant
corrections within an uptrend. Right now the
situation we find in financial markets is as
follows. The US stock market and other stock
markets around the world have risen from their
late October lows in typical post election
rallies (see November report entitled,
"Conflicting Trends"). However, it is quite
common that these post election rallies fade out
relatively soon, as was the case when Richard
Nixon was elected in November 1972. This was
followed by further strength but the stock market
made its final high in January 1973 -- slightly
higher than in December 1972 - before entering a
devastating two years' bear market.
Since, at present, the US and also other stock
markets around the world have become
significantly overbought (see relative strength
indicator in figure 2) amidst record bullish
investors' sentiment it is very likely that
either a top is already in place or about to
occur within days, which should be followed by a
correction of around 5% at the very least and
lasting into mid December.
From a mid December low we should then get a year
end rally into January, whereby I am expecting
that numerous technical indicators will fail to
better their current high readings. This should
then lead to a more pronounced downturn into
February.
The first week of January brought a downward move for
the stock market. There was a rally in December, but it
ended in December. In this light, it is useful to consider
the other half of Faber's prediction.
Above I mentioned that the US stock market is now
-- in the near term at least -- in significant
over-bought territory. The opposite seems to be
the case for the US dollar, which has now reached
an extremely over-sold position. . . . I am not
so sure that the dollar is now over-valued
against the Euro. Quite on the contrary, from a
recent trip to Europe it is my impression that at
the current exchange rate the dollar is - purely
on its purchasing power compared to the Euro -
somewhat undervalued. As a result, I think that
the most likely financial developments in the
next few weeks will be a setback in US equities
and a rebound in US dollars. In particular, I
should mention that numerous large currency and
commodity funds have huge leveraged dollar bear
positions outstanding, which could rapidly be
unwind once the dollar begins to rally. I suppose
that if the US stock market could decline within
a long term uptrend by 21% in one day -- this
happened on October 19th 1987 - the US dollar
could easily rally by 5% to 10% within a short
period of time. (http://snipurl.com/b6q4)
THE DEVIL MADE THEM DO IT!
Alan Greenspan has been unwilling to do what his
predecessor Paul Volcker did, 1979-82: stabilize money, let
interest rates rise, suffer a recession (some would say
two), and eliminate the inflation psychology from the
markets. Volcker faced a far worse situation in 1979 than
Greenspan faces today: roaring inflation, T-bill interest
rates over 20%, and mortgage money at 14%. He stuck by his
guns until Friday, August 13, 1982, when Mexico threatened
to default. The reinflation began in earnest the following
Monday.
The FED under Greenspan since 2000 has created
extensive monetary inflation, an downward unprecedented
manipulation of short-term rates even before the 2001
recession began, and a housing run-up in most regions and a
bubble on the two coasts. This followed the FED's
expansive policies, 1995-2000.
Now, if we are to believe the figures, the FED has
repented. The Open Market Committee has gone forward at
the altar call, pledging to turn back from their wicked
monetary ways. We shall see. If the FED sticks to its
guns the way that Volcker did for almost three years, the
inverted yield curve will return. There will be another
Bush recession. The housing bonanza will end. But the
dollar may stabilize.
How likely is this scenario? Not very. The FED will
not stick to its guns for three years. Greenspan has shown
again and again, from the first month he was in office
(October, 1987), that the FED stands ready to supply
liquidity.
Today, the FED is following the traditional post-
election policy of tightening money. In fact, this policy
began even before the election. This policy of stable
money after a period of expanding money traditionally ends
a stock market boom, as Faber has described: Nixon, 1973.
This is followed by a recession: Ford, 1975.
Central bank policies of stop-and-go monetary
inflation produce stop-and-go recessions. In 1972, F. A.
Hayek's book, "A Tiger by the Tail," appeared. It was a
collection of essays on the monetary policies of the West.
He argued that monetary intervention had created a tiger of
debt and misallocated resources. By the time of his death
two decades later, this tiger had grown much larger. The
expansion of nominal debt had been subsidized by the
expansion of fiat money. The aggregates grow larger. The
web of debt grows more intricate.
How do we get off the tiger? If we failed after 1972,
why would anyone believe that Greenspan is ready and
willing to play Roy to Volcker's Siegfried?
CONCLUSION
I am not worried about price inflation in the near
term. The FED's monetary policies over the last six months
-- really, over the last year -- have already turned down
the burner.
I don't think the flame will be kept at low simmer.
But until the FED's policy-makers see the reappearance of
the inverted yield curve, they are unlikely to return to
the monetary policies of 2001.
This is why the stock market is still in trouble. To
rescue the dollar in relation to the euro, the FED has
adopted a stable money policy. The trade deficit will
continue if the dollar stabilizes against the yen, and if
China continues to link the yuan with the dollar.
The boom, such as it is, is doing more for export-
driven manufacturers in China and Asia than it is for
Detroit. Stabilizing the dollar will not alter this effect
of FED policy . . . until a recession hits. Not until
consumers get scared -- really scared -- are they going to
turn down Asian offers to buy now, pay later.
Americans seem to be addicted to easy money, low
interest rates, and imported goods. Greenspan has
announced higher interest rates, which can be attained only
by tighter money. The FED is providing tighter money. But
there is no indication that the public is ready to cut back
on buying imported goods. There are too many yuan and yen
flowing into our capital markets.
When that flow is reduced, then the party will come to
an end. Until this happens, American consumers seem
determined to take advantage of the largesse of Asian
investors and central banks. Americans are letting Asians
buy future income streams generated by America-located
capital, and they are using the money to buy goodies.
We are selling our seed corn. It's easier to sell it
than grow it. It's easier to buy on credit than to save.
Asians are taking advantage of our present-oriented time
perspective. It is if they were structuring their
economies in terms of the book of Deuteronomy.
The LORD shall open unto thee his good treasure,
the heaven to give the rain unto thy land in his
season, and to bless all the work of thine hand:
and thou shalt lend unto many nations, and thou
shalt not borrow. And the LORD shall make thee
the head, and not the tail; and thou shalt be
above only, and thou shalt not be beneath; if
that thou hearken unto the commandments of the
LORD thy God, which I command thee this day, to
observe and to do them (Deut 28:12-13).
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