Jim Rickards, The Gold Chronicles December 18 2015:
- The Fed has raised the interest rate by .25%, and it may go down in history as one of the Fed’s greatest blunders
- The Fed always follows the economy, it never leads it
- Janet Yellen’s models include the Philips Curve which has been thoroughly discredited, does not work and has no empirical support
- Labor force participation is at a 40 yr low
- If you lose one $85,000 job in the oil patch in North Dakota and gain three $25,000 part time service jobs the overall effect is net new jobs but a decline in aggregate demand and GDP
- Unemployment is a lagging indicator, it does not tell you where the economy is going it tells you where the economy has been
- World and US trade are collapsing in the absolute sense – total import / export levels are dropping at the same time
- Expecting .50% (50 basis points) increase in rates through summer of 2016
- Fed models are obsolete
- Negative interest rates would destroy the trillion dollar money market industry
- China is back to Yuan devaluation
- Historically when the US economy goes into a recession, it takes 3% cut in interest rates to get the economy out of the recession. The question is then how does the Fed do this when the
- interest rate is zero or near zero
- The Fed has never accurately forecasted a bubble, or a recession
- This expansion has been going on since 2009, and has been the weakest expansion on record
- The saying goes that expansions cannot die of old age, but they can be murdered by the Fed
- One of the main reasons the Fed is hiking now is to try and preserve what little is left of its credibility
- The other reason the Fed is hiking is to try and “let the air out” of asset bubbles, however these bubbles do not go away slowly but rather abruptly
- The Fed is in a desperate race to get to 3% before the next recession so they can cut
- 45% of growth in China’s GDP is from investment and half of that is pure waste and should be written off
- Real growth in China is probably closer to 3%-4%
- Real global growth after subtracting China is closer to sub 1%
- By summer 2016 the markets are going to figure out we are in recession
- If the Fed cuts rates 60 days before the Presidential Election there will be strong political resistance
- We will likely get to Dec 2016 with a total mess and 2017 will have to go back to easing
- Fed tightening monetary policy and increasing rates through June 2016 will create a stronger dollar and a decline in corporate earnings
- Given what’s happened to every other commodity gold has held up surprisingly well
- Gold has bounced off of the $1050 level 8 times in the last few years
- USD Gold price is a comparison of two kinds of money
- Gold and Dollars are both money, neither produce yield unless invested
- At some point the market will realize that this strong dollar policy has been a mistake and demand the Fed weaken the dollar
- Likely to have a stronger dollar for the next 6 months, and the earliest Fed cut would likely be a 2017 event barring some catastrophe
- The coming non US dollar denominated debt collapse is up to $9 Trillion in range before factoring in derivatives
Listen to the original audio of the podcast here
The Gold Chronicles: 12-18-2015:
Jon: I’m Jon Ward on behalf of Physical Gold Fund. We’re delighted to welcome you to our latest webinar with Jim Rickards in a series we’re calling The Gold Chronicles.
Jim Rickards is a New York Times bestselling author and the Chief Global Strategist for West Shore Funds. He’s the former General Counsel of Long-Term Capital Management. He’s a consultant to the U.S. Intelligence Community and the Department of Defense and is also an Advisory Board member of Physical Gold Fund.
Jim, welcome. We’re really glad to have you with us on a rather special day today.
Jim: Thank you, Jon. It’s great to be with you.
Jon: We also have with us Alex Stanczyk, Managing Director of Physical Gold Fund. Hello, Alex.
Alex: Hello and good morning. It’s good to be here.
Jon: Alex will be looking for questions that come from you, our listeners. Your questions for Jim Rickards today are more than welcome.
Well Jim, they did it. The Federal Reserve unanimously agreed to raise short-term interest rates by 0.25%, the first rate hike in nearly ten years. They tell us this is based on an improving outlook for the U.S. domestic economy.
Two questions: 1) Did the Fed make the right call here, and 2) Why is this tiny rate increase such a big deal?
Jim: They definitely did not make the right call. I think, in the fullness of time, we’ll look back on this as one of the great blunders in Fed history, and that’s a major statement because they’ve made so many blunders. It’s a long list, but this will be added to those — right up there with 1929, 2008, and a few other occasions.
Let me explain the reasoning behind my response, because I never like to put out views without getting into the analysis and the thinking behind it. The Fed should have raised interest rates in 2009. Joe Kernan asked me during a CNBC interview in August of 2009, “What should the Fed do now?” I said, “They should raise interest rates 25 basis points. Don’t do it again soon, signal that it’s going to be baby steps, and not every meeting.” That is exactly the policy they enunciated Wednesday, but I said they should do it back in August 2009. Some people say 2010 or 2011, but the year is less important than the fact that they should have raised rates years ago. If they had done that, they could have raised interest rates up to 1.5% or 1.75%, and then sat tight for a while if that was necessary. Then, today, they would be in a position to cut, which is what they should be doing.
The U.S. economy is uncomfortably close to a recession, possibly going into recession in 2016. You’re not supposed to tighten into a recession; you’re supposed to ease into a recession. We can talk about the easing toolkit, but if they raised rates when they should have, they’d be in a position to cut them today.
This is really Bernanke’s fault, not Yellen’s. Under Bernanke, the Fed missed a whole interest rate cycle. Here’s the way interest rates interact with the business and credit cycle traditionally over a long period of time: First the economy expands, gets a little stronger, unemployment goes down, labor market conditions go tight, inflation ticks up a little bit. The Fed’s are watching, watching, and then, finally, the economy gets a little too hot, they hike rates, but it’s not enough. The economy is still growing, inflation is still going up, labor markets are still tight, so the Fed hikes again, they hike again, and then finally, they cool off the economy. The economy peaks, it starts to go down, all while the Fed is watching again. They’re like, “Okay, now unemployment is going up, inflation is coming down, there’s more slack to the labor markets, so we’d better cut.” They cut rates and then, finally, the economy picks up again.
Think of that as just a classic sine wave. The economy grows, the economy shrinks, it grows, it shrinks. The Fed tightens and eases and tightens and eases to try to smooth out the amplitude of those sine waves.
The point is that the Fed always follows; the Fed never leads. The Fed doesn’t make the economy do anything; they just kind of tag along, or at least historically that’s the case. They’re always behind the curve, and that’s sort of the way they view their job. This is the first time maybe ever – there might be one or two examples, but they’re not too encouraging – when the Fed is trying to somehow lead the economy into feeling good.
All of the data now indicates a recession or heading towards recession or contraction or significant slowdown in growth both globally and in the U.S. The Fed is just whistling past the graveyard. They raise rates, put on a happy face, and talk about strengthening the U.S. economy, but it’s completely a case of putting the cart before the horse. The Fed is supposed to see strong data and then raise rates. Instead, they’ve raised rates because they expect to see strong data. That’s not how it works.
Where is this outlook coming from? The question we can ask rhetorically is what is the Fed thinking? I think it’s important to understand that Janet Yellen is only loosely connected to the real world. She is a big-brain, model-based quant who has never spent a day in her working life outside of one of four places: Yale, UC Berkeley, the White House, or the Federal Reserve. She’s never had a private sector job, never run a business, never met a payroll, never sat in a trading floor, never had to bet her capital or other people’s capital on an economic outlook. She’s never done any of those things. As I said, she’s a quantitatively-driven and fairly liberal Democratic labor economist.
Janet Yellen has a model that says that when you get to a certain balance of unemployment and job creation, inflation is right around the corner. That model is based on something called the Phillips Curve. I thought the Phillips Curve was completely discredited by the early 1980s and I would grow old and die never hearing the words “Phillips Curve” again, but it’s back like a zombie that’s come out of the grave.
Yellen is giving speeches of an academic scholastic bent about the Phillips Curve. It’s simply the tradeoff between unemployment and inflation, so when unemployment and job creation gets to where it is now, you should expect inflation. That’s what she’s looking at.
The Phillips Curve doesn’t work; it has no empirical support. Even Yellen herself said, “You can’t just take the 5% unemployment rate and job creation at face value,” because we all know labor force participation is at a 40-year low. Yes, we’ve created jobs, but if you lose one $85,000-a-year job in the oil patch in North Dakota, and you gain three $25,000-a-year jobs bartending, you may have created net two jobs, but aggregate demand has gone down, GDP has gone down.
I am not against bartenders, by the way, and I’m happy for any unemployed person who got a job bartending, but when I look at the mix of part-time and full-time jobs, at labor force participation, and at what’s going on in real wages, I don’t see any strength in the labor market. The unemployment rate is a lagging indicator. It doesn’t tell you where the economy is going; it tells you where the economy has been.
Monthly job creation looks like it peaked in November 2014. We’re still creating a couple hundred thousand jobs a month, and that’s a lot at an annual pace, I’ll grant that, but it looks like it peaked 14 months ago. As a lagging indicator, I don’t take any comfort from that.
When you look at everything else that’s going on, the bulls, they point to car sales. With an annual rate of 18 million cars a year, I would point out that a lot of those car sales are being financed with the new subprime, which is auto loans. They’ve completely relaxed the credit standards, so again, I’m happy for anybody who got a new car out of it, but a lot of that debt is not going to be repaid. That’s at the outer limits. Inventories are piling up. They just brought a lot of pent-up demand forward with cheap finance and easy money. It appears to be hitting the wall, and you see that in inventory accumulation.
Take those things away from the happy-talk crowd, and everything else looks pretty bad. The scariest statistic to me is that world trade and U.S. trade are collapsing, and in the absolute sense. Most analysts look at trade surpluses and trade deficits – does that contribute or detract from GDP? It’s an interesting question, but forget about the surplus or the deficit; look at the absolute level of imports and exports. It’s going down. That very rarely happens. Trade deficits and surpluses bounce around based on terms of trade and exchange rates, but you almost never see imports and exports going down at the same time.
We did see it in the Great Depression, and Charles Kindleberger did a lot of great scholarship on this. I was advising a group of clients from one of the world’s largest banks about a week ago, and their chief U.S. economist was in the room. We disagreed on a few things, but he’s a good guy. After I made the point that I just made on this call, he raised his hand and said, “That’s true around the world including China, but it’s not true in the U.S.” The next day, the U.S. trade figures were released, and it was true. Both imports and exports went down.
Look at container shipments, the Baltic Dry Index, transportation indices. There are many data points, all of which are very meaningful. I would summarize the difference between Janet Yellen and me like this: Janet Yellen lives in a model-based world, and I’m trying to live in the real world of people actually buying stuff, shipping stuff, and making stuff.
It looks like we’re heading into a recession. I would have said that even if they hadn’t raised rates, because the fundamental economy is not that responsive to a little rate hike here and there. I think the Fed blundered, but 25 basis points by itself is not the difference between a recession and an expansion or continued expansion, although it certainly doesn’t help.
Just to spend another moment on this path, the Fed gave us some pretty good guidance about what they think is going to happen. I’ll caveat that by saying what they think is going to happen is not what’s actually going to happen.
Let’s talk about what they think is going to happen. They said they’d like to raise interest rates 1 percentage point a year for the next three years in 25-basis-point increments. That’s four 25-basis-point hikes a year if you’re going to do 1% a year. They meet eight times a year, so implicitly it would be a hike every other meeting. They didn’t say that in so many words, and Yellen was careful to say that it’s not on a strict calendar. She said it’s “data dependent.”
Fair enough – they always say that – but in terms of expectations, you would say, “25 basis points every other meeting for the next three years.” If you do that, you’ll get to 3.25% by the end of 2018. Steady Eddie, easy breezy, that’s kind of how they see it.
In the short run, what that means and what I do expect based on what the Fed is saying is that they will not raise interest rates in January, and there is no meeting in February. The next meeting is March, so you would expect a 25-basis-point increase in March, then nothing in April, no meeting in May, and then raise 25 basis points in June. It’s kind of baked in the pie to look for a 25-basis-point hike in March and a 25-basis-point hike in June. We’ll get to the 4th of July, and the floor on Fed Funds Rate will be 75 basis points.
That’s when it gets interesting. If the economy is fundamentally weak, a lot weaker than the Fed thinks (because their models are obsolete, in my view) and some of these trends that I just described play out, then they are in a pretty rigorous tightening cycle right into a recession. You don’t raise rates in a recession; you’re supposed to cut rates in a recession or do some other easing by using one of the other easing tools.
For people who say, “Well, until Wednesday, they were at zero, how could they cut?” There are a lot of other things they could do. First of all, they can go to negative interest rates, which interestingly, Janet Yellen mentioned in her press conference. She didn’t say they were going to do it, and I think it’s a very high hurdle to do that. Negative interest rates would pretty much destroy the money market industry, which is a trillion-dollar industry, and they don’t want to do that. But the fact that she even mentioned it as something they’re researching and thinking about is pretty interesting.
The easing options are: Go to negative interest rates, do more QE — unlikely because, again, that’s been pretty discredited and the research is showing that QE doesn’t work, do currency wars, or try to cheapen the dollar, but that’s not on the table now. If you’re raising interest rates, which they are, you’re making the dollar stronger, which they are, so currency wars aren’t in prospect.
They could do forward guidance. If you think about what they’re actually saying, they’re kind of doing a version of that. They’re raising rates, which they did on Wednesday, but they’re telling you that it’s going to be a very slow tempo of further rate increases. It’s a form of forward guidance whenever you talk about what you’re going to do next as opposed to leaving the markets guessing.
They’re tightening and easing at the same time. They’re tightening by raising rates and they’re easing by giving you forward guidance about not raising rates too fast. If that sounds a little schizophrenic, it is.
China just went through something similar. Until August, China was easing by lowering reserve ratio requirements and interest rates, but they were tightening by trying to maintain a peg to the U.S. dollar. When the market wants your currency to go down, and you’re trying to put a floor under it and maintain a peg, the way you do it is by printing money and using your reserves to buy your own currency. The People’s Bank of China was using dollars to buy yuan to maintain the yuan/dollar exchange rate. Well, when you buy yuan, you’re shrinking the money supply. That’s a form of tightening.
China was easing with two policy tools, interest rates and reserve ratio requirements. At the same time, they were tightening with another policy tool, which was buying the yuan. This made no sense and was not sustainable.
If something is not sustainable, it won’t be sustained. We saw that in August with a shock devaluation. They had to do it, because they were losing their reserves. They’ve lost $600 billion of reserves so far this year. Assuming that continued not at a linear pace but at an accelerating pace, China would be broke by the end of 2017. Although $4 trillion sounds like a lot of money, when it starts to walk out the door at an accelerating tempo, it’s never enough.
By my estimate, they would have been at zero reserves by the end of 2017 if they hadn’t done something. Of course, that was not going to be allowed to happen, so they did do something. They cheapened the yuan, and the way they did it was to shock the world. It caused a U.S. stock market correction. We all remember August 29th to 31st when the U.S. stock market was just falling into an abyss. Then the Fed didn’t raise rates in September (that was the start of the happy talk and dovishness), and then markets stabilized, and suddenly it’s all good now that they did raise rates.
But guess what? China is back to devaluing the yuan. They just learned a lesson: Don’t do it all at once in one day when the market’s not looking; do it in baby steps. The yuan has gone down against the dollar 12 days in a row. Now look out for 13 days in a row starting Monday. Little tiny steps, and they’re continuing that.
Something that was not sustainable wasn’t sustained in China. They’re not going to close the capital account because they want in with the IMF, and they’re not going to give up independent monetary policy because they want the ability to cut rates when they feel like it, so they caved in on the pegged exchange rate. There are three corners of the so-called Impossible Trinity, which was theoretically developed by Mundell in the early 1960s: 1) An open capital account, 2) A fixed exchange rate, and 3) An independent monetary policy. As I said, you can’t have all three on a sustainable basis, so they threw in the towel on exchange rate.
The United States is a little less vulnerable to the Impossible Trinity, because we don’t really need reserves since we print dollars, but the Fed is now on a non-sustainable path.
The Fed says they want inflation. It’s no secret that they want 2% inflation. The Fed thinks they see inflation coming because of this flawed Phillips Curve analysis they’re using, even though a lot of data points in the opposite direction.
When you raise rates, you strengthen the dollar. A stronger dollar is deflationary. If the Fed wants inflation, why are they pursuing a policy that causes deflation? That makes no sense. They’re on the same non-sustainable path. The question is, when will they cut? When will they ease?
If you follow this path – hike in March, hike in June, get to 75 basis points by the 4th of July – where do we go from there? This is where it gets really sticky.
Larry Summers did a great analysis about a week ago in an article in The Financial Times. He did a bunch of regressions and said, “Historically, when the U.S. economy goes into a recession, it takes 300 basis points of cuts to get out of the recession.” That’s how much the Fed has to ease to get the U.S. economy out of recession. If you start the recession at 6%, you have to cut to 3%, or if you start the recession at 5%, you have to cut to 2%. Basically, you have to take 300 basis points or 3% out of Fed funds to give the economy enough of a lift to get out of a cyclical recession.
But how do you do that if you’re at zero? How do you do it if you’re at 25 basis points? You can understand the Fed is now in a desperate race, and this explains why they hiked. I just went through a whole analysis indicating that the U.S. economy is weak and probably heading into a recession, plus they missed an interest rate cycle and should have raised in 2010. What on earth are they thinking by raising now when they should be cutting?
What they’re thinking is, first of all, we’re not going to have a recession. I would point out that the Fed has never correctly forecast a recession. They don’t get that right. They’ve never seen a bubble and they’ve never seen a recession. Of course, bubbles happen and they pop; recessions happen like clockwork, but the Fed has never accurately forecast either one. The fact that the Fed doesn’t see a recession means nothing to me, but that’s how they’re looking at it.
Think about what they’re doing. They’re going to raise 1% a year for the next three years. That gets you to 3.25% by the end of 2018. Then if you had a recession in 2019, you could, following Larry Summers’ lead, cut 300 basis points all the way back down to 25 basis points from 325 and get the U.S. out of the recession. Does anybody think we’re going to get to 2019 without a recession? I don’t think we’re going to get to 2017 without a recession!
Now just to talk about that a little bit, this expansion has been the weakest expansion on record. It’s been going on almost six and a half years since 2009, but it’s been so weak that if you talk to everyday Americans, they don’t even think we’re in an expansion. They somehow think we’re still in a recession. For them personally, they may be right about that, but we’re actually in the 79th month of an expansion.
The average expansion since 1980 – which is a period of long expansions, right? – is 78 months. We had the Ronald Reagan/George Bush 41 expansion in the 1980s, and then we had the Bill Clinton expansion of the 1990s. This expansion we have now is 79 months old. That doesn’t mean it ends tomorrow. You know the expression “expansions don’t die of old age” is true, but as someone has pointed out, they can be murdered by the Fed.
No matter what you think, we are certainly in overtime in terms of this expansion even though it’s fairly weak. It’s hard to imagine how on earth we could get to 2019 without a recession. The Fed is in a desperate race to get to a place where they can reverse a recession. They’re hiking to cut. That’s the best way to understand this. They’re trying to get to 300 basis points, the Larry Summers bogey, so they can cut 300 basis points to deal with the next recession.
They’re not going to get there. We’re not going to make it to 2019, so the Fed is going to come up short. In fact, if you think of it as a recursive function, they’re hiking so they can cut, but the hiking itself makes the recession more likely, and they’re going to have to cut more. They’re just not going to get their goals, because they’re hiking into weakness. It’s not responsible for the weakness by itself, but it’s going to make it worse and is certainly going to be deflationary. The U.S. is a sponge for all the deflation in the world.
Let’s step out of the U.S. economy a little bit and look at the global situation. There’s an idea around that from 1989 to 2008, we were globalized on the way up, but we’re not going to be globalized on the way down. This is nonsense, because there’s no decoupling.
Brazil is in a very severe contraction that’s worse than a recession. Russia and Japan are in a recession, Canada is close to one, and the U.S. is probably close to one. China is not technically in a recession, but the official numbers of growth over the last six years has gone from 10% to 9% to 8% to 7% to 6.8%. Add on the fact that 45% of growth in China’s GDP is from investment at least half of which is pure waste. I’ve been on the ground in China at the ghost cities. If they’re applying anything remotely resembling generally accepted accounting principles, they’d write that off.
If you subject another two or three points from the reported figures because of wasted investment, you’re talking about a collapsing growth from 10% to probably 3.5% or 4% at best. I’d say 3.5% is a better estimate. That may not technically be a recession, but because they’re such a large part of the global GDP, the impact on global growth is greater than a recession anyplace else.
A 40% drop in something that’s almost 15% of global GDP is taking six points out of the global GDP over a period of years. Global GDP growth is only about 3.5% to begin with. Of course, that’s happened incrementally over six years, but even if the year-over-year impact is closer to 2%, you’re talking about taking global growth down to sub-1%.
This is the environment the U.S. is operating in, and I already talked about contracting world trade, contracting shipment, Baltic Dry Index, Regional Reserve Bank surveys, declining industrial production, buildup of inventories – a long list of things.
Now let’s take it forward to July/August 2016. My expectation is by then, this negative recessionary data will be so strong that even the Fed can’t ignore it. We can see it coming now, Wall Street will probably wake up to it by the summer, and the Fed will be sitting there in August/September saying, “Huh, it looks like a recession. It looks like we tightened at the wrong time.”
But then what do they do? They could start an easing cycle at 75 basis points, but it will be 60 days from the election. Bear in mind, Janet Yellen is a Democrat. If the Fed cuts rates 60 days before an election, Ted Cruz will burn down the Fed. You won’t have to rely on egg farmers or everyday Americans, because some of the Republican candidates will do it for you. What if they cut rates and the Republicans won? The first order of business in January 2017 would be to abolish the Fed, so they’re not going to do it.
They’ve tightened into weakness and they’ll tighten a couple of more times. The weakness will be evident by late summer. At that point, they’ll probably feel like they should cut, but they won’t be able to cut because of the election. We’re going to get all the way to December 2016 with an overly tight monetary policy in the teeth of a recessionary and deflationary global economy, and probably the U.S. economy as well with a super-strong dollar. It’s going to be a mess.
At that point, they’re going to have to go back to easing. Now we’re talking late 2016/early 2017, probably starting with forward guidance, and then back to zero by the middle of 2017. We’ve seen that in eight major economies in the last five years including Japan, Sweden, Norway, and others. The European Central Bank has raised rates only to cut them again. They thought they could raise on some kind of economic boost or expansion, and within months or a couple of years at the most, they cut them and are back to zero.
I saw a poll the other day indicating that a high percentage of U.S. economists think the Fed will raise and then get back to zero within five years. My reaction was, “Five years? Try five months.” Well, it won’t be five months; it’ll probably be 15 months or early 2017.
They’re going to get up to 75 basis points, two more hikes, hit stall speed, the economy is going to start to either go into recession or be very, very weak, and then they’ll be back to zero by early 2017.
That’s my big picture analysis of the Fed blunder and the data behind it. As to what the Fed was thinking, there were three reasons for hiking on Wednesday. Number one, which has nothing to do with economics, was merely Fed credibility. They said they were going to hike by the end of 2015, but they went seven meetings and didn’t do it. When they got to the eighth meeting 16 days before the end of the year, if they hadn’t hiked in December, what little was left of their credibility would have been in the shredder, so they felt they had to do it. Economics? Who cares? They just had to do it to maintain institutional credibility. That was one of the reasons, which is not a good reason, but they painted themselves into that corner by saying last year that they would raise this year. And why did they say that? Because they had the same flawed model as they’re using now, but that’s their problem.
The second reason for hiking is letting the air out of asset bubbles. They didn’t say a lot about this, but they had mentioned it from time to time with Jeremy Stein, a Fed Governor who resigned about a year and a half ago, as a leading voice. I think he resigned from the Fed because he didn’t want to be around when this happened.
They always use the metaphor of letting the air out of the balloon slowly, but that’s never what happens. It’s more like hitting an overinflated balloon with a sharp object. It pops, it explodes. Just as the Fed never sees a recession, they never see an asset bubble.
There is this notion that maybe stocks or the bond market are in a bubble, commodities certainly are not in a bubble, emerging markets stocks and high-yield … there are a lot of bubbles to go around, maybe even residential housing in the United States for the moment. They think they need to let the air out of the bubble. I think one more rate hike in March could be hitting it with a pin, so “Look out below” there.
The third reason is one we talked about, which is hiking rates to cut rates. Just saying it shows how nonsensical it is. If you’re hiking rates to cut rates, why don’t you just leave them alone? That’s not what they’re thinking, because they feel they’ve got time. They think they can get to Larry Summers’ 300-basis-point bogey before the next recession. I’m like, “Sorry, guys, that’s 2019. You’re not going to make it.”
The three rationales are hike to cut, maintain credibility, and let the air out of the bubbles. My response is that it’s too late. They should have hiked five or six years ago, bubbles don’t deflate, they pop, your credibility is pretty much in shreds anyway, and you’re going to lose more credibility when you have to go back to zero in 2017, but that’s a story for another day.
I’ll let it rest there, Jon. I think we’ve exhausted the Fed subject, but I’m happy to pick up on any other topics you want to look at.
Jon: I do want to pick up on something, actually. You briefly mentioned Wall Street. We all know that stock markets love easy money, and the Fed has just signaled that easy money is going out of style. Why do the markets still seem relatively bullish, and how long can that last?
Jim: It’s a good question. The reaction on Wednesday was the stock market going up a lot, and that was kind of a bullish signal. A number of analysts have pointed out, and I agree, that a first-day reaction never tells the tale. What happened Thursday was possibly a better reflection.
I have to admit that I don’t watch markets day to day. I watch trends and a lot of economic fundamentals. While on this podcast, I don’t have a ticker in front of me and I’m not sure where the stock market is this minute, but I actually don’t care that much because I’m not a day trader. I’m not sure the reaction is bullish, and indeed, the reaction may turn out to be negative and consistent with the recessionary scenario I laid out. Bear in mind that historically stock markets discount recessions about six months in advance.
The stock market has gone sideways for a year. I understand it hit some new highs back in May, had a technical correction in August, and bounced back up in October, but if you look at it year for year, it’s basically gone nowhere with a lot of volatility along the way.
If it starts to go down, that would be consistent with this recession forecast. I spoke to Ben Bernanke about this when I was with him in Korea a few months ago, and he said that the Fed actually doesn’t care. His exact words were, “The Fed doesn’t care if the stock market goes down 15%.” In other words, the Fed doesn’t think it’s their job to prop up the stock market, and if the reaction to Fed policy is a 15% decline, they don’t care.
That’s interesting. What about a 20% decline, Mr. Chairman? In other words, at what point does the Fed start to care? I’m not predicting that that’s in the cards, because I think it’s more likely we’ll see a slow grind down.
Again, let’s come back to the underlying dynamics and not just throw a forecast out there without drilling down as to what’s behind it. The Fed’s tightening cycling, which has now begun, will continue, in my view, through June and maybe longer, but at least through June. This creates a stronger dollar.
A stronger dollar is bad for corporate earnings. We’ve seen corporate earnings go down significantly in 2015, and they should go down again in 2016. That’s because a lot of our major corporations and large cap-weighted components of the major indices get anywhere from 30% to 80% of their revenues from oversees. A stronger dollar means those overseas revenues are worth less in dollars when you translate them back, and that means corporate earnings decline.
That is also something that lags. You can say, “The strong dollar story has been out there for a couple of years; hasn’t that worked its way through the pipeline?” The answer is no, because corporations don’t like to speculate in currencies. They hedge their overseas currency exposure, but the hedging market only lets you go about a year.
Going back to 2014 or even late 2013, the dollar started to strengthen significantly. Really, it was a 2014/2015 story. The impact on earnings did not show up right away because they were hedged, but the hedges have rolled off, and the dollar continues to get stronger, and even the new hedges are going to have their expiration dates.
This impact on corporate earnings is still coming through on a lag basis, so the combination of fundamental recessionary trends, deflationary trends, plus a corporate earnings decline coming from the strong dollar would lead us to expect stock markets to go down.
This is a reason to have gold in your portfolio, by the way. Again, I’m not predicting a market crash, but if you ask me if it could happen today or Monday, I would say absolutely, that’s just in the nature of how complex systems melt down. I saw it happen in October 1987 when the stock market went down 22% in one day. If you converted 22% to today’s Dow points, that would be 4000 Dow points.
If the Dow went down 400 points, that would be headline news all over the world, so imagine 4000 points. Imagine what that would do to your portfolio. That’s what happened in October 1987, and that’s the reason I recommend 10% of your investable assets in gold. Whether gold’s going up or down – it has been volatile – that’s your fire insurance in case the rest of the house starts to burn down.
Getting back to the stock markets, the history of stock markets and recessions is that stock markets lead the way down about six months in advance. With the Fed tightening at the wrong time – not standing pat, not easing, but tightening – that would just make that worse because of the impact of the strong dollar.
I’m not sure it is “happy days are here again” for the stock market, but we’ll see how it plays out.
Jon: Let’s briefly talk about gold a bit more before we hand this over to Alex with questions from our listeners, because it is an important topic to our audience here. The dollar price of gold has been slowly drifting down and is hovering around $1060 today.
Given all of the instabilities and risks you’ve talked about these last few months, is it cause for surprise that the price has hovered so relatively low? And looking forward, what would you expect of gold in the brave new world that began with Wednesday’s rate hike?
Jim: The surprising thing about gold at $1060 to me is that it’s not lower. I know it’s at a six-year low and I know it’s come down 50% since the all-time high of 2011. I can read a ticker and I understand all of that.
But given what’s happening to every other commodity including oil, copper, iron ore, and other currencies such as the Canadian dollar, the Australian dollar, the Chinese yuan, and given all the recessionary trends around the world that we just talked about, it’s a little surprising that gold’s not at $950 or $875.
Gold has bounced off this $1050/$1060 level eight times in the last several years. I’m not saying it’s a hard concrete floor and I’m not saying it can’t go lower – it could – but it has actually been fairly resilient at that level and has certainly gone down a lot less than other proxies or other commodities in comparison to the dollar.
I was very happy to hear you say “the dollar price of gold.” You didn’t say gold went down; what you said is the dollar price of gold went down, and that is exactly the right way to think about it, in my view.
Gold is a form of money. I understand it’s dug out of the ground, there’s a mining industry, and I know a little bit about mining and how you do it physically, and feasibility studies, and the chemistry of it, and the electronics of refining. There’s a lot to it, but at the end of the day, you’re doing all of that digging and mining and milling and refining to get money, so gold is a form of money.
When I think of gold versus the dollar or bitcoin or any other currency – take your pick – I’m just comparing two kinds of money. None of these have yield. Gold has no yield. It’s a well-known standard criticism of gold, but I don’t consider it criticism; I consider it a tautology.
A dollar has no yield, right? Take a dollar bill out of your wallet and look at it. What’s the yield? The yield is zero. You say, “Oh, I can put it in the bank and get a yield.” Yes, you can, but then it’s not money any more. The Fed calls it money, because they’re in the business of maintaining this mystical illusion about where money comes from and what money really is. But if you put your dollar in the bank, you don’t have money any more; you have an unsecured liability of what may be a technically insolvent financial institution.
If you assume that you can easily get your money out, most days you can, but talk to the people in Cyprus or Greece. Talk to the people in the United States in March 1933 when the President closed every bank in the country by executive order.
I went to an ATM yesterday in New York and tried to get $500 out, but it said, “No can do.” There was plenty of money in the account; that wasn’t the issue. It said, “I’ll give you $300.” I smiled because I’ve been saying for a long time that in the next panic, the ATMs in the United States will be reprogrammed so that they’ll only give you $300 a day for gas and groceries. The folks on this podcast have heard me say that before, because I’ve certainly said it a number of times.
I use it as an illustration of how Greece can come to America, and $300 was the number I picked as the needed gas-and-grocery money. The government will just say, “Why do you need more than that?” I thought it was funny that this machine in New York would only give me $300 yesterday, so maybe that was my punishment for giving the forecast.
The point is that a dollar in the bank is not money but an unsecured liability of a financial institution that can easily shut its door. You can get yield, you can buy stocks, you can buy bonds, you can buy real estate, you can buy all kinds of things, but real money, such as the dollar or bitcoin or gold, doesn’t have a yield, and it’s not supposed to.
The dollar price of gold, to me, is not really a gold story, it’s a dollar story, and it’s pretty simple. In a strong dollar environment, you would expect a low dollar price of gold. In a weak dollar environment, you would expect a high dollar price of gold. If you want to know what’s happening with gold, you have to ask yourself what’s happening with the dollar. We just spent some time talking about what’s happening with the dollar in terms of the Federal Reserve.
There are other forces at work. There’s this whole mismatch or out-trade or whatever you want to call it between the physical gold market and the paper gold market. I think folks on the call are pretty familiar with that. There is manipulation going on.
I’ve spoken to more than one PhD-level statistician who has done studies that say the manipulation of the gold futures market is blatant. It’s amazing no one’s been arrested, but if the people behind it are the Chinese, then don’t expect them to get arrested!
There’s another trend going on that I hear about from my friends at the Physical Gold Fund who are very plugged-in as well as other dealers and participants in the physical market. They say the demand for physical gold is voracious and people are lined up to get the metal.
When I look at strong dollar, weak commodity prices and then look over at gold, if that were the only thing going on, my question would be, “Why is gold not lower?” I think it’s had very good resilience at this $1050/$1060 level. If you ask me for an explanation, I would say that it’s probably this voracious demand for physical gold.
While all the talking heads on TV are saying, “Gold’s down, gold stinks, whatever,” smart people around the world are buying. This doesn’t include Americans, however. You see it in Australia, China, parts of Europe, with the Swiss, the Germans, in South America, and around the world, but I don’t see it so much in the United States. Americans have been hopelessly programmed to think of gold as having not much value, but around the world, people are backing up the truck. They’re like, “Hey, $1050, I’ll take it. Just get me some gold.”
In fact, we’re hearing about delays in supply. It’s a United States law that if you’re a physical gold dealer and a customer comes in and says, “I’d like to buy some gold,” and you don’t have any on hand, you’re response is, “Okay, I’ll take the order. Here’s the price, and I’ll get it to you in two weeks, or whatever.” It’s against the law if that waiting period is more than 28 days, because that’s the definition of a regulated futures contract. If you’re a dealer who sells gold more than 28 days forward, you have technically crossed the line into an illegal off-exchange futures contract subject to enforcement action by the SEC. In the extreme case, it could actually be a crime, so dealers have to deliver within 28 days.
I recently talked to a dealer who said that’s not happening. It’s routinely taking more than 28 days to source the physical gold, but everyone’s turning a blind eye and not reporting it. The customer doesn’t care because they want the gold. The dealer doesn’t care because they want the order. Everyone’s tiptoeing around the 28-day rule, but the point is that those kinds of delays are not unusual right now. There are a lot of other stories to that effect, but it gives you some sense of what’s going on in the physical space.
You have price suppression and manipulation by the futures market, voracious high-end demand from Russian and China that is not abating, and you have voracious retail demand from everyday people around the world buying up the gold, although not apparently the United States. There is a giant tug of war going on around gold where the deflationary recessionary forces want to take it down, the technicals and the demand for physical want to prop it up, and it’s in an unstable equilibrium around right around the $1050/$1060 mark.
Where is it going to go? In the short run, I would expect everything I just described to persist for a while. The deflationary interest rate hike and weak economy forces are still trying to move it down, but the physical demand and strategic buying by Russia and China are still going on, so those opposing forces are still in play.
At what point does the market look around and say, “You know what? This strong dollar is killing us. It’s killing the U.S. economy, it’s a political liability, the Fed has blundered and raised rates at the wrong time. We have to get some inflation going on, and that’s going to be good for the dollar price of gold.” When does that happen?
A very interesting thing happened on Wednesday that is no coincidence. On the same day that the Fed raised rates, the Congress blew a hole in the budget caps. This was led by Paul Ryan with cooperation from Nancy Pelosi, Senate leadership, and the White House. They are on a spending spree, and they blew through these caps they enacted a couple of years ago.
Remember all the talk about the fiscal cliff and shutting down the government and no more spending that we lived through in 2012, 2013, and 2014? It went away, because they enacted these hard caps that have guided the budget for the last couple of years. Guess what? The caps have been blown up.
This is like a crime spree, a smash-and-grab by Republicans and Democrats in it together. What did the Democrats get? They got social spending, big solar tax credits, climate change, and the sort of stuff they like. What did the Republicans get? They got pork and more defense spending. They were all in it together.
What’s the significance to that? Think of it as a relay race. It’s hard to picture Janet Yellen in a tracksuit, but picture her in one as part of a mile relay where each runner has to run a half mile before passing the baton. Janet Yellen just passed the baton to Paul Ryan.
On the same day that they raised rates, Yellen, in fact, was saying, “We’re done. Zero rates, six years. Enough’s enough. We’ve done all we can. Don’t ask us to do more. We’re not even sure it’s working. We have to get back to business here at the Fed. We’re raising rates. Over to you, Paul.” She hands the baton to Paul Ryan. He blows a hole through the budget ceiling and starts spending money. What is that? That’s helicopter money.
A lot of people don’t understand the difference between QE and helicopter money, but it’s very simple to explain. QE, or quantitative easing, is money printing. The Fed prints money, they give it to the banks, the banks give it back to the Fed in the form of excess reserves, and the money doesn’t go anywhere.
The banks don’t lend it, people don’t want to borrow it, and nobody spends it. It has no what’s technically called velocity. It’s a very sterile exercise that doesn’t do anything for the economy. It may have some marginal impact on long-term asset prices, but the money just goes in a circle.
Helicopter money is different. We’ve all heard the metaphor Ben Bernanke talked about in a very famous speech in 2004 referring to something Milton Friedman had said long before that. And that is the Fed can always cause inflation. All we have to do is print money, rent some helicopters, push it out of the helicopters, people run around, pick it up, and spend it. Boom, there’s your inflation.
That was the metaphor, but how do you actually execute helicopter money? Helicopter money requires cooperation between the fiscal authority and the monetary authority. The monetary authority is the Federal Reserve while the fiscal authority is the Congress and the White House. What they do is run bigger deficits or basically spend money they don’t have, run bigger deficits, the Treasury borrows the difference to cover the deficits, and the Fed buys the Treasury bonds.
It’s essentially debt monetization, pure and simple. We continue to run deficits, but in terms of combining Fed debt monetization with bigger deficits, we haven’t had that since 2009. Well, we’re getting it now, and I would look for more of that in the future.
We’ve gone from QE as a form of ease, which didn’t really work, to helicopter money as a form of ease, which, in theory, should work, and the baton has been passed from Yellen to Ryan. It will not have a big impact in 2016 since the amounts aren’t big enough, but this cat is out of the bag, and I would expect the deficits to get bigger as the economy gets worse.
When we actually go into a technical recession, which I do expect, and unemployment starts to go up a little bit because we’re in a recession – which will be a reversal, but as I said earlier, that’s a lagging indicator, so don’t look for that to happen in the next couple of months, but maybe 2016 – the political consensus for larger deficits is going to be pretty strong.
If you’re a politician, what’s not to like about spending money, right? The Fed is sitting there saying, “Bring it on. We’ll buy the bonds if need be, but we don’t want to buy them in a sterile QE exercise. We want to buy them in an honest-to-goodness debt monetization exercise with you guys (meaning the Congress) spending money like crazy.”
That, in theory, should actually work. Now you have to spend a lot. We’re talking about going back to trillion-dollar deficits. Is there political appetite for that? Not today in a presidential election. Trump, Cruz, or one of these guys would go burn down the Fed. But after the election, regardless of who wins, in a recession, political winds will shift very abruptly and there will be appetite for it.
I don’t know who’s going to win the election, but whoever does, and certainly if it’s a Republican, it’s going to be their chance to do what Obama did in 2009, which is just expand the deficit.
If that happens, and it is happening in small ways, I expect it to continue. Then that’s going to be the turning point when the market’s going to wake up and say, “You guys are serious. No more of this QE stuff; you are going to spend whatever it takes as long as it takes to get the inflation. If you’re doing that, I’m buying gold, because I don’t want to be the last guy on the bus.”
That’s how it’ll play out. Patience is a virtue. I think that gold, absent of geopolitical shock or a severe financial panic, which is always a possibility (I’m not predicting either one, but you can’t rule those out), I would expect gold to kind of chug along sideways and maybe up a little bit through this tightening period, mainly because it will be a victim of the strong dollar. Eventually, even the Fed will understand that they blundered and they’ll reverse course – the Congress is already ahead of them – and then we’ll finally get the inflation people have been talking about for seven years.
Jon: Thanks, Jim. I can’t remember when we’ve concentrated so much information in one webinar. I know we have to let you go at the top of the hour for an appointment, but Alex, we have time for one question from a listener for a brief response from Jim here.
Alex: We want to thank the audience for all of the questions they send in. We get them on the webinar, in e-mail, and also over Twitter. I want to thank Jim for addressing the last question regarding gold, because that’s the majority of the questions we’re getting right now.
There are a lot of questions regarding gold sentiment. Most of it is obviously about western sentiment – which doesn’t necessarily mean the East and the Arabs, etc. are having the same sentiment – but in USD terms, there’s a lot of concern about the gold price.
I want to acknowledge that we have a lot of international clients and people who are interested in what Jim has to say, so this particular question is going to be more of an international nature. How bad will the global dollar-denominated debt problems become if we have a stronger USD over the next 6 to 12 months? I want to add to that what do you think is going to happen? Do you think we’re going to have a stronger or weaker dollar towards the end of 2016?
Jim: We’re going to have a stronger dollar for at least the next six months, maybe a little bit longer. At that point, I don’t think it will go weaker. It would go weaker if the Fed cut, but I explained how the Fed will not be able to cut for political reasons having nothing to do with the economics, because it will be, at that point, two or three months before the election. The earliest Fed cut would be in December, maybe not even then, but that would be the earliest.
So a weaker dollar feels like a 2017 event. Just to answer the first part of the question, the non-U.S dollar-denominated debt collapse is going to make this high-yield collapse we’ve seen the last two weeks look like a picnic. We’re talking about $9 trillion of dollar-denominated debt borrowed by emerging markets. We’re not talking about sovereign debt or things the IMF can come in and fix. We’re talking about mostly corporations or provinces or regions, as the case may be.
With the global economy slowing down radically and the dollar getting stronger, they’re not going to be able to pay off that debt, and we’re going to see a wave of defaults. It’s already starting. Everyone’s just whistling past the graveyard on this, but we’re going to see multitrillion dollar defaults.
The question is to what extent do the central banks of the countries of these borrowers intervene? It’s not a mystery, because we know who they are. We’re talking Russia, Brazil, South Africa, Indonesia, Turkey, Malaysia. To what extent are their central banks willing to exhaust their reserves to prop up their local borrowers?
In theory, if a corporation that owed dollars was getting local currency revenue and couldn’t afford the dollars in real terms, they could go down to their local central bank and get some foreign exchange to roll over their debt. But how low will the central banks be willing to go in their reserves?
My view is not very far. Is Russia really going to exhaust their reserves to bail out some auto distributor in Moscow? I don’t think so. Those defaults are going to come in a big way. They haven’t hit yet, but we’ve seen the beginning, we see waves breaking on the beach. In the energy sector, certainly fracking, that’s already happening. Other forms of high-yield are showing problems – a lot of that high-yield story is energy – but that’s going to spread dramatically over the course of the next year, and we’re not going to get any relief from a weak dollar until 2017.
I think by then it’ll be too late. The combination of weak growth and strong dollar is going to sink a lot of these borrowers.
Alex: Very good. Thanks, Jim. We appreciate it.
Jim: Merry Christmas and Happy New Year, and we’ll see you next time.
Jon: Thank you, Jim. The same to you, from all of us.
Thank you to our listeners for spending time with us time today. Let me encourage you to follow Jim on Twitter. His handle is @JamesGRickards. Goodbye for now. I hope you’ve enjoyed this very rich and information-packed presentation as much as we have in participating in it here. We look forward to joining you again in 2016. Goodbye for now.
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