Wednesday, July 3, 2013

The Fate Of The States: How Municipal Debt Will Reshape America

I'm reading an excellent book during this holiday week called "Fate Of The States: The New Geography Of American Prosperity" by Meredith Whitney.

The book focuses on the coming trouble in the municipal debt markets for many cities and states throughout the United States. The first half of the book goes in depth on both why the crisis is coming and where it will be located. The chapter on pensions is incredible and opened my eyes to how difficult it will be for many areas of the country to dig out from these monstrous unfunded liabilities.

The second half of the book focuses on a more positive outlook, which is the growth of states that did not over leverage during the boom years and how they now have the ability to provide low taxes, healthy businesses environments, and infrastructure growth over the next 10 years.

Meredith sees a movement toward the central states in the country where states will experience a prosperity boom combined with economic growth similar to a developed nation outside the United States. This will only be fueled more by their ability to produce energy and agriculture.

For anyone interested in how the United States will be re-shaped in the decade ahead, or anyone considering making an investment that is dependent on their local economy (purchasing a home, an investment property, or opening a business), I would highly recommend reading this book before doing so. The coming changes will impact the quality of education for children in local markets and for some of the most troubled markets it will impact how safe you will be living there.

The following is an interview Meredith recently gave with Steve Forbes discussing some of the topics found within the book.


Monday, July 1, 2013

History Does Not Repeat But It Does Rhyme

Peter Schiff wrote about an article in the New York Times today. Here was the quoted piece from the article:

Two years ago gold bugs ran wild as the price of gold rose nearly six times. But since cresting two years ago it has steadily declined, almost by half, putting the gold bugs in flight.  The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels.

The rout says a lot about consumer confidence in the worldwide recovery. The sharply reduced rates of inflation combined with resurgence of other, more economically productive investments, such as stocks, real estate, and bank savings have combined to eliminate gold's allure.

Although the American economy has reduced its rapid rate of recovery, it is still on a firm expansionary course. The fear that dominated two years ago has largely vanished, replaced by a recovery that has turned the gold speculators' dreams into a nightmare.

This piece sounds identical to the steady drum of mainstream media articles that have been written over the past week. The only problem is this article was not written in the past week.

It appeared in the New York Times on August 26, 1976. 

Gold had just declined from a high of $200 down to $103. This article was written four days after gold bottomed. What would happen from there? Gold would launch over 800% to $850 an ounce just a few years later.

Two great headlines over the past week in real time:

Yahoo! Finance: "Gold Is Unsafe At Any Price"

Bloomberg: "UBS Says QE's End May Render Gold Obsolete"

Entering the week gold had experienced the lowest 10 day average on the Daily Sentiment Index in the 26 year history of the index. That includes the bear market bottom years in the early 2000's and the collapse of 2008.

The following chart from Zero Hedge perhaps sums of the sentiment in the gold market best with the COMEX gross short position reaching a new all time record high:


The market vane bullish consensus index, another gauge of sentiment in the market, is now well below all time record lows.


The next chart shows the four largest corrections during the current secular bull market and the length of time it took to reach new record highs. Although the current correction is terrifying for those new to the market, it is standard procedure for those that have been longer term buyers.


Finally we have the updated value of gold reserves as a percentage of the monetary base, or how much the reserves "back" the money supply at today's price of gold. Using this estimate, gold is now cheaper on a fundamental level than it was in 2001.


This is not due to the U.S. running out of gold reserves, which have held steady for decades (since the U.S. removed itself from the gold standard in 1971).

It is due to explosive growth on the opposite side of the ledger; the new paper money created.


h/t King World News, FRED

Jim Rickards Discusses The Fed's Next Move

Jim Rickards discusses the Fed's next move in September, which will be an increase in the size of its QE program, not a "taper." This will be due to both the continued decline in economic data as well as the clear dependence to the Fed's steady injection of heroin on just about every aspect of the economy .

In a bit of a contrarian view, Jim feels that Europe is in better long term shape than both the United States and China because they have already taken some of the necessary pain to reform their economy. At the peak of the European crisis in late 2011, Rickards was one of the lone voices saying that the European Union would stay in tact and the euro would strengthen against the dollar. This is exactly what took place.

In addition to this video interview, if you want more from Rickards who I consider one of the brightest finance minds on the planet, click the following link for one of his best audio interviews ever:

Jim Rickards On The Global Economy Moving Forward



2013 Second Half Outlook: Introduction

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

To begin the year we walked through a large case study of what would happen if the most important financial instrument on the planet, the 10 year treasury yield, experienced a rise in interest rates. At the time it seemed ridiculous to consider the 10 year treasury yield the crux of the entire financial system or to consider that a rise in rates could really impact every asset on the planet. If you have not, I would review the 2012 Outlook before we begin because it provides a good basis for this discussion:

The 2012 Outlook: A Case Study On Rising Interest Rates

Last month something interesting happened in the financial markets. The "hypothetical" case study of rising interest rates became a reality. The 10 year treasury yield launched from under 2% to over 2.6% in just a few weeks. This move in rates created a massive dislocation in the financial system, impacting almost every asset class around the world and sending some of them into a complete tailspin.


Most participants in the market, specifically the mainstream media, look at what is happening present day in the financial markets and then write stories to justify why the markets moved on that day's news. 

It is natural human psychology to want the "justification"of events after they happen, which is why mainstream news gets such a strong following. It is also why investors making investment decisions on today's market news almost always get hurt over the long term. It is similar to driving while looking in the rear view mirror.

June's movement in the markets, specifically the fall of stocks and bonds simultaneously, caught almost everyone by surprise. We will discuss why market participants were surprised in the sections ahead, and we will review what rising rates from here (should they "hypothetically" occur) would mean for both the global economy and financial system.

Up Next: Second Half Outlook: How Rising Rates Impact The Overall Economy

2013 Second Half Outlook: How Rising Rates Impact The Overall Economy

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

The Federal Reserve's number one goal in printing money to purchase bonds is very straightforward: to lower the interest rates on those bonds. The term is known as Quantitative Easing for good reason in that it eases the burden of debt payments for future borrowers and increases the value of debt for those that currently own it (as bond yields fall the underlying principle value of the bond rises).

There is a secondary stimulative effect on the economy as a whole when interest rates fall, which we have experienced over the past 5 years as the Fed has continued its relentless barrage of printing money to purchase debt, driving rates lower and lower. 

Rather than review all the positive impacts of QE as interest rates fall, we will now review what would happen should the process move in reverse because it is possible that the 10 year rate of 2.5% (where it is today) is not the ultimate ceiling.

The first thing that happens when rates rise is that new debt becomes more difficult to pay because the monthly interest payments to borrow are greater. This both discourages borrowers from taking on new or additional debt as well as triggers higher costs for debtors that have short term refinancing needs on existing debt.

70% of the United States GDP is based on consumption. Consumers have only X amount of dollars per month to spend based on their income. If the total amount they pay on interest rises, they then have less per month to consume.

Corporations have had the luxury during the past 5 years of obtaining money in the debt markets with record low financing costs. Higher interest payments on this debt provides less total profits, less money available to grow, creating a lower rate of hiring.


These first two groups, individuals and corporations, feed on each other. If consumers are spending less, then small businesses who rely on that consumption grow at a slower rate. They hire less or lay off workers, who then spend even less. It is relentless feedback loop. 



At the next level you have government debt. The U.S. federal government has had the ability to run enormous deficits due in large part to the fact that their total interest burden, even with the total debt skyrocketing, has been very small. With most of the federal debt financed short term, if rates were to rise and this debt were to rollover at higher rates, then the total burden would mushroom. This would then spark additional fear in those that invest in government bonds causing them to sell and rates to go even higher. It becomes a relentless feedback loop.



Real estate prices, which we will discuss in detail in a coming section, are negatively impacted by interest rates rising. This has repercussions on the entire economy, from the wealth effect of individuals and their propensity to spend, to bank balance sheets, to state and local tax revenues which are tied in large part to the real estate tax coffers.


State and local governments are massively in debt with a large part of their holdings short term like the federal government. If both real estate prices and their local economies shrink due to the individual and corporate feedback loop just discussed, then their tax revenues will shrink considerably as a result. This would come at a time that the cost to service their debt is rising. If investors become spooked, they will sell debt and rates will rise further, creating another vicious feedback loop.


I hope this simple walk through of some of the largest areas of the economy paints a clear picture on what would unfold should interest rates rise. Hint: Something Very Bad.

This feedback loop is what Bernanke fears most. It is a deflationary spiral that is very difficult to reverse once it begins. This is why he has kept his foot full throttle on the QE pedal since the financial system disintegrated in 2008. The Fed has become the financial system. The first and only buyer of last resort for treasury and mortgage debt.

The problem is that the markets have now become dependent on interest rates falling forever in order to continue the current artificial growth. If they reverse, then it is game over.

Bernanke has painted himself into a corner. This is why QE will never end. It is not possible for it to end. We have moved so far over the cliff that the reversal of rates from here will shatter the markets and the economy.

While I could discuss an almost endless amount of ways rising rates will impact the global economy, we'll be taking a more in depth look at specific asset classes.

Up Next: 2013 Second Half Outlook: Why The Fed Can Never Exit

2013 Second Half Outlook: The Great Rotation Meets No Other Alternative

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

The main headline entering the start of 2013 was "the great rotation." It was so pervasive in every mainstream media and financial advisor headline that it was drowning out almost everything else. The great rotation meant that after four long years of retail investors moving money out of stock funds and into bond funds that this process would slow, or even reverse, providing the next catalyst upward for the stock market.

Financial advisors present the world of investing in a vacuum. Here is the standard approach provided:

"You have X amount of years until you retire and based on your age you should allocate X amount into bonds and X amount into stocks."

Here is the justification for this approach, which I am sure you have also heard:

"This diversification provides you protection because historically when stocks fall, bonds perform well, and when bonds fall, then stocks rise. Over the past 32 years U.S. bonds have increased in value in an almost perfect straight line. U.S. Stocks, which have seen their dips, are now at new all time record highs. Anyone that bought stocks or bonds during any dip over the past 32 years is now wealthier today."

If someone were to ask my advice, which I usually never provide unless I am specifically asked, I ask a simple question (the same one I asked during the Outlook to begin the year):

What would happen if both stocks and bonds fell simultaneously?

This question will either seem confusing at first, hopefully in a good way, or perhaps make them upset and defensive. If they become defensive then the next quote is the one we have heard almost every day since the year began from the mainstream financial news and financial advisors across the country when discussing stock purchases:

"There is no other alternative for income."

I discussed this topic in length just two weeks before the stock markets topped in:

Why Buy Stock? "There Is No Other Alternative For Income"

There is an alternative to buying stocks or bonds, but the financial advisors are correct in that it provides no income. The alternative is cash, which was the most hated investment class on the planet until about 6 weeks ago.

Since the spike in bond yields (and plunge in value) a few weeks ago, money has flooded out of bond funds at a record rate, which can be seen in the chart below. Bond funds have experienced $23 billion in withdrawals in the latest week and $58 billion over the past 4 weeks.



This was the scenario called for by market prognosticators to start the year which would usher in the great rotation. Investors then turned to the stock market fund data to cheer on the huge inflows. The problem is that what they found was $13.1 billion removed from equity funds in just the last week.

Stocks and bonds were falling together.

So where did the money go? Cash. Money market funds have experienced huge inflows since the wreckage has begun.

Sunday, June 30, 2013

Jim Grant Discusses The Tapering Market Turmoil

The Fed heads came out in full force this week to try and retract the previous statements of Bernanke on the coming taper. This was due to the horror that took place in the global markets following Bernanke's testimony which we discussed in Markets Rocked Around The World.

As Jim Grant says in the video below, "the Fed didn't like what they saw and they are doing their best to put in back in the box." What they saw was the coming reality of what will occur when these artificial markets unwind and come back to reality. This will come if the Fed and central banks around the world try to get ahead of the curve and remove themselves from the markets (unlikely), or in the form of total chaos when the markets just over power the central banks.

The truth is that the Fed has no idea what they are doing because there are no academic text books available to provide a historical precedent on the current global financial environment. They are flying through a storm with no concept of what is coming around the corner, and their only solution is to just step on the gas full throttle and close their eyes.