Once again, commentary that the Fed is monetizing the debt and that the market is aware of it……
from Ken Landon, J.P.Morgan Strategy, NY (Oct 12, 2010)
* MONEY ILLUSION – As attached chart 10Y_TIPS.gif shows, the yield of the 10Y TIPS, which is a rough proxy of the riskless real rate of return on capital in the US, has fallen to an historic low below 0.4%. Equities have rebounded smartly over the past six weeks, but the overall financial market is sending ominous signals about expected growth over the coming decade.
It has long been a theme of the Lowdown that a deteriorating Policy Mix in Washington will weigh on growth for years to come. This “hollowing out” of American prosperity is occuring because policymakers are showing no understanding that the engine of growth is driven by people who invest capital and those that utilize that capital to create something that did not exist before. That is, investors and business decision-makers are the actual engines of growth. Policies that create incentives and remove obstacles of increased investment and production are positive. Policies that remove incentives and place obstacles in the way of productive individuals are negative.
In this respect, Fed Vice-Chairman Yellen’s recent comments are instructive. On Monday, Yellen said, “It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.” Although the statement is true, nowhere was there to be found any mention of the Fed’s policies on investors and on capital flows. Lower interest rates may cause borrowers to boost leverage. However, low interest rates also my cause lenders to avoid risk-taking altogether. A slide in real rates in the US will, over time, cause capital to seek out higher returns in faster-growing regions of the worlds (e.g., EM). Notice that new capital restrictions in many EM countries have accompanied the recent slide in US real rates.
On balance, the Policy Mix started to turn negative in June 1999 and became progressively worse since then. It was from that time that the “supply side” revolution of the 1980s started to be eclipsed by the notion among policymakers that markets are inherently prone to “failure” and that central planners must intervene to control freedom of exchange in markets (despite his “free market” reputation, Greenspan led that charge).
Attached chart SPX_GOLD.gif shows the nominal S&P 500 stock index against the same index priced in terms of gold. Many observers speak of “bubbles” and “asset inflation” when referring to the 72% rebound in the S&P 500 since March 2009. However, in terms of gold, the S&P is up just 18% since then, which is a pitiful performance during the early stage of an economic recovery.
* MONEY ILLUSION – Economists refer to people’s focus on the nominal, as opposed to the real, price of things as “money illusion.” In other words, people do not focus on the actual purchasing power of money, but its nominal value. In fact, it is this money illusion that much of Keynesian economic theory is based on. To “stimulate” employment, for example, the standard economic model says that a boost in inflation will lower real wages, which in turn will lead to a pick up in employment (i.e., businesses will hire because of the lower real cost of labor relative to the prices received for finished goods and services).
Similarly, a significant portion of the 11% rebound in the S&P 500 since late-August is nothing more than a money illusion. In terms of gold, the S&P is up only 2.8% over the same period. (I use gold as the yardstick because it has a proven track record of maintaining relatively stable purchasing power over many decades and even centuries. If you want a more detailed discussion of this, then please ask and I’ll send you my report from March 2007.)
Of course, the other side of the coin of the “money illusion” is inflation. Attached chart 10Y_INFL.gif shows that the 10Y Inflation Breakeven priced in the US Treasury market has surged nearly 50 bps since late-August. The market is taking the Fed at its word. Investors are not taken in by the “money illusion,” which is also reflected in the recent surge in gold to all-time highs.
* Speaking of the Fed, the FOMC will release minutes from its meeting of September 21st. It was the FOMC’s statement from that day that caused the market to expect additional debt monetization. As a result, the market will carefully assess every word and comma in today’s minutes that refers to debt monetization (i.e., colloquially known as “quantitative easing).
In my opinion, the mold is already set. The US government is chosing to inflate away the trillions of dollars of debt that it has issued over the past few years. The Fed will be used to fund the spending of the Federal Government. The result will be a debauchment of the currency and higher inflation. I therefore remain bearish toward the USD and view the occassional rebounds as opportunities to sell once again. The same goes for gold. Sell-offs will provide better entry points for those who seek to preserve their capital.
”Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” — John Maynard Keynes in The Economic Consequences of the Peace, Chapter VI, pg.235-6
Kenneth Landon, Oct 12, 2010 kenneth.landon@jpmorgan.com
