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The Fed is Screwed - They Know It - 3 Bubbles Set to Pop

by David EngstromMarch 27, 2015

You learned your ABC’s a long time ago.  The question now is do you know your BBB’s?  I will give you a hint.  It has nothing to do with a backyard barbeque or the Better Business Bureau.  The three B’s I speak of represent 3 bubbles, each of which have expanded so large that just the sight of a pin could burst any one of them at any time.  Heaven help us if they all burst at once.

The three bubbles are Stocks, Bonds and the Dollar.  Some may question the very existence of said bubbles, but the facts tell us those who fail to acknowledge these bubbles exist are simply living in denial.  The bubbles will burst!  It’s just a matter of time before bubbles meet pin and that sticky mass splats all over the face of the global financial community.

Bubble #1 - Stocks

Since the last crisis, the stock bubble has been blown up by low interest rates, multiple stimulus programs and more recently by corporate buybacks.  Let’s be honest.  In the olden days rising stocks were the product of rising industrial output, rising employment and rising wages.  Today, we have none of that.  Full-time jobs have been replaced by part time jobs, wages have fallen accordingly and cost cutting has become a primary source of corporate profit. 

For those who remain in denial of these facts, just look at the Labor Force Participation Rate.  In October of 2009, smack dab in the middle of the debt crisis, the unemployment rate peaked at 10%.  At the same time, the Labor Force Participation Rate was 65%.  Today our unemployment rate is said to be 5.5% yet our LFPR has fallen to just 62.8%.  How does that work?  How can the data show less employment and less unemployment at the same time? 

A better question may be, why is the Dow 8,000 points higher today than it was in October of 2009 when we had more of our population working at higher wages than we have today?  Go ahead!  Try to deny that.  Try to rationalize away the fact that the stock market is a super bubble blown up by artificial stimulus.

Once you accept that the market bubble has been blown up by artificial means, it is easy to see how that bubble could burst once the stimulus is removed. 

Bubble #2 - Bonds

The second bubble is bonds.  Let me see.  If you print $4 trillion dollars and spend $3 trillion or so on government treasuries, that results in normal treasury prices and normal yields.  [sarcasm added]  And, if you stop buying treasuries with printed money, the price of bonds will not fall as demand falls.  Wake up!  You ARE having a nightmare!

Since the last crisis, high demand for treasuries has been totally artificial due largely to the Fed’s QE bond buying program.  High demand equals higher prices and lower yields/interest rates.  Remember, interest rates are inversely related to treasury prices.  The higher the price the lower the yield.  Now, it only stands to reason, if you take away the artificial demand, treasuries will fall in price.  That liquid pile of high value treasury assets, being used to support money markets, annuities, savings, insurance policies, CD’s, your pension fund and perhaps more of your financial assets than you care to admit, will shrink into a puddle of burst bubbles.

Since the Fed has begun to taper its bond buying program, who is going to step in and buy all those bonds needed to be sold in order to fund the national budget?  It is inevitable.  In order to continue to sell bonds at the rate the Fed was purchasing, the bond prices need to fall and the interest rates need to rise.  Surely, to buy our treasuries now is to buy them at or near their highest prices in history. 

Where’s the upside?  Who wants to commit to earn just 2% on their money for the next 10 years?  As the number of buyers willing to accept these measly returns begins to diminish, that’s when the bond bubble bursts.

Bubble #3 – The Dollar

As the dollar currently trades on foreign exchange markets, it trades at its strongest levels since September of 2003.   Measured against a basket of foreign currencies, today’s dollar is king of the hill.  Unfortunately, the hill upon which the dollar stands is a junk heap and the rest of the world is more than happy to relinquish ownership.  To be king of this hill is the kiss of debt for our own markets and our economy.    

Here’s 5 reasons why. . .

Reason 1 - An Adverse Effect on Foreign Trade

For U.S. companies who rely on foreign trade to boost profitability, a strong dollar is a major handicap.  Simply, it prices exported U.S. goods out of the market.  Let’s zoom in on the Euro.  Not long ago, a Euro was worth $1.36.  U.S. companies who priced their product in Euros once received $1.36 for every dollar’s worth of product sold in Europe.  As of this writing the Euro is worth $1.06 - 22% less.  To maintain profitability, U.S. companies have two choices.  Either raise the price of the goods sold abroad or cut production costs at home to stay competitive.

Reason 2 – Foreign Labor Gets Cheap - Jobs Move Out

This is not rocket science.  If the dollar is strong, foreign labor is cheap.  If the price of our exports rise then corporate American will fight to maintain profitability by exporting jobs to foreign countries where the dollar buys more wages.  You can bet this is one reason for Apple’s meteoric rise in stock price.  What happens to Apple profits if the dollar falls?  Watch and learn. 

Reason 3 – It Inhibits Tourism

Let’s consider our neighbors to the North.  Just a few months ago the Canadian dollar found itself on par with the U.S. dollar.  A one for one trade, if you will.  Now the Canadian dollar is worth about 80 cents.  That vacation to the sunny beaches of Florida or the desert golf courses of Arizona, just got 25% more expensive.  To be sure, this has altered the travel plans of many Canadians in search of a sunny reprieve.

Reason 4 – It Promotes an Outflow of Domestic Capital into Foreign Markets

Just as foreign goods sold by U.S. companies become more expensive to the rest of the world, products of foreign countries become cheaper to U.S. consumers and travelers.  The European vacation just got cheaper.  The summer cottage in Canada just got cheaper.  Here’s a big one.  Those European cars.  Yup – they just got cheaper.   A prolonged period of “strong dollar” could have a dire effect on our own economy as a mass exodus of cash commences.

Reason 5 – Debt Becomes Unpayable

If there is an ideal debt scenario, it is to borrow dollars today that are presumably worth more than dollars in the future.  Inflation assures us that will be the case.  Let’s use an example that most can relate to.  A house is purchased today for $100,000.  The interest on the mortgage is 5%.  If inflation runs at the same 5% rate, we can expect the house to be worth $105,000 one year after purchase.  In effect, the $5,000 you paid in interest, over the first year, was returned to you via increased home value. 

In a true inflationary environment, wages rise at the rate of inflation making it easier, as time goes on, to afford the initial payment set at the time you borrowed money.  In the case of an amortized loan, not only is the interest returned to you in the form of rising home value but you are building equity. 

Now consider the opposite.  You borrow $100,000 to buy a house and 5% deflation sets in.  One year after you signed the mortgage, your house is only worth $95,000.  Not only has the 5% in interest paid been lost but $5,000 of home equity is lost as well.  If your wages decline accordingly, making your payment becomes more challenging.  Sound familiar?

Bringing Home Three Points of Three Pins

To understand the effects of inflation and deflation on our debt, economy and the markets, is to catch a glimpse of the inevitable.  America is the largest debtor nation in the world.  If deflation, hence dollar strength prevails, the U.S will not only be fighting the battle to pay back debt but will be fighting to pay back debt with dollars that are worth more than they were when borrowed. 

Pin One – Rising Interest Rates

The situation would be exacerbated by rising interest rates.  Generally, rates rise to slow inflation and bring deflationary pressure to bear.  The side effects are declining wages, jobs and corporate profits.  This is the pin that could pop the stock bubble.  This is why stocks have rallied with each time the Fed announced another round of stimulus. 

Pin Two – Do Nothing

If the Fed does not raise rates - effectively does nothing - it will become increasingly difficult to sell bonds (borrow money) to fund our budget.  In this regard the Fed is trapped.  Absent a pro-active effort by the Fed to control interest rates by raising them, (they have no more room to lower them) market forces take over and simply refuse to buy bonds at the current high prices.  The market will bid treasuries lower and the bond bubble could burst under its own weight. 

Because of the inverse relationship between treasury prices and yields, the lower bond prices go, the higher interest rates rise.  And if interest rates rise?  You guessed it - more deflationary pressure and both the stock and bond bubbles burst together.

Pin Three – More QE?

It should now be apparent the Fed is caught between 3 bubbles and it’s wearing a pin-stripe suit.  One false move and the bubbles begin to burst in a destructive sequence.  If they raise rates, either by intent or by default, two bubbles explode.  Deflation is not an option. 

That leaves inflation and with interest rates already at or near zero, they cannot achieve inflation by lowering rates. It seems they only have one option.  Hit the self-destruct pin on the dollar bubble and unleash the inflation beast.  Some say more Quantitative Easing is coming - but is it?    

The Fed has tried printing money to fund government stimulus programs.  All that did was increase debt and kick the can toward the end of the road.  They have tried to print money to buy bonds.  But that’s what blew up the bond bubble.  If not QE, what’s left?  For the answer, we turn to the Maestro. 

Alan Greenspan has captured many headlines lately.  He believes inflation is right around the corner.  In his many interviews he reminds us of the enormous size of the Fed’s balance sheet.  On the books are some $4 trillion of assets to include nearly $3 trillion of treasuries.  If the Fed were to unleash those assets into the economy, that could serve as the stimulus needed to side-step deflation and bring back economic growth. 

However, it would not come without a price and that price is inflation.  The dollar bubble would burst.  We can only speculate how trillions of dollars from the Fed balance sheet can make its way into the economy.  Will it come through banks and be passed on again to the public via easy money policies?  Will they just write everyone a check?  It has been discussed.  Or how about this?  What if the Fed intervened in foreign exchange and spent trillions of dollars to buy foreign currencies?

The Maestro himself did it.  From Federal Reserve of New York records we learn, The United States intervened in the FX market on eight different days in 1995, but only twice from August 1995 through December 2006.”  Now you know why he has been dubbed the Maestro.  Is the Fed about to dip into the Maestro’s old bag of tricks to explode the dollar bubble and unleash the inflation beast? Is this why Alan Greenspan said gold is going “measurably higher?”

The Only Certainty Plus One

Another financial crisis is coming!  Our debt is just too massive.  It’s not just the $18 trillion the mainstream continually refers to.  Some put our real debt, to include unfunded liabilities, at over $200 trillion.  We are a bankrupt country, further burdened by bankrupt states, cities and millions of citizens with a net worth below zero. 

Sure, we can kick the can down the road for awhile longer.  The dollar is still the world’s reserve currency.  That, however may be coming to an end.  Throughout history, the average lifespan of a currency has been about 40 years.  The dollar’s time is almost up. 

The Chinese are already promoting their own currency on the global stage as the new world reserve currency – one backed by gold.  China hasn’t secretly been buying thousands of tons of gold because they want to produce a new gold watch.  They want to produce a new world money.

In the months, perhaps weeks ahead, China is capable of making an announcement that will shock the world.  Every 6 years they seem to come clean on the amount of gold held in their official reserves.  The last time China reported was in 2009.  When they did, it was revealed their reserves had multiplied four times over. 

If another similar announcement takes place, the mystery of hundreds even thousands of tons of missing gold will be solved.  China has it and it is for one purpose – to dethrone the dollar as the world’s reserve currency and pop the dollar bubble once and for all.  The Fed almost has no choice but to launch a pre-emptive strike against its own dollar. 

If the Chinese do it first, the dollar’s value will be destroyed before we have a chance to buy assets to hedge against a dollar collapse.  Maybe the Fed will stock up on foreign currencies to complete that hedge.  Maybe, even, they will buy gold and silver.  I think if the Maestro had his way that’s what the Fed would do.  Don’t hold your breath.

Neither the Maestro nor any of us are going to make that decision for the Fed.  We can, however, make that decision for ourselves.  It’s time to back the certainty of another debt crisis with another certainty.  Gold and silver have never been worth zero.   


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