New From Sprott: "Have We Lost Control...Yet?"

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Have we lost control yet?
By Eric Sprott & Etienne Bordeleau

Recent comments by the Federal Reserve Chairman Ben Bernanke have shocked the world financial markets. It all started on May 22nd, 2013, at a Testimony to the US Congress Joint Economic Committee, where he first hinted at tapering the Fed’s quantitative easing (QE) program. Then, on Wednesday, June 19th, during the press conference following the FOMC meeting, the Chairman outlined the Fed’s exit strategy from QE.

Since the first allusion to tapering, volatility has been on the rise across the board (stocks, currencies and bonds) (Figure 1A). Moreover, the yield starved, hot money that had flown to emerging markets has been rushing for the exits, triggering significant declines in emerging market (EM) equity and bond markets (Figure 1B). Finally, the prospect of the end of monetary accommodation has triggered rapid and significant decreases (increases) in the price (yield) of longer dated Treasury bonds (also Figure 1B).

 FIGURE 1A: VOLATILITY INCREASING FIGURE 1B: ASSET PRICES DECLINING

It has been clear to us for some time that the Fed was uncomfortable with the relative certainty (i.e. Bernanke Put) that has prevailed in the markets since the introduction of QE-infinity last fall. Officials definitely wanted the market to start thinking about a future without non-conventional monetary policy. However, we seriously doubt that the resulting chaos is what they had anticipated. This was evident in the Chairman’s response to a journalist’s question about the rapid rise in rates, saying the FOMC was “a little puzzled by that”.1 The genie is really out of the bottle now.

Indeed, we believe that the recent “market appeasement rhetoric” by James Bullard and Narayana Kocherlakota (Presidents of the St. Louis and Minneapolis Federal Reserve, respectively)2,3 are further proof that the Federal Reserve has realized it went too far and that it is now in damage control mode. (Update: William Dudley, President of the New York Fed mentioned in a June 27th speech that “asset purchases would continue at a higher pace for longer” if the economy was to grow slower than the FOMC’s estimate)4.

However, as the Bank for International Settlements (BIS) so elegantly put it in its most recent annual report, “[…] central banks continue to borrow time for others to act. But the cost-benefit balance is inexorably becoming less and less favourable.” To this they add: “expectation that monetary policy can solve these problems [deleveraging, financial stability] is a recipe for failure”.5 Clearly, the Federal Reserve knows this and wants to exit their QE program. But can they really?

A large portion of the current economic growth depends on housing. However, mortgage rates are closely tied to long-term treasury rates. While housing affordability is still relatively good because of low house prices, significantly higher mortgage rates might slow the housing market. Furthermore, banks are still very cautious about lending and most borrowers have difficulty accessing credit. While gentle increases in yields are good for banks (who lend long and borrow short), meteoric increases in yields (as in Figure 1B) are damaging because they are hard to hedge and create large losses on the banks securities portfolios (mostly composed of government bonds and mortgage-backed securities) as well as mark-to-market losses on their derivatives portfolios. So, the large and rapid increases in rates the talk of tapering has engendered will damage the economic growth the Fed has been working so hard to engineer, potentially requiring even more stimulus down the line.

The US government itself would also suffer from increases in yields. In its Annual Report, the BIS shows that even a small increase in interest rates would have a large impact on the projected government debt-to-GDP ratio. As shown in Figure 2, under the CBO’s base case scenario (bottom line), the US debt-to- GDP ratio would hover around 110%, whereas a 1% increase in rates would take it to 118% in 10 years (middle line). According to the Chairman’s comments, the fiscal drag that has been partly to blame for the lackluster performance of the economy should subside going forward. But, larger debt servicing costs (because of higher rates) will put more pressure on government finances, forcing it to spend an ever increasing portion of its budget on interest payments. This will have the effect of increasing the fiscal drag, going against the hopes of the Fed.

FIGURE 2: U.S. GENERAL GOVERNMENT DEBT PROJECTIONS UNDER ALTERNATIVE SCENARIOS - AS A PERCENTAGE OF GDP

To add to all this uncertainty, the situation in the Euro Zone’s periphery is far from stabilized. Following the surprise Cyprus bail-in, international bank regulators have made a push for a democratization of this alternative to outright government bail-outs of banks. This idea is quickly gaining traction amongst central planners. We recently discussed the shortcomings of the BIS’s “Template For Recapitalising Too-Big-To- Fail Banks”.6 The BIS, again in its annual report, reiterated that “we need resolution regimes to make it possible for large, complex institutions to fail in an orderly way.” As uninsured depositors and bank bond holders realize that they do not benefit from government guarantee anymore, bank funding costs will rise and funding might dry up for peripheral European banks.

Conclusion: At the last FOMC meeting, by prematurely announcing the timeline and the specifics of an exit from QE, Bernanke might have lost control of rates and volatility. The current US economic growth is still feeble and hinges on housing, which would be slowed down by raising rates. Banks, while better capitalized than pre-crisis, are still not lending to most borrowers and would be dearly affected by too fast increases in rates. Moreover, European woes still threaten the stability of the international financial system and the recent rush to the exit might further exacerbate funding pressures for weak European banks. Finally, the US government (amongst others) debt load, while already unsustainable, would keep on climbing if rates were to increase only by 100bps.

The chaotic reaction by market participants and the corresponding increase in yields now risks destabilizing this very fragile equilibrium. It is yet unclear whether or not the damage control from the other Fed Presidents will put a lid on yields and market volatility, or if the damage to the Fed’s (poorly executed) exit strategy is permanent.

1    http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf
2    http://www.stlouisfed.org/newsroom/displayNews.cfm?article=1829
3    http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=5128
4    http://www.bloomberg.com/news/2013-06-27/dudley-says-qe-may-be-prolonged-if-economy-misses-fed-forecasts.html
5    83rd Annual Report, Bank for International Settlements, Basel, 23 June 2013, pages 4 and 6.
6    We discuss this in the Sprott Thoughts article: “The Dijssel_Bomb”. http://sprottgroup.com/thoughts/articles/the-dijssel-bomb

147 Comments

rocoach's picture

i had to

first?

opalboy's picture

words of wisdom

not from me!

bullion only's picture

i second your first

second?

bullion only's picture

Game changer?



The Moscow stock exchange plans to transport precious metals from production companies, keep them in its own stores and deliver to the buyer the next day.

http://rt.com/business/moscow-exchange-trading-metals-326/

Strongsidejedi's picture

Yes we have

Bounce back by $30.

Lassonde was right.
Sprott is right.

Yellow hatted one is also right.

I'm calling the bottom at 1186 today.

bullion only's picture

Germany's gold

So Venezuela demands their 200 tons of gold and gets it right away.

Germany wants 300 tons and we say "sure in 7 years"

Now Merkl is up for re-election and trying to save her banks while the Irish banks mock the Germans.

Could it be there is stronger demand for the gold from Germany and GLD is the last and only source?

And how does Russia and Iran feel about their major holding being driven down by the feds.

These are interesting times.

Pierre Lasonnde said yesterday we are give or take $30 from $1200 from the bottom.

We came close enough this morning to $1170 for me.

I don't see how Armstrong can predict gold selling for way below production cost.

Only if central banks start selling their gold. And why would they when they can print?

They would sell their treasuries first.

And finally the trillions of derrivatives are interest rate sensitive.

Inquiring minds want to know.

RT

kryton619's picture

Gun Confiscation in Alberta Canada

Due to the recent flooding in Calgary, Alberta and other towns....the RCMP forcibly entered evacuated homes and confiscated guns for "safekeeping".  The Prime Minister's office has now stated that it expects the RCMP to return them......I guess!!

http://news.nationalpost.com/2013/06/28/more-important-tasks-pmo-says-it-expects-rcmp-to-return-guns-seized-from-evacuated-high-river-homes/

Igiveup2's picture

top ten

like gold, it's a tradition

Turd Ferguson's picture

Taper this!

MODERATOR
mrneutron's picture

Ireland falls back into recession despite multibillion-euro aust

Ireland falls back into recession despite multibillion-euro austerity drive

http://www.guardian.co.uk/business/2013/jun/27/ireland-back-recession-austerity-data-revision

Merkel Slams Irish Bankers As "Impossible To Stomach"

http://www.zerohedge.com/node/475824

zman's picture

Sprott

Good stuff from Sprott,  I agree 100% with what he is saying.

Higher interest rates hurt the economy and banking system. Higher rates also hurt the governments ability to pay the interest on the debt.

A weaker economy brings in less tax revenue and larger deficits, thus the need for even more QE.

Turd Ferguson's picture

It does sound a lot like what

MODERATOR

It does sound a lot like what yours truly has been arguing for quite some time now.

Response to: Sprott
ctob's picture

I am starting to think

That we are at a point where the PMs are going to be the key indicators for certain things.  If Silver goes to somewhere around 16-ish and gold to something aroudn 1100 or 1000-ish in the next month or two.  Then I am starting to think it indicates the chaos is hitting into a feedback loop of ever increasing craziness.

If it bounces off and goes sideways for a while we are back into the same doldrums.  If they then take metals to 16 etc then this means mines are being targeted for buy ups and nationalization.  If it bounces off and goes sideways for rest of year indicates things will tread water for a while.

If it bounces up and and begins a new rise, I dunno.  I don't think that is gonna happen any time soon.  I would say that indicates the bullion banks are trying to get out of QE dependence.

Orange's picture

Turd

A little advice. Kids grow up really quickly. Make sure you take the time to have a vacation as well.

Enjoy.  By the way little Turd did a great job in the video.

pbreed's picture

COMEX Gold delivery...

I've been reading Harvey off and on for several years....

It always been Comex is about to default.... yet it never seems to do so...

Reading last nights report it seems that June gold must be delivered Today and the amount that JPM needs to deliver exceeds its inventory....

Does this mean they will deliver late? not at all, cash payoff?

Either I'm misunderstanding something or this seems like a big deal and nobody is really talking about it?

Don't  ALL June gold contracts standing for deliver have to be delivered in June? (Or is there some margin?)

Anyone here ever actually tried to take delivery of a comex contract? Other than scraping up the $$ what is involved with doing so....

turdpond's picture

Finally!

Finally a little Troll Relief!

zman's picture

Which ultimately leads us to

Which ultimately leads us to believe that "tapering" is nothing more than a big bluff!!, or it's going to be a very short term try, that quickly fails.

How some investors, or even people on this site think this economy, or global economies can function with "normal" interest rates is puzzling.  Sure, if we have real economic growth of 4-5% GDP, maybe it's possible for a while, but that's not likely.

No one answers the big question, how is going to buy the debt at even a 3% on the 10 year bond?   Crickets.  

Urban Roman's picture

I liked it so much

I bought some more PSLV today. 

agNau's picture

We now see the "box".....

and know it's limits.
It's time out once again for little Bennie. "Off to the corner with you!"

Cue Gross............3,2,1

ctob's picture

pawn starts

http://www.zerohedge.com/news/2013-06-28/even-pawn-star-knows-governments-can-screw-currency

Interesting that Rick says supply is rather hard to get but says he is considering selling some and buying it back later (for tax reasons).  I understand the logic for the minimization of losses etc., but what makes him think the "having real trouble getting physical metal" (in his words) isn't just going to get worse?  Also the Old Man will get really pissed if he sells any; there was an episode wher some dude came in and sold a lot of silver and Rick mentions the Old Man is convinced we are headed for trouble ever since Nixon took us off the gold standard.

argentus maximus's picture

Of course tapering is a

Of course tapering is a bluff. If it was going to be a real withdrawal of QE they could have said so.

"Tapering" was used so it can mean anything, and thus apply to the smallest tiniest most meaningless reduction of QE: a discussion about QE withdrawal.

He's trying to talk stocks down because that's all he can do right now. But make no bones about it, there is leakage out of financials. Stagflation can accellerate.

ctob's picture

As long as politicians keep digging

the Fed is stuck.  Even worse like I told a friend in February I projected QE to be hitting a ceiling of diminishing returns by August, which seems right on track.  In that Pawn Start clips I posted above Rick Harrison says the Fed can't taper when the business environment is made worse and worse.  There is a lot more to it than that, but the central idea is right.  The Fed can't get out but they must get out.

This is Wiemar 2.0.  Same shit with different stuff.

gordy's picture

Significance of Gold Going East

Help me out....

If 580 tons of gold leave the West heading East, does this not portend that gold price will move rapidly to the upside (and to a higher zenith)  when the trend shifts?

Or, because in truth prices are set at the LBMA / Comex based on contracts for the rights to gold -many of which are not executed - maybe it doesn't make a big difference?

What's your take here, Turd?  How significant is movement of this seemingly enormous tonnage? 

agNau's picture

?

Turd Ferguson's picture

Of course it will make a

MODERATOR

Of course it will make a difference...a tremendous, paradigm-shifting difference.

Just remain patient.

slavador's picture

Any miners have decent sized hedges?

Now that gold is priced below the cost of production, it would appear that if any miners have contracts to sell at prices like $1500/0z they could mothball their mines, and buy on the COMEX at a profit with expenses slashed. Any significant hedging coupled with production shutdowns would set up a pretty awesome price recovery for gold and a huge opportunity for these stocks.

SteveW's picture

@ pbreed COMEX gold delivery

FWIW, I read on another site that the blogger had taken delivery from COMEX, some time ago, and it took 3-4 weeks to arrive. Getting it into your own hands (vault) is the settlement. 

Now I have no idea how long the COMEX dealers have to settle before there is a failure of settlement but it sure looks like JPM is overextended. I'm sure they'll figure out something but the way the COMEX is being drained it looks on its last legs.

Orange's picture

Significance of Gold going East

Read this interview.

http://www.zerohedge.com/contributed/2013-06-28/henry-smyth-rothschild-moment-gold

or just read this

you are witnessing history real time

HS: It appears that China has since the turn of the century had a state policy of encouraging gold ownership by its citizens. Given this policy and the evolution of their bilateral trading and clearing agreements and systems, it is reasonable to assume the Chinese have global ambitions for their currency, and that their gold holdings will be a significant support to the international acceptance of that currency.  A reserve currency is the ultimate projection of state power. I think the Chinese get that.

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