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

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Fri, Jun 28, 2013 - 9:30am

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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 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf
2 https://www.stlouisfed.org/newsroom/displayNews.cfm?article=1829
3 https://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=5128
4 https://www.bloomberg.com/news/2013-06-27/dudley-says-qe-may-be-prolonge...
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”. https://sprottgroup.com/thoughts/articles/the-dijssel-bomb

About the Author

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turd [at] tfmetalsreport [dot] com ()

  147 Comments

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Nomad
Jun 29, 2013 - 12:08pm

King Spart/philipat. - Great Cognacs!

Hennessey XO is a great cognac (up to 2% caramel is allowed in cognac and I believe they use the full 2%). Martel have great cognacs too, but if you appreciate these, have a try at Delamain (single vintage if possible) or their Tres Venerable (one of the perks of spending the summer in France!).

Spartacus Rex
Jun 29, 2013 - 12:05pm
Oddzontmosley
Jun 29, 2013 - 11:25am

Tmosley

Let me be clear...I've been doing this for years (along with many on this blog) and I think I have a pretty good understanding.

With that said, I have no idea what is going to happen...and no one else does either.

Yes, PM will go up over the long term, we will have a "come to Jesus" event sometime in the future with the debt and the economy, we are head for some "major" events, but I have no idea what is going to happen tomorrow, next week or next year.

That's the point. The EE isn't just manipulating PM...they are manipulating everything. They don't want to to get it, they don't want you to understand, they certainly don't want you to benefit from it. They want to keep the lid on everything and try to get you to give up and go away.

Trust me, you will not be able to read some clues and figure out what's next. I myself have given up on that quite some time ago.

You would be better served to look at situations and events that they MUST address and can not avoid. For example, the FED must keep printing. No tapering, no doing "the right thing" they must print. Regardless of their trial balloons, they must print. So I am looking for some event that will justify the FED to keep and probably increase printing. My guess at the moment is a war. A war would address a lot of the immediate needs.

However, if you want to continue guessing what they will do next....good luck with that.

Pete
Jun 29, 2013 - 11:21am

Possible Culmination of ABC Correction in Gold

https://i42.tinypic.com/2uj1jfd.png

Gold may well have completed a 5-wave W.C to complete the ABC from Sep 2011 top. I'm no EWP expert and would welcome any feedback.

A few features for the techno-minded:

w.4, at its acme, reached the typical minimum 38% R level of w.3

w.5, on Friday, reached 162% w.1, common where w.3 > 162% w.1

When price turns quite precisely at the Andrews ml or mod. Schiff ml (top of c), the warning lines become potent for a turn.

Price rallied Friday more than at any time since e (formal end of w.4), and put in a volume reversal on the day as well, a valuable confirming factor for culmination.

The low came within $5 of the daily LH from monthly swing extremes (within 0.4%). It reached the LH on the monthly chart and closed above it on Friday (end of the month).

The only unfulfilled factor is the 162% W.A target of 1152. Using the % decline method, the 1193 target for W.C was reached.

Friday should mark at least an important daily pivot low and it may prove to be the low for the correction. All evidence points to serious short covering here and now.

Beastly Stack
Jun 29, 2013 - 10:55am
tmosley
Jun 29, 2013 - 10:21am

Oddzon: Thanks for the input.

Oddzon:

Thanks for the input. What would happen Sunday night/over the next week in terms of price and technical data if we lived in a world where the East is draining a dwindling supply of PMs, and where the world wants to eliminate the dollar? I can't think of a simple test for that. Don't worry if the evidence for that theory is also taken by one of my other "worlds", because such evidence would at least decrease the likelihood of one of these worlds.

As more hypotheses are added, we need to come up with more ways to tell between them. We don't have to get it all done before Sunday night, but since it looks like Sunday night will be a turning point, it would be helpful to, so we can use what happens as a test of our hypotheses (we have to be forward looking here, you can't design a hypothesis to fit past information unless you also plan to test its predictive power somehow, else it is just speculation).

Key Economic Events Week of 8/10

8/10 10:00 ET Job openings
8/11 8:30 ET Producer Price Idx
8/12 8:30 ET Consumer Price Idx
8/13 8:30 ET Initial jobless claims
8/13 8:30 ET Import Price Idx
8/14 8:30 ET Retail Sales
8/14 8:30 ET Productivity & Unit Labor Costs
8/14 8:30 ET Cap Ute and Ind Prod
8/14 10:00 ET Business Inventories

Oddzontmosley
Jun 29, 2013 - 10:04am

Flaw in you proposed Worlds

Where does the supply enter into your equation?

The East along with others have been draining substantial quantities of PM...more than the mining output. The gold price has even gone down lower than the cost to extract it from the ground. Needless to say, there is NOT an unlimited amount of PM available and what has been happening is unsustainable.

The World wants to eliminate the Dollar as the default currency. They don't want the US to dictate monetary policy anymore. Hoarding PM, using other currency to trade and halting the purchase policy to buy our bonds....doesn't this enter into the equation?

These two points don't even address the derivatives, EU country debt, the QE in the US, the QE in Japan and the free market manipulation across all free markets.

This is so big, I am surprised we aren't in a major war yet.

With all this going on, I believe they are driving down the prices to allow the EE to reverse their short position before they announce the findings of CFTC on manipulation.

To my point...this isn't checkers its chess with world class players.

Hrunner
Jun 29, 2013 - 9:53am

Job

As we go through gut-wrenching times in the market, when considering the endless propaganda and corruption from our "leaders", I find a strange comfort in reading the book of Job. Whether or not you believe in God, you may find wisdom here:

Job 15

2 “Would a wise person answer with empty notions
or fill their belly with the hot east wind?
3 Would they argue with useless words,
with speeches that have no value?
4 But you even undermine piety
and hinder devotion to God.
5 Your sin prompts your mouth;
you adopt the tongue of the crafty.
6 Your own mouth condemns you, not mine;
your own lips testify against you.

7 “Are you the first man ever born?
Were you brought forth before the hills?
8 Do you listen in on God’s council?
Do you have a monopoly on wisdom?
9 What do you know that we do not know?
What insights do you have that we do not have?
10 The gray-haired and the aged are on our side,
men even older than your father.

Good weekend,

H

tmosley
Jun 29, 2013 - 8:43am

Spartacus: Ok, let's try to

Spartacus:

Ok, let's try to frame this a little more effectively. I have proposed two possible worlds and designed tests to determine which one we live in. I want to have other people look at my descriptions of said worlds and make sure that the results I laid out would in fact be evidence that we live in one of those worlds. I am also happy to accept any other proposed worlds whose existence we can find evidence for come Sunday evening or with CoT movements next week. This is a predictive exercise, with any past evidence going to describe whichever the different worlds in which we may find ourselves.

For ease of reference, I will repost my cleaned up proposal:

1. If the market continue to behave as they have in the past (ie quasi-normal markets that aren't manipulated much more than they have been for the last 30 years), we will probably see a short squeeze in the PMs. Likely an epic one (as the short interest is much higher than it was in 2008, or even at the start of the bull market). This would likely lead to a renewed bull run. A short squeeze is fairly strong evidence for markets acting as they have for the last XX years (whether they have been manipulated or not is not in question here, that is a subject for another post).

2. If manipulated markets are falling apart (ie the "paper prices are headed to zero" thesis), we will see PMs continue to fall with no apparent reason behind it, or with reasoning that runs contrary to equity bullish reasoning, with short interest continuing to rise, above levels that could ever be reached by free markets. This scenario is fairly strong evidence of central bank intervention on behalf of the shorts (ie infinite free money to open new short positions).

In the case that PMs plunge at the open, we don't get any new strong evidence either way, as that is likely just a continuation of whatever force has been driving PMs down since QE(inf) was announced. This past behavior, however, is evidence of 2 over 1, but the point of this exercise is to make predictions.

In the case of no significant move, or a slow move upwards, I think we can say that there is another hypothesis that I (we) have missed.

If anyone disagrees with these cases, please let me know so we can move closer to understanding exactly what we are dealing with here. Other hypotheses are welcome, so long as there is some type of price or technical movement increases or decreases its likelihood come Sunday.

Ant
Jun 29, 2013 - 8:35am

Delays on delivery

Just thought I'd throw this in here.

On the 25th of June, I received an e-mail from a bullion dealer in Melbourne. It said:

"This email is in relation to the delays we have seen in the delivery of purchased physical gold and silver bullion and those clients whom are still waiting to receive notification that their bullion is available for collection.... We are waiting for Perth Mint to fulfill many of our orders, some from as far back as April."

Interesting.

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Key Economic Events Week of 8/10

8/10 10:00 ET Job openings
8/11 8:30 ET Producer Price Idx
8/12 8:30 ET Consumer Price Idx
8/13 8:30 ET Initial jobless claims
8/13 8:30 ET Import Price Idx
8/14 8:30 ET Retail Sales
8/14 8:30 ET Productivity & Unit Labor Costs
8/14 8:30 ET Cap Ute and Ind Prod
8/14 10:00 ET Business Inventories

Key Economic Events Week of 8/3

8/3 9:45 ET Markit Manu PMI July
8/3 10:00 ET ISM Manu PMI July
8/3 10:00 ET Construction Spending
8/4 10:00 ET Factory Orders
8/5 8:15 ET ADP employment July
8/5 9:45 ET Markit Service PMI
8/5 10:00 ET ISM Service PMI
8/6 8:30 ET Initial jobless claims
8/7 8:30 ET BLSBS for July
8/7 10:00 ET Wholesale Inventories

Key Economic Events Week of 7/27

7/27 8:30 ET Durable Goods
7/28 9:00 ET Case-Shiller home prices
7/29 8:30 ET Advance trade in goods
7/29 2:00 ET FOMC Fedlines
7/29 2:30 ET CGP presser
7/30 8:30 ET Q2 GDP first guess
7/31 8:30 ET Personal Income and Spending
7/31 8:30 ET Core inflation
7/31 9:45 ET Chicago PMI

Key Economic Events Week of 7/20

7/21 8:30 ET Chicago Fed
7/21 2:00 ET Senate vote on Judy Shelton
7/22 10:00 ET Existing home sales
7/23 8:30 ET Jobless claims
7/23 10:00 ET Leading Economic Indicators
7/24 9:45 ET Markit flash PMIs for July

Key Economic Events Week of 7/13

7/13 11:30 ET Goon Williams speech
7/13 1:00 ET Goon Kaplan speech
7/14 8:30 ET CPI for June
7/14 2:30 ET Goon Bullard speech
7/15 8:30 ET Empire State and Import Price Idx
7/15 9:15 ET Cap Ute and Ind Prod
7/16 8:30 ET Retail Sales and Philly Fed
7/16 11:00 ET Goon Williams again
7/17 8:30 ET Housing Starts and Permits

Key Economic Events Week of 7/6

7/6 9:45 ET Markit Service PMI
7/6 10:00 ET ISM Service PMI
7/7 10:00 ET Job openings
7/9 8:30 ET Initial jobless claims
7/9 10:00 ET Wholesale inventories
7/10 8:30 ET PPI for June

Key Economic Events Week of 6/29

6/30 9:00 ET Case-Shiller home prices
6/30 9:45 ET Chicago PMI
6/30 10:00 ET Consumer Confidence
6/30 12:30 ET CGP and SSHW to Capitol Hill
7/1 8:15 ET ADP Employment
7/1 9:45 ET Markit Manu PMI
7/1 10:00 ET ISM Manu PMI
7/1 2:00 ET June FOMC minutes
7/2 8:30 ET BLSBS
7/2 10:00 ET Factory Orders

Key Economic Events Week of 6/22

6/22 8:30 ET Chicago Fed
6/22 10:00 ET Existing home sales
6/23 9:45 ET Markit flash PMIs for June
6/23 10:00 ET New home sales
6/25 8:30 ET Q1 GDP final guess
6/25 8:30 ET Durable Goods
6/26 8:30 ET Pers Inc and Spending
6/26 8:30 ET Core inflation

Key Economic Events Week of 6/15

6/16 8:30 ET Retail Sales
6/16 8:30 ET Cap Ute and Ind Prod
6/16 10:00 ET Chief Goon Powell US Senate
6/16 4:00 pm ET Goon Chlamydia speech
6/17 8:30 ET Housing Starts
6/17 12:00 ET Chief Goon Powell US House
6/18 8:30 ET Initial Jobless Claims
6/18 8:30 ET Philly Fed
6/19 8:30 ET Current Account Deficit
6/19 1:00 pm ET CGP and Mester conference

Key Economic Events Week of 6/8

6/9 10:00 ET Job openings
6/9 10:00 ET Wholesale inventories
6/10 8:30 ET CPI for May
6/10 2:00 ET FOMC Fedlines
6/10 2:30 ET CGP presser
6/11 8:30 ET Initial jobless claims
6/11 8:30 ET PPI for May
6/12 8:30 ET Import price index
6/12 10:00 ET Consumer sentiment

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