Taylor On US Markets & Gold
Financial Markets
U.S. Treasuries May Remain Strong
Toward the end of 2004, your editor and many other market forecasters
opined that the key to 2005 would be interest rates. Rising interest rates
in an economy that has become addicted to artificially low rates of interest could finally puncture the remaining equity market bubbles and, most significant of all, the East Coast and West Coast housing bubbles. During December, there were definite signs that the "kindness of strangers"
that has allowed us Americans to live for today with a "what the hell"
attitude about tomorrow was wearing thin. I say that based on at least the
following two items that were voiced in public by two strong allies of the
U.S., namely Japan and Italy.
- On Sunday, December 5, Japan sent a warning to the Bush Administration
that there will be "enormous capital flight" from the dollar if the Bush
Administration maintains its laissez-faire approach to the mounting
currency crisis. The message, which was delivered to the White House by
Kaoru Yosano, a senior member of the ruling Liberal Democratic Party,
clearly suggested that Japan could start to sell off its
multibillion-dollar holdings of U.S. Treasuries, unless the U.S.
orchestrated a policy to defend the dollar.
- On December 15, Silvio Berlusconi, Prime Minister of Italy, complained to
President Bush about the weak U.S. dollar. President Bush responded to the
Italian prime minister by saying that he would try to bring about "the
conditions such that a strong dollar will emerge" by doing "everything we
can in the upcoming legislative session to send a signal to the markets
that we'll deal with our deficits, which hopefully will cause people to
want to buy dollars." Then, in a very unusual remark, President Bush added
that the Federal Reserve had, under "Alan Greenspan, raised the interest
rates yet again, a signal to the world markets that the chairman is also
aware of the relative currency valuations between the euro and the dollar."
Bush and Greenspan Respond to the Japanese and Italians
Since those thinly veiled threats from Japan and Italy, the
administration's posture as well as that of the Fed has grown increasingly
restrictive. Clearly attitudes and, more importantly, policies have changed
in this post-election environment and about the time of the
complaints/threats from Japan and Italy, you will note from the chart below
that the dollar index, has mounted a fairly strong rebound. The
all-important support level at $0.80 on the dollar index which was first
established back in 1991 has held. However, attitudes won't change the fact
that America's debt addicted economy won't face severe withdrawal pains
when something more akin to responsible policies is implemented into the
U.S., rather than the "let the baby have his milk" policies with which our
politicians have pampered a spoiled American electorate in recent years.
What is needed is for the U.S. to stop living beyond its means by saving
more and consuming less, but the switch over would, in my view, throw us
into an awful economic decline.
And so the question is whether Bush and Greenspan and his successor have
the courage to implement tough policies when it means finally causing
America to suffer a devastating decline in income and standard of living.
Or will they push these policies to the brink, only to chicken out at the
last minute?
Writing an essay for FallStreet.com on January 18, titled, "Ritual Slaughter?" Brandy Willett summed up the question I just posed as follows:
"In short, if Bush really wants to reduce the budget deficit to appease
foreign policy makers/dollar purchasers, and Greenspan really wants to do
his best impersonation of Volcker before he rides off to greener pastures,
this is, unequivocally, bad news for stocks. However, note the word
'really' because once policy makers take away the punch bowl they may have
a hard time explaining and sustaining their 'tough love' beliefs to
investors."
Will President Bush Have the Courage? Will Courage Matter?
Given my views that we are inevitably headed toward a deflationary
cleansing of the excesses of the market, I have always had a sense that at
some point the dollar would show surprising strength. But given the U.S.
addiction to foreign capital, I have come more recently to believe that
avoiding a major collapse of the U.S. dollar is a policy that must be
maintained at virtually all costs. It is a well-documented fact that we
Americans have enjoyed a consumption spree beyond belief because of low
interest rates made possible by foreigners reinvesting their export
earnings in the U.S.
What fewer people have focused on, however, is the really big reason why
the U.S. cannot afford to let the dollar fall too far, even if defending it
means a collapse of the U.S. housing and equity market and an evolution
into the Kondratieff winter depression. The survival of an American empire
that can send its military into foreign lands to secure sources of oil,
secure trade routes, and intimidate foreign leaders into "playing ball"
requires that the dollar remain the world's reserve currency. NOTHING IS
MORE IMPORTANT TO THE SURVIVAL OF U.S. SUPERPOWER STATUS THAN THE DOLLAR REMAINING AS THE WORLD'S RESERVE CURENCY.
Therefore, if it comes to a choice between sacrificing the U.S. stock
market and/or the U.S. economy by throwing it into a depression so as to
save the dollar and the bond market, I have no doubt such steps would be
taken. There is little doubt in my mind that that is what the ruling elite
will do, not only because their very existence will depend on it, but also
because they will have positioned themselves in advance to profit from a
catastrophic economic decline of us common folks. The notion that we have
policy makers who sincerely care about the American people is of course a
notion that must be fostered to maintain civil order. But I think if you
read books like "The Creature from Jekyll Island" by G. Edward Griffin, or
"Confessions of an Economic Hit Man" or "The Shadows of Power" by James
Perloff, to name just three sources, you will begin to understand that the
President and the Congress are more or less puppets to those who fund their
campaigns and print the money to keep government debt financed. In other
words, the banks, major corporations, and the folks that have been cashing
out of stocks over the past few years even as CNBC continues to encourage
you to keep putting your 401-k money into stocks.
So, will President Bush and Alan Greenspan or his successor have the
courage to throw the U.S. housing market, the U.S. economy, and the stock
market to the wolves in order to restore balance to the global markets and
thus save the dollar? I don't know about the courage of President Bush or
the Fed Chairman. But what I am more confident about is that ultimately Mr.
Bush will be guided to make the decisions that benefit the ruling elite,
and when those choices conflict with the best interests of the American
people, the American people will just have to suffer.
Implications for 2005 Markets
If I'm right about the need for U.S. policy to become restrictive, what will that likely mean for the markets we watch on an ongoing basis? First off, we see the early results of this policy switch in the dollar. The dollar's significant decline through most of 2004 has been abated at least for the moment.
What will it mean to the bond market? The Fed can raise short-term interest rates, and that is exactly what it has been slowly doing in a controlled manner since early in 2004. Yet, as can be seen from the yield on the 30-year bond, rates on the long end of the yield curve have actually
declined as the Fed has raised short-term rates. This tendency toward a
"flattening" of the yield curve is something we want to watch carefully
because, as John Mauldin recently pointed out, a flat yield curve has been
100% accurate as a recession forecasting tool in the U.S. With short-term
(3-month) Treasury rates at about 2.35%, and 30-year rates at around 4.66%, we have a way to go before we get a flat yield curve. But the direction is clearly there and as/if the Fed continues to raise short-term rates, and longer-term rates remain low, the prospects of a flat yield curve and thus a recession in 2005 would appear to be quite high, in my view.
What are the prospects for long-term rates remaining low? First of all, in
a very weak economy, which is what I assume we will have if policy remains
restrictive and the dollar remains stable, inflation rates should over the
longer term continue to trend down, until we experience across-the-board
deflation during the Kondratieff winter. Lower rates of inflation are
bullish for bonds. Secondly, I want to just briefly mention the work of my
friend Professor Antal E. Fekete, who argues very effectively, in my view,
that attempts by the Fed to fight deflation by pumping money into the
system actually worsens the deflationary dynamics of the cycle. He also has
recently talked about the powerful force of the yen carry trade in
continuing to drive down long-term U.S. interest rates. Antal provides some
very original thinking on Kondratieff cycle dynamics that I think
complements the work of Ian Gordon to a great extent and also helps us
understand why, despite delays, the Kondratieff winter is now bearing down
hard on us. In other words, I am turning more bullish on long-term U.S.
Treasuries and may in fact offer some ideas on how we might incorporate
longer-term Treasury exposure into our Model Portfolio. But as I noted
above, I want to mull this over after I have had a chance to discuss it
with Ian Gordon and Bob Hoye this coming weekend. With regard to corporate bonds, however, I am not nearly so bullish. As we enter the freeze-up period of the Kondratieff winter, credit quality can be expected to decline markedly, so that junk bonds and even some higher quality corporate obligations will begin a bear market. In other words, I anticipate a very significant widening of yields between U.S. Treasuries (which can always be repaid by way of the government printing press) and private sector obligors who do not have such a license to steal as do central banks.
What about Gold in This "Restrictive" Policy Environment?
The gold bull market that began in 2001 remains very much intact. I have no
doubt that if policy makers, and more specifically a subset of policy makers described by "The Wall Street Journal" as the "Plunge Protection Team," had not been dishoarding gold over the past decade, the price of gold would be much higher now; and stocks and financial assets would never have gotten as out of control as they have if these "creatures" had never done their best to trash the yellow metal in their efforts to promote the false idea that worthless paper is better for money than a gold-backed paper monetary system. But I take it as a given that as long as they are able, our current promoters of fiat money will do all they can to trash gold, or at the very least diminish it in the minds of ordinary folks, and marginalize folks like yours truly who insist gold is the money we must use if we are to ever move back toward a truly free market economy.
Okay, Taylor that's enough philosophy. Tell us what gold will do in light of your newly formed views that the dollar may not fall out of bed and that
the bond markets may remain strong at least for a while.
Ultimately, gold is sought as a medium of exchange whenever confidence is
lost in the existing monetary system. We last witnessed that in the United
States during the Kondratieff summer when inflation rates rose to double
digits and fears were that they would accelerate into a hyper-inflationary
environment. Because people were losing confidence in the purchasing power
of the dollar, Americans and folks around the world began to sell dollars
and buy commodities and gold in an effort to keep their wealth from
evaporating away. Paul Volcker threw the U.S. economy into the toughest
recession since the 1930s in 1980-82. It saved the fall of the dollar and
put gold into a 20-year bear market until 2002, when the current bull
market in gold began.
Because of that experience, most people think of gold as an inflation
hedge. But during Japan's deflationary period, gold briefly became sought
after when policy makers said they would reduce deposit insurance coverage.
People in Japan knew the Japanese banks were virtually bankrupt so without
insurance coverage people could have lost the yen that they had deposited
in Japanese banks. The Japanese reversed their policy of reducing insurance
because they knew they couldn't let gold become de facto money in Japan.
For the time being, that stopped the move from fiat money to gold but it
serves as an example of how people demand gold during a deflation because
they lose confidence in the monetary system.
I anticipate at some point in the future, that the ability to retain control of our monetary system will be lost, or that at least confidence in that ability will be severely impaired. That may arrive simply from some exogenous threat such as war, or oil prices rising dramatically (which I view as deflationary not inflationary for the U.S.), or some other unforeseen event-or it could simply take place more slowly as the U.S. economy continues to deteriorate during the Kondratieff winter purely under the enormous debt burden that we have taken on by applying Keynesian policies in an attempt to outrun deflation.
January 21, 2005
Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com
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