This Is The Biggest Debt Bubble In History

The new edition of the Thunder Road report takes an holistic view on the economy, markets, and currencies. It concludes with the implications for gold. In this article we pick out the highlights of the current evolution in equities, currency wars, the debt crisis and gold.

Economic and equity markets update

Economic conditions remain weak worldwide. While the US appears to be in a slightly better condition than the rest of the world, it remains unstable, for sure given the draconian monetary measures undertaken by the central banks.

Starting earlier this year, mainly the US equity markets began a decoupling with a bunch of other indicators, including global economic growth, stock markets globally, industrial production, employment, and (most) commodity prices including lumber (which is an indicator of the housing market strength). By contrast, the S&P 500 for instance, shows an almost perfect correlation only with the excess deposits, i.e. Deposits minus Loans in US commercial banks.

s&p500_vs_QE3

The divergences which we just mentioned are probably indicative of the increased impact of extreme monetary policies, at the expense of fundamentals, and huge associated flows of liquidity – currently back from emerging to developed markets. Presumably, QE creates excess deposits in the banking system which are deployed by the banks (since they create an “investment need” according to JPMorgan Chase) and have a positive impact on risk assets, including equities, via collateralised transactions in the shadow banking system. That is probably the underlying driver for the continuation of the bull market in US equities.

The one million dollar question is if US equities are the last to follow the downtrend and for how long monetary stimulus will continue to create impact.

Currency war update

The BRICS nations have been instensifying their actions (not only words) which signal the risk of a currency war resulting from loose monetary policies of developed nations. The recent tapering debate and the sudden strength in the dollar have turned this situation on its head. What is clear is that the BRICS are becoming increasingly annoyed with being on the receiving end of the VARIABILITY in G7 monetary policy and the instability it is causing.

The significance of the BRICS meeting in March 2012 should not be underestimated. During the meeting, the BRICS made it their policy to increase trade in local currencies. China has led the way, setting up bilateral currency swaps with almost all of its major trading partners. More than 15% of its external trade is now settled in Yuan. The BRICS are in the early stages of the dismantling of the dollar’s monopoly on world trade.

Meanwhile, it’s clear that tensions are rising between the BRICS and G7, especially the US. This is worrying given the fragile state of the global economy. We are not there yet…we might not get there…but there is increased RISK OF A FULL-BLOWN CURRENCY CRISIS HITTING THE BRICS, beginning with India, Brazil and South Africa. India looks particularly vulnerable. If this unfolds, it would almost certainly lead to a stand-off between the BRICS and the US. In an extreme case, the former could try to support their currencies with their vast (mainly US$) forex reserves.

Debt crisis update

There are an increasing number of signals that the debt injection effect is slowing down. Several of those signs are discussed below. Additionally, the sharp rise in interest rates lately is probably the worst nightmare of central planners. To illustrate that, the following paragraph compares today’s situation with the one in the Great Depression.

There is spectacular irony in the danger from rising interest rates with respect to Bernanke… Before being appointed Fed Chairman, he gave several speeches on combating deflation. Among them is “Money, Gold and the Great Depression” from 2 March 2004. In this speech, Bernanke recounted a series of policy mistakes which led to the Great Depression and, subsequently, contributed to its severity. Each mistake Bernanke highlighted during 1928-33 involved a tightening of monetary policy, exactly as the Fed has proposed recently. However, the real irony is the manner in which the Fed tightened monetary policy in 1932 via the reversal of open-market operations – basically reducing QE! The open-market operations had pushed down rates on government bonds and corporate debt which started to rise. According to Bernanke

“These policy makers did not appear to appreciate that, even though nominal interest rates were very low, the ongoing deflation meant that the real cost of borrowing was very high because any loans would have to be repaid in dollars of much greater value.” Here is the recent trend in real interest rates in the US, based on the benchmark 10-year:
Barclays US Inflation linked 7-10 years real yield (%).

rising_interest_rates_july_2013

Rising real rates combined with so much debt is a potent force which could prematurely burst the credit bubble. BERNANKE HAS TIGHTENED POLICY WITHOUT DOING A THING. He has effectively achieved a “reverse Draghi.” Meanwhile, let’s consider the current strength of the US economy in terms of purchasing manager surveys, jobs, housing, etc. Ironically, when QE3 was announced on 13 September 2012, the latest reported figure for the ISM manufacturing survey was 50.7, for August 2012. When the FOMC announced its intention to taper, the latest ISM manufacturing number was even lower at 49.0 (May 2013) and signifying contraction. Since then, the June 2013 number was reported at 50.9, basically unchanged versus the QE3 announcement. The Non-manufacturing ISM has been on a downward trend for four months and is 2.1 points lower than when QE3 was announced.

US_non_manufacturing_index_july_2013

Furthermore, there is a rising divergence between monetary stimulus and employment post-QE3 as the Fed has increasingly attempted to establish the (tenuous) link between QE and employment.

The bright spots in the US economy are obviously housing and the auto market. Data in those markets look contained but show signs of a slowdown. They are not confirmed yet. It could take some months before we get an accurate view on the trend.

Money & Gold During The Biggest Debt Bubble In History

Excessive monetary stimulus and low interest rates create financial bubbles. This is the biggest debt bubble in history. It is a potent deflationary force and central banks are forced into deploying increasingly aggressive (offsetting) inflationary forces. The avoidance of a typical deflationary resolution to this economic long (Kondratieff) wave is pushing the existing monetary system beyond the point of no return. The purchasing power of the developed world’s currencies will have to bear the brunt of the “adjustment”. Preparations for this by the BRICS nations, led by China, are advancing rapidly. The end game is an inflationary/currency crisis, dislocation across credit and derivative markets, and the transition to a new monetary system. A new “basket” currency is likely to replace the dollar as the world’s reserve currency. The “Inflationary Deflation” paradox refers to the coming rise in the price of almost everything in conventional money and simultaneous fall in terms of gold.

It’s abundantly clear that this is where (massive) systemic risk lies…we can only hope that we don’t return to “stressed market conditions” for as long as possible. The Federal Reserve is acutely aware of these risks – as we’ll demonstrate – but doesn’t identify them specifically. The closest we got is probably the speech on 28 June 2013 by Fed governor, Jeremy Stein, who commented: “Although asset purchases also bring with them various costs and risks – and I have been particularly concerned about risks relating to financial stability – thus far I would judge that they have passed the cost-benefit test.”

As for the gold market, we have been shouting from the rooftops since 2006-7 that the gold market is a gigantic fractional reserve system consisting of a vast quantity of paper claims to gold bullion and a much smaller inventory of actual bullion. Thanks to Ned Naylor-Leyland of Cheviot Asset Management for pointing me in the direction of the Reserve Bank of India’s January 2013 report “Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loans by NBFCs.” On page 58 is the following data sourced from the CPM Gold Yearbook 2011:

bank_of_india_futures_vs_physical_gold_2013

In the words of the RBI: “the traded amount of ‘paper linked to gold’ exceeds by far the actual supply of physical gold: the volume on the London Bullion Market Association (LBMA) OTC market and the major Futures and Options Exchanges was OVER 92 TIMES that of the underlying Physical Market.”

The CFTC’s Bank Participation Report on trader positions on COMEX for June 2013 showed that the US bullion banks had moved to a net long position of nearly 30,000 contracts (3 million oz.) from a huge net short position of 106,000 contracts (10.6 million oz.) when gold peaked in October 2012 – an overall swing of about $20 billion in fiat terms – into a declining market.

The July 2013 data shows that the US bullion banks increased their net long position to almost 45,000 contracts, while speculators (hedge funds?) increased shorts and reduced longs.

Are the banks (finally) getting ready to squeeze the funds, or are they preparing for another big raid? We hope the latter given that the apparent depletion of gold inventory in the vaults continues.

Furthermore, Rabobank has followed in the footsteps of ABN Amro in suspending delivery of physical bullion to its clients. With rumours circulating that a major bullion bank is preparing to change its delivery agreements, the implication being that it too will suspend or curtail physical delivery, we are wondering whether the breakdown in the physical versus paper gold markets is approaching…leading to price discovery for physical gold itself.

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