Michael
Pento: Farewell Paul Volcker Hello Monetary Madness
God bless Paul Volcker. He
was truly a one of a kind central banker, and we probably won’t see another one
like him ever again. It took his extreme bravery to crush the inflation caused
by the monetary recklessness of Arthur Burns and the fiscal profligacy of
Presidents Johnson & Nixon. Raising interest rates to 20% by March 1980 was
wildly unpopular at the time. But in the end, it was what the nation needed and
paved the way for a long period of economic stability and prosperity.
Back in 1971, the world fully
had developed a new monetary “technology.” Governments learned that money need
no longer be representative of prior efforts, or energy expended, or previous
production, or have any real value whatsoever. It can be just created by a
monetary magic wand; and done so without any baneful economic consequences.
This phony fiat money can, in
the short-term, cause asset values to increase far above the relationship to
underlying economic activity. And now, having fully shed the fettering
constraints of paper dollars that are backed by gold, central banks have
printed $22 trillion worth of confetti since the Great Recession to keep global
asset bubbles in a perpetual bull market. Now, anyone whose brain has evolved
beyond that of a Lemur understands that this can only be a temporary
phenomenon–one where the ultimate consequences of delaying reality will be all
the more devastating once they arrive.
This magic monetary wand is
also being used to push borrowing costs down to record low levels—so much so,
that some governments and corporations are now getting paid when they borrow.
Therefore, it’s no wonder to those of us who live in reality that both the
public and private sectors tend to pile on much more debt when both real and
nominal interest rates are negative. Indeed, debt has been piling up at a
record pace. Amazingly, central bankers find themselves in complete denial when
it comes to this reality.
To this point, The U.S.
budget deficit for the month of November was $209 billion and is running a
deficit of $343 billion for just the first two months of fiscal 2020. And, we
have the following three data points from my friend John Rubino .
• Total US credit (financial
and non-financial) jumped by $1.075 trillion in Q3 2019, the strongest
quarterly gain since Q4 2007. The total is now $74.862 trillion, or 348% of
GDP.
• U.S. Mortgage Lending
increased $185 billion, the strongest quarterly gain since Q4 2007.
• M2 money supply surged by
an unprecedented $1.044 trillion over the past year, or by 7.3%.
Not only this, but Morgan
Stanley’s research shows that nearly 40% of the Investment Grade corporate bond
market should actually be rated in the junk category based upon their debt to
EBITA ratios. In fact, the entire corporate bond market has a record net debt
to EBITA ratio. And, the total amount of US corporate debt now equals a record
high 47% of GDP. In the third quarter of this year, US business debt eclipsed
household debt for the first time since 1991. And, according to Blackrock,
global BBB debt, which is the lowest form of Investment Grade Debt, now makes
up over 50% of the entire investment grade market versus only 17% in 2001.
Here is another fun fact: The
IMF calculated that in the next financial crisis– if it is only half as severe
as 2008–zombie corporate debt (which consists of companies that don’t have
enough profits to cover the interest on existing debt) could increase to $19
trillion, or almost 40% of the total amount of corporate debt that exists in
the developed world.
The problem should be clear
even to the primates that govern our money supply. Global governments have
already proven completely incapable of ever normalizing interest rates, and
every moment they continue to force borrowing costs at the zero-bound level
compels these corporations to pile on yet more debt. This means the corporate
bond market is becoming increasingly more unstable, just as it also raises the level
from which bond prices will collapse–when not if, the next recession arrives.
And speaking of recession,
during the next economic contraction, the US national deficit should rise
towards $3 trillion per year (15% of GDP) and that will add quickly to the
National Debt, which is already at $23 trillion (106% of GDP). Meanwhile, while
US Treasury issuance will be exploding in size, the $10 trillion worth of US
corporate debt will also begin to implode. This means the Fed should be forced
to purchase trillions of dollars in Treasury debt at the same time it has to
print trillions more to support collapsing corporate bond prices.
That amount of phony fiat
money creation would eclipse QEs 1,2,3, & the Fed’s currently denied QE 4
all put together. I wonder what name Jerome Powell will put on his non-QE 5
when the time arrives? If investors are unprepared to navigate the dynamics of
depression and unprecedented stagflation, it could mean the end of their
ability to sustain their standard of living. A totally different kind of
investment strategy is needed during an explicit debt restructuring as opposed
to one where the government pursues an inflationary default on its obligations.
I believe governments will pursue both methods of default at different times. Determining
when and how the government reneges on its obligations is crucial. That is what
the Inflation/Deflation and Economic
Cycle Model SM was built to do. Get prepared while you still have time.
4 Stages of Monetary Madness
There are four stages of fiat money printing that have been used
by central banks throughout their horrific history of usurping the market-based
value of money and borrowing costs. It is a destructive path that began with
going off the gold standard and historically ends in hyperinflation and
economic chaos.
Stage one is the most benign of the four, but it sets the stage
for the baneful effects of the remaining three. The first level of monetary
credit creation uses the central banks’ artificial savings to set short-term
interest rates through the buying and selling of short-duration government
debt. This stage appears innocuous to most at first but is insidiously
destructive because it prevents the market from determining the cost of money.
This is crucially important because all assets are priced off of the so called
“risk-free” rate of return. A gold standard keeps the monetary base from rising
more than a few percentage points per annum and thus restrains bank lending.
However, having a fiat currency also means a nation has a fiat monetary base.
This leads to unfettered bank lending and the creation of asset bubbles.
The second stage of monetary madness has been around for decades
but is now commonly known as Quantitative Easing (QE). After several cycles of
lower and lower short-term interest rates that are intended to bring the
economy out of successive recessions, the central bank (CB) ends up pegging
rates at zero percent or below. Once CBs run out of room on the downside of
short-term rates they go out along the yield curve and begin to artificially
push down borrowing costs for long-term debt. It is important to note that at
this stage CBs only purchase assets on private banks’ balance sheets and at
least pretend they will someday liquidate these holdings.
The third level of monetary madness is now being threatened to be
imposed upon the population by central banks across the globe. This stage is
called “Helicopter Money” and is the brainchild of noted economist Milton
Friedman. But in reality, versions of it have been used many times prior to Mr.
Friedman’s appellation of central bank money drops. Friedman argued the use of
Helicopter Money to combat deflation, but it has been traditionally used to
help an insolvent government service its debt.
At its core, Helicopter Money is defined to be the issuance of
non-maturing government debt or the direct issuance of credit to the public
that is financed by the central bank. Both forms of money drops operate most
efficiently by circumventing the private banking system. This is because CBs
and governments don’t have to worry about private banks deciding to forgo
buying more government debt if favor of holding the fiat credit as excess
reserves. Helicopter Money allows citizens the direct access to new credit
without the threat of having it unwound from the CB. The main difference
between non-maturing debt issuance and direct public credit is the former
allows the government to direct who gets the new money, and the latter gives
the CB that discretion. But in either case, Helicopter Money amounts to a
direct increase in the broad money supply and inflation.
As I mentioned in last week’s commentary, The Bank of Japan and perhaps
even The European Central Bank are seriously contemplating saying “get to the
chopper” very soon. Alas, once you get to level 3 there will be an inexorable
march towards the next level. This is because there is no calling in the
helicopters without causing a devastating plunge in asset prices and a bond
market collapse, which results in massive economic chaos.
This brings us to the final stage of central bank intervention,
which is the interminable and direct purchase of sovereign debt by a central
bank for the sole purpose of keeping interest rates from spiraling out of
control. Hence, the 4th stage of Monetary Madness occurs once inflation becomes
fully entrenched in the economy.
It would be pure folly to assume that central banks can achieve
their 2% inflation targets with impeccable precision. Years’ worth of deficit
spending, surging debt to GDP ratios and a gargantuan increase in central
banks’ balance sheets will eventually lead to a significant erosion in the
confidence of central bankers to maintain the purchasing power of fiat money.
Therefore, inflation won’t just magically stop at 2%; it will eclipse that
level and continue to rise.
But that’s only half of the issue. Sovereign bond yields have been
slammed so far down by CBs that nearly 30% of the entire supply of
government-issued debt now trades below zero percent. The return of inflation
must surely cause a mass exodus of longs from the bond market, just as short
sellers begin to pile on top. The bond market will also respond in violent
fashion—taking yields up 100’s of basis points rather quickly—due to the
anticipation of waning bond bids from central bankers.
Of course, surging debt service payments will render
debt-saturated governments completely insolvent, which forces central banks
into stage 4. Sadly, this is the conclusion that lies ahead for the developed
world. Investors should not become complacent with the current innocuous state
of global bond yields. In reality, they have become incendiary bombs that will
inevitably explode with baneful implications for those that are not fully
prepared.
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