The Arrival Of The Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:

“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.”

The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

If it was only down to America without further feed-back loops, we can now suggest the following developments are likely for the US economy. Warnings about an economic slowdown are persuading the Fed to soften monetary policy, a process recently set in motion and foreshadowed by US Treasury yields backing off. However, price inflation, which is being temporarily suppressed by falling oil prices, will probably begin to increase from Q2 in 2019. This is due to a combination of the legacy of earlier monetary expansion, and the consequences of President Trump’s tariffs on consumer prices.

After a brief pause, induced mainly by the threat of an unstoppable collapse in equity prices, the Fed will be forced to continue to raise interest rates to counter price inflation pressures, which will take the rise in the heavily suppressed CPI towards and then through 4%, probably by mid-year. The recent seizure in commercial bond markets and the withdrawal of bank lending for working capital purposes sets in motion a classic unwinding of malinvestments. Unemployment begins to rise sharply, and consumer confidence goes into reverse.

Equity prices continue to fall, as liquidity is drained from financial markets by worried investors, but price inflation remains stubbornly high. Consequently, bond prices continue to weaken under a lethal combination of foreign-owned dollars being sold, increasing budget deficits, and falling investor confidence in the future purchasing power of the dollar.

The US enters a severe recession, which is similar in character to the 1930-33 period. The notable difference is in an unbacked pure fiat dollar, which being comprised of swollen deposits[ii] (currently 67% of GDP versus 36% in 2007), triggers an attempted reversal of deposit accumulation. The purchasing power of the dollar declines, not least because over $4 trillion of these deposits are owned by foreigners through correspondent banks.

One bit of good news is the US banking system is better capitalised than during the last crisis and is unlikely to be taken by surprise as much it was by the Lehman crisis. Consequently, US banks are likely act more promptly and decisively to protect their capital, driving the non-financial economy into a slump more rapidly by calling in loans. Price inflation will not subside, because that requires sufficient contraction of credit to offset the declining preference for holding money relative to goods. Any credit contraction will be discouraged by the Fed, seeking to avert a deepening slump by following established monetary remedies.

The Fed’s room for manoeuvre will be severely restricted by rising price inflation, which it can only combat with higher interest rates. Higher interest rates will become a debt trap springing tightly shut on government finances, forcing the Fed to buy US Treasuries under cover of monetary stimulation. The true reason for QE will be that with a rapidly escalating budget deficit exceeding $1.5 trillion and more, the Fed will want to suppress borrowing costs compared with what the market will demand. Economic conditions will be diagnosed as a severe case of stagflation. In reality, the US will be ensnared in a debt trap from which the line of least resistance will be accelerating monetary inflation.

It will prove difficult for neo-Keynesian central bankers to understand the seeming contradiction that an economy can suffer a slump and escalating price inflation at the same time. It is, however, the condition of all monetary inflations and hyperinflations suffered by economies with unbacked fiat currencies. The choice will be to rewrite the textbooks, discarding current groupthink, or to soldier on. We can be certain the neo-Keynesians will soldier on, because they are intellectually unable to reform existing monetary policy in a manner acceptable to them.

That would be the likely outcome of the developing credit crisis if it wasn’t for external factors. There is precedent for it, and we can expect it from a purely theoretical analysis. It would be a rolling crisis, becoming progressively worse, taking six months to a year to unfold, followed by a period of economic recovery. But there is a major snag with this analysis for the US economy, and that is US monetary policy has long been coordinated with the monetary policies of other major central banks through forums such as the Bank for International settlements, G20 and G7 meetings.

The surprise election of President Trump upset this apple-cart with his untimely budget stimulus and the havoc he is wreaking on international trade. The result is the Fed is no longer on the same page as the other major central banks, particularly the Bank of Japan and the European Central Bank. Therefore, unlike crisis phases of previous credit cycles, the Eurozone enters it with negative interest rates, as does Japan, which are creating enormous currency and banking tensions. We will put Japan to one side in our search for knock-on systemic and economic effects triggered by the Fed’s increase in interest rates, and instead focus on the Eurozone, the heart of the European Union.

The Eurozone is irretrievably bust

It is easy to conclude the EU, and the Eurozone in particular, is a financial and systemic time-bomb waiting to happen. Most commentary has focused on problems that are routinely patched over, such as Greece, Italy, or the impending rescue of Deutsche Bank. This is a mistake. The European Central bank and the EU machine are adept in dealing with issues of this sort, mostly by brazening them out, while buying everything off. As Mario Draghi famously said, whatever it takes.

There is a precondition for this legerdemain to work. Money must continue to flow into the financial system faster than the demand for it expands, because the maintenance of asset values is the key. And the ECB has done just that, with negative deposit rates and its €2.5 trillion Asset Purchase Programme. That programme ends this month, making it the likely turning point, whereby it all starts to go wrong.

Most of the ECB’s money has been spent on government bonds for a secondary reason, and that is to ensure Eurozone governments remain in the euro-system. Profligate politicians in the Mediterranean nations are soon disabused of their desires to return to their old currencies. Just imagine the interest rates the Italians would have to pay in lira on their €2.85 trillion of government debt, given a private sector GDP tax base of only €840bn, just one third of that government debt.

It never takes newly-elected Italian politicians long to understand why they must remain in the euro system, and that the ECB will guarantee to keep interest rates significantly lower than they would otherwise be. Yet the ECB is now giving up its asset purchases, so won’t be buying Italian debt or any other for that matter. The rigging of the Eurozone’s sovereign debt market is at a turning point. The ending of this source of finance for the PIGS[iii] is a very serious matter indeed.

A side effect of the ECB’s asset purchase programme has been the reduction of Eurozone bank lending to the private sector, which has been crowded out by the focus on government debt. This is illustrated in the following chart.

Following the Lehman crisis, the banks were forced to increase their lending to private sector companies, whose cash flow had taken a bad hit. Early in 2012 this began to reverse, and today total non-financial bank assets are even lower than they were in the aftermath of the Lehman crisis. Regulatory pressure is a large part of the reason for this trend, because under the EU’s version of the Basel Committee rules, government debt in euros does not require a risk weighting, while commercial debt does.[iv] So our first danger sign is the Eurozone banking system has ensured that banks load up on government debt at the expense of non-financial commercial borrowers.

The fact that banks are not serving the private sector helps explain why the Eurozone’s nominal GDP has stagnated, declining by 12% in the six largest Eurozone economies over the ten years to 2017. Meanwhile, the Eurozone’s M3 money increased by 39.2%. With both the ECB’s asset purchasing programmes and the application of new commercial bank credit bypassing the real economy, it is hardly surprising that interest rates are now out of line with those of the US, whose economy has returned to full employment under strong fiscal stimulus. The result has been banks can borrow in the euro LIBOR market at negative rates, sell euros for dollars and invest in US Government Treasury Bills for a round trip gain of between 25%-30% when geared up on a bank’s base capital.

The ECB’s monetary policy has been to ignore this interest rate arbitrage in order to support an extreme overvaluation in the whole gamut of euro-denominated bonds. It cannot go on for ever. Fortunately for Mario Draghi, the pressure to change tack has lessened slightly as signs of a US economic slowdown appear to be increasing, and with it, further dollar interest rate rises deferred...

- Source, James Turk's Goldmoney, Read More Here

The Tragedy Of The Euro

After two decades, the euro’s minders look set to drive the Eurozone into deep trouble. December was the last month of the ECB’s monthly purchases of government debt. A softening global economy will increase government deficits unexpectedly. The consequence will be a new cycle of sharply rising bond yields for the weakest Eurozone members, and systemically destabilising losses in the bond portfolios owned by Eurozone banks

The blame-game

It’s the twentieth anniversary of the euro’s existence, and far from being celebrated it is being blamed for many, if not all of the Eurozone’s ills.

However, the euro cannot be blamed for the monetary and policy failures of the ECB, national central banks and politicians. It is just a fiat currency, like all the others, only with a different provenance. All fiat currencies owe their function as a medium of exchange from the faith its users have in it. But unlike other currencies in their respective jurisdictions, the euro has become a talisman for monetary and economic failures in the European Union.

Recognise that, and we have a chance of understanding why the Eurozone has its troubles and why there are mounting risks of a new Eurozone systemic crisis. These troubles will not be resolved by replacing the euro with one of its founding components, or, indeed, a whole new fiat-money construct. It is here to stay, because it is not in the users’ interest to ditch it.

As is so often the case, the motivation for blaming the euro for some or all the Eurozone’s troubles is to shift responsibility from the real culprits, which are the institutions that created and manage it. This article briefly summarises the key points in the history of the euro project and notes how the mistakes of the past are being repeated without the safety-net of the ECB’s asset purchases.

The birth of the euro

To swap a number of existing currencies for a wholly new currency requires the users to accept that the purchasing powers of the old will be transferred to the new. This was not going to be a certainty, and the greatest reservations would come from the people of Germany. Germans saved, and therefore risked the security of their deposits in a new money and monetary system. They were reassured by the presence of the hard-money men in the Bundesbank, who had a mission to protect the mark’s characteristics against the weaknesses that would almost certainly be transferred into the new euro from more inflationary currencies.

These anxieties were assuaged to a degree by establishing the ECB in Frankfurt, close to the watchful eye of the Bundesbank. The other nations were sold the project as bringing greater monetary stability than offered by their individual currencies and the reduction of cross-border transaction costs. Borrowers in formally inflationary currencies also relished the prospect of lower interest rates.

It was clear at the outset that the new omnibus euro required new disciplines, and it was here that the system failed from the outset. Having sensibly set out the euro’s parameters in the Maastricht Agreement, political considerations then took over. The raison d’être of the euro, so far as the politicians were concerned, was to further the European Project and getting countries into the new Eurozone became more important than compliance with the terms.

The terms had been set in the Maastricht Treaty in February 1992, which was signed by the twelve members of the pre-existing European Community. To qualify, membership of the euro required an inflation rate no more than 1.5% higher than the average rate of the three lowest member states, a fiscal deficit of no more than 3% at the end of the preceding fiscal year, a ratio of gross government debt to GDP of no more than 60%, membership of the exchange rate mechanism for two years without devaluation, and long-term interest rates no more than 2% higher than the inflation rates of the three lowest inflation rates.

This was sensible stuff but was then ignored by the Maastricht signatories. Only Luxembourg fully qualified for membership under the Maastricht terms.[ii]

Even the EU’s sheet-anchor, Germany, failed. Her budget deficit in 1996 was 4% of GDP. France’s was managed (manipulated?) down to 4% from 5%. Greece’s budget deficit after some very creative accounting was shown as 8%, and Italy’s must have had a papal blessing, because it miraculously fell from 8% to 4%.[iii]

Germany’s government debt to GDP in 1996 embarrassingly just exceeded the 60% criteria level set at Maastricht. Belgium’s stood at 130%, Italy’s at 124%, and Greece’s (reportedly) at 110%. What debt? We see no debt. Of the original Maastricht signatories, only France and the UK squeezed through on this condition.

Despite this fudge, ten of the twelve Maastricht signatories went ahead and adopted the euro in 1999 and as circulating currency in 2002. The UK had dropped out of the EMU in September 1992, and Greece was so obviously non-compliant its entry was delayed by two years.

Until the Lehman crisis, national interest rates had converged towards Germany’s under the aegis of a common monetary policy. The ECB’s interest rate policy was necessarily a compromise. At one end of the spectrum were the low rates previously enjoyed by the economies with solid savings rates. These were Germany, Luxembourg, Finland, the Netherlands and Austria.

At the other end were the bad boys: notably Greece and Italy. In 1992, when Maastricht was signed, Greece’s overnight lending rate was 28%. By 1996, when the Commission released its first convergence report, it had fallen to 12.8%. When Greece joined the euro in 2001, it had fallen to 3.3%. Italy’s 3-month interbank rate fell from 13% to 9%, and then to 3.4% at these same times.

The ECB’s task was not helped by the careless assumption that savings rates were a drag on consumption. Capital which had originated as credit expansion instead of genuine savings migrated to nations with higher bond yields, first as a trickle but then in increasing quantities as confidence grew that monetary unification under the euro was there to stay. This being the case, it was believed by investors that investing in Italian and Spanish debt was as safe as investing in German and French debt for less return.

The capital flows into these savings-starved nations boosted their asset prices and GDPs. And the more that credit-originated capital flooded into them, the more asset prices and GDPs benefited. This meant that based on improving statistics, the euro was deemed a great success, lifting the Mediterranean nations out of poverty. The reality was that capital flows ended up in malinvestments and government profligacy. No one thought to complain, and Germany’s sound-money men were silenced by those who pointed to Germany’s growing exports to the high-spending euro members.

In this manner, the ECB’s monetary policy gave impetus to localised credit cycles, particularly for the PIGS and Ireland.[iv]Asset booms were turned into bubbles, which finally burst in the wake of the Lehman crisis. The EU’s monetary system was then saddled with trillions of euros of debt that could never be repaid, and the PIGS suddenly found further finance from the markets was unavailable. Interest rate convergence was reversing. Furthermore, the whole Eurozone banking system was threatened with collapse, which always happens when extreme credit bubbles go pop.

Member states had no realistic option but to bail out their banks, and public sector borrowing rocketed, funded by the EU, the ECB and the IMF. The crisis in Greece was worsened when in late 2009 the government was forced to admit it had lied about its budget deficit for years, and finally admitted to a far higher current-year deficit than previously disclosed. Greece’s 2009 budget deficit was doubled from about 7.5% to 15.1%. The rise in bond yields meant Greece was unable to continue to fund her deficits and roll over existing debt and capital fled to supposedly safer Eurozone jurisdictions.

Greece’s corrupt government was replaced in January 2015 by a far-left government, elected because it promised the voters it would reject onerous bailout terms. It turned out that as far as the ECB and Brussels were concerned, Greece’s problems were to stay in Greece, and any hopes that its troubles would be shared with the Eurozone were dashed.

In effect, it appeared that the expense of rescuing a very small member of the Eurozone risked destabilising the others. Yanis Varoufakis, the Greek finance minister, said the reason for the EU’s uncompromising approach was it was protecting the German banks from losses. A sensible compromise to help a member state struggling with debt had been dismissed out of hand.

- Source, James Turk's Goldmoney

Alasdair Macleod: Asset Price Collapse Like 1929

The financial situation right now is looking like before the Great Depression, says Alasdair MacLeod from GoldMoney. 

MacLeod first updates us on Brexit. Is the UK going to do a hard Brexit, go for Theresa May's proposal, or something else? 

He shares the positives and negatives of the possibilities. MacLeod says the US is experiencing an asset price collapse, which looks similar to right before the Great Depression. 

He shares the factors, such as seasonal buying and a weaker trend for the US dollar, creating a perfect storm for gold in 2019.

- Source, Silver Doctors

Gold: A Perfect Storm For 2019

For gold bulls, 2018 was disappointing. From 11 December 2017, when gold made a significant bottom against the dollar at $1243, it has ended virtually unchanged today, after being 4.2% up. Gold had to struggle against a rising dollar, whose trade-weighted index rose a net 3.7% over the same period, and as much as 9.4% from its mid-February low.

Dollar strength has been driven less by trade imbalances and more by interest rate differentials. A speculating bank for its own book or for a hedge fund client can borrow 3-month Euro Libor at minus0.354% and invest it in 3-month US Treasury bills at 2.36%, for a round trip of over 2.7%. Gear this up ten times or more, either on a bank’s capital, or through reverse repos for annualised returns of over 27%. To this can be added the currency gain, which at times has added enough to overall returns for an unhedged geared position to double the investment.

Not that these forex returns have been guaranteed, but you get the picture. The ECB and the Bank of Japan have been frozen into inactivity, reluctant to raise rates to correct this imbalance, and the punters have known it.

Financial commentators have routinely misunderstood the fundamental reason for the dollar’s strength, attributing it to foreigners’ desperate need for dollars. In fact, non-US holders of dollars hold it in record amounts, with over $4 trillion in deposits in correspondent bank accounts alone, and a further $930 billion in short-term debt.[i] This $5 trillion of total liquidity was the last reported position, as at end-June 2017. Speculative dollar demand since then, driven by interest rate differentials, will have added significantly to these figures. The continuing US trade deficit, currently running at close to a trillion dollars annually, is both an associated and additional source of dollar accumulation in foreign hands.

Meanwhile, the same US Government data source reveals that US residents’ holdings of foreign securities was $6.75 trillion less than the foreign ownership of US securities, and the US Treasury reports that major US market participants (i.e. the US banks and financial entities operating in the spot, forwards and futures contracts) sold a net €2.447 trillion in the first nine months of 2018. Assuming these sales were not absorbed by official intervention on the foreign exchanges or by contracting bank credit, they can only have added to foreign-owned dollar liquidity.[ii]

To summarise the point; far from there being a dollar shortage, as market participants believe, the world is awash with dollars to an extraordinary degree.

The great dollar unwind is now overhanging markets, which will remove the principal depressant on the gold price. And when it begins, as a source of supply these hot-money dollars will be seen as the continuation of escalating supply, with the prospect of future US trade and budget deficits to be discounted. These dynamics are a duplication of those that led to the failure of the London gold pool in the late-sixties, which led to the abandonment of the Bretton Woods gold-dollar relationship in 1971. And as I argue later in this article, the supply of physical liquidity in bullion markets to satisfy demand arising from dollar liquidation is extremely tight.

Geopolitics and gold in 2018
It is likely that at a future date we will look back on 2018 as a pivotal year for both geopolitics and gold. Russia has moved to a position whereby it has substantially replaced its dollar reserves with physical gold. It is now able, if it should care to, to do away with the dollar entirely for its energy exports payments. It is even possible for it to link the rouble to gold.

China took the seemingly innocuous step of launching an oil contract denominated in yuan. It had prevaricated since at least 2014 before making this move, presumably conscious that it was an in-your-face threat to the monopoly of the dollar in pricing energy.

There was expectation that the oil-yuan futures contract would be a segway into a yuan-gold futures contract either in Hong Kong or Dubai, allowing countries such as Iran to avoid receiving dollars entirely. And indeed, a number of gold exchanges and interests in Asia have banded together to open a 1500-tonne vault in Qianhai to facilitate gold storage resulting from pan-Asian trade flows.

These include the China Gold and Silver Exchange Society, the Hong Kong Gold Exchange, and gold market interests in Singapore, Myanmar and Dubai. The objective is to give Hong Kong the opportunity to coordinate Asian gold markets and develop a “gold corridor” for the countries along China’s Belt and Road initiative. Therefore, both private and public sectors will be able to accumulate the oldest form of money as a backstop to local currencies, as an alternative to accumulating those of their trading partners.

Geopolitics evolved from fighting proxy wars in the Middle East and Ukraine, which were effectively won by Russia, to the less obvious war of trade tariffs. President Trump has styled himself as “A Tariff Man”. We have presumed that he is ignorant of economics, but that is no longer the point. Tariffs have evolved from a policy to make America great again to bankrupting China. China is seen as the greatest economic threat to America, and in this duel, tariffs are Trump’s weapon of choice.

The objective is to impede China’s technological development. It was tolerated when China, to steal a line from Masefield’s Cargoes, was the world’s supplier “…of firewood, iron-ware and cheap tin trays”. But China is moving on, creating a sophisticated economy with a technological capability that is arguably overtaking that of America. The battle for technological supremacy came out into the open with the detention on 1 December in Vancouver of Meng Wanzhou, the CFO of Huawei. Huawei is China’s leading developer of 5G mobile technology, installing sophisticated equipment around the world. 5G’s capability will make internet broadband redundant and will become widely available from next year.

Ms Meng’s arrest represents such an escalation of deteriorating relations between China and America that many assume it was ordered by rogue elements in America’s deep state. Maybe. But these things are difficult to reverse: does America tell the Canadian authorities to just let her go? It would uncharacteristic for America to admit a mistake, and it would probably need President Trump to personally intervene. This is difficult for him because application of the law is not in his hands.

If Ms Meng is not released, we will enter 2019 with the Chinese publicly insulted. They will realise, if they haven’t already, that ultimately there can be no accommodation with America. Fighting tariffs with more tariffs is a policy that will achieve nothing and damage China’s own economy.

It therefore becomes a matter of time when, and not if, China deploys financial weapons of its own. These will be targeted at the US’s obvious weaknesses, including her dependency on China for maintaining and increasing holdings in US Government debt. The increasingly compelling use of physical gold to both protect the yuan from attack in the foreign exchanges and limit the rise of yuan interest rates would serve to insulate China from the fall-out of a collapsing dollar.

The economic outlook, and the effect on the dollar

For market historians, the economic situation rhymes strongly with 1929, when the Smoot-Hawley Tariff Act was being debated. Eighty-nine years ago, the first round of votes in Congress was passed on 30 October, and Wall Street fell heavily that month in anticipation of the result. Following the G20 meeting two weeks ago, where it was vainly hoped there would be progress in the tariff negotiations between the US and China, markets fell heavily, reminding market historians of the 1929 precedent.

When President Hoover stated his intention to sign Smoot-Hawley into law on 16 June 1930, Wall Street crashed again. The lesson for today is that equity markets are likely to crash again if Trump continues with his tariff policies. Smoot-Hawley raised import tariffs on over 20,000 imported raw materials and goods, increasing the average tariff rate from 38% to over 60%. The difference today is that instead of tariffs being used only for protectionism, they are being targeted specifically against China.

There will be two likely consequences. The first is the the undermining of financial markets, which in the 1930s led to the virtual collapse of the US banking system and the global depression. And secondly, there is the escalation of a wider financial war raging between China and the US. These two factors are potentially very serious, with stock markets already on shaky ground.

This is not the uppermost reason for market weakness in investors’ minds, who worry about the economic outlook more generally. The conventional credit cycle features rising interest rates as a consequence of earlier monetary expansion, and the exposure of malinvestments. Markets discount the phases of the credit cycle when they become apparent to far-sighted investors, and only indirectly contribute to the collapse itself. But when valuations have become wildly optimistic, the fall in markets becomes a crisis on its own, contributing to the collapse in business that follows. This was the point taken up by Irving Fisher in the wake of the 1929-32 bear market.

In any event, the global economy appears to be at or close to the end of its expansionary phase, and is heading for recession, or worse. As well as the potential impact from an unanchored reserve currency, price inflation in the US will be boosted by Trump’s tariffs, which amount to additional consumer taxes. Price inflation pressures will then call for further rises in interest rates, while economic prospects will point to easing monetary conditions.

We have yet to see how this will be resolved. A further problem is that an economic downturn will increase government welfare commitments and therefore borrowing requirements. Bond yields will tend to rise and therefore borrowing costs, driving spendthrift governments into a debt-trap, just when price inflation is likely to demand higher interest rates. The most likely outcome will be further losses of fiat currencies’ purchasing power.

The 1930s depression saw a rising purchasing power for the dollar, with all commodity and consumer prices declining. The dollar was on a gold standard, and prices were effectively measured in gold, the dollar acting as a gold substitute. This is no longer true, and the purchasing power of the dollar, along with all other fiat currencies will at best remain stable measured against consumer products, or more likely will decline. In other words, a severe recession which looks increasingly likely on cyclical grounds, will lead to higher gold prices, irrespective of fiat currency interest rates...

- Source, James Turk's Goldmoney, read more here

The Arrival Of The Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:

“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.”

The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

If it was only down to America without further feed-back loops, we can now suggest the following developments are likely for the US economy. Warnings about an economic slowdown are persuading the Fed to soften monetary policy, a process recently set in motion and foreshadowed by US Treasury yields backing off. However, price inflation, which is being temporarily suppressed by falling oil prices, will probably begin to increase from Q2 in 2019. This is due to a combination of the legacy of earlier monetary expansion, and the consequences of President Trump’s tariffs on consumer prices.

After a brief pause, induced mainly by the threat of an unstoppable collapse in equity prices, the Fed will be forced to continue to raise interest rates to counter price inflation pressures, which will take the rise in the heavily suppressed CPI towards and then through 4%, probably by mid-year. The recent seizure in commercial bond markets and the withdrawal of bank lending for working capital purposes sets in motion a classic unwinding of malinvestments. Unemployment begins to rise sharply, and consumer confidence goes into reverse.

Equity prices continue to fall, as liquidity is drained from financial markets by worried investors, but price inflation remains stubbornly high. Consequently, bond prices continue to weaken under a lethal combination of foreign-owned dollars being sold, increasing budget deficits, and falling investor confidence in the future purchasing power of the dollar.

The US enters a severe recession, which is similar in character to the 1930-33 period. The notable difference is in an unbacked pure fiat dollar, which being comprised of swollen deposits[ii] (currently 67% of GDP versus 36% in 2007), triggers an attempted reversal of deposit accumulation. The purchasing power of the dollar declines, not least because over $4 trillion of these deposits are owned by foreigners through correspondent banks.

One bit of good news is the US banking system is better capitalised than during the last crisis and is unlikely to be taken by surprise as much it was by the Lehman crisis. Consequently, US banks are likely act more promptly and decisively to protect their capital, driving the non-financial economy into a slump more rapidly by calling in loans. Price inflation will not subside, because that requires sufficient contraction of credit to offset the declining preference for holding money relative to goods. Any credit contraction will be discouraged by the Fed, seeking to avert a deepening slump by following established monetary remedies.

The Fed’s room for manoeuvre will be severely restricted by rising price inflation, which it can only combat with higher interest rates. Higher interest rates will become a debt trap springing tightly shut on government finances, forcing the Fed to buy US Treasuries under cover of monetary stimulation. The true reason for QE will be that with a rapidly escalating budget deficit exceeding $1.5 trillion and more, the Fed will want to suppress borrowing costs compared with what the market will demand. Economic conditions will be diagnosed as a severe case of stagflation. In reality, the US will be ensnared in a debt trap from which the line of least resistance will be accelerating monetary inflation.

It will prove difficult for neo-Keynesian central bankers to understand the seeming contradiction that an economy can suffer a slump and escalating price inflation at the same time. It is, however, the condition of all monetary inflations and hyperinflations suffered by economies with unbacked fiat currencies. The choice will be to rewrite the textbooks, discarding current groupthink, or to soldier on. We can be certain the neo-Keynesians will soldier on, because they are intellectually unable to reform existing monetary policy in a manner acceptable to them.

That would be the likely outcome of the developing credit crisis if it wasn’t for external factors. There is precedent for it, and we can expect it from a purely theoretical analysis. It would be a rolling crisis, becoming progressively worse, taking six months to a year to unfold, followed by a period of economic recovery. But there is a major snag with this analysis for the US economy, and that is US monetary policy has long been coordinated with the monetary policies of other major central banks through forums such as the Bank for International settlements, G20 and G7 meetings.

The surprise election of President Trump upset this apple-cart with his untimely budget stimulus and the havoc he is wreaking on international trade. The result is the Fed is no longer on the same page as the other major central banks, particularly the Bank of Japan and the European Central Bank. Therefore, unlike crisis phases of previous credit cycles, the Eurozone enters it with negative interest rates, as does Japan, which are creating enormous currency and banking tensions. We will put Japan to one side in our search for knock-on systemic and economic effects triggered by the Fed’s increase in interest rates, and instead focus on the Eurozone, the heart of the European Union.

- Source, Alasdair MacLeod via James Turk's Goldmoney

Pop Goes The Money Bubble with James Turk

What To Do Before It Pops is the latest book by James Turk and John Rubino. In their first book The Coming Collapse of the Dollar and How To Profit From It: Make a Fortune by Investing in Gold and Other Hard Assets, the authors questioned the housing bubble and advised the public to buy gold. The Money Bubble goes one step further: rather than addressing discrete asset classes, it deals with the world's major currencies -- and the bubble they represent.

- Source