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COMMODITY FUTURES FORECAST
WEEKLY REPORT
The Fed and the Death Spiral
According to the general consensus, the U.S. has issued approximately $18 trillion in debt. This does not even consider a further $120 trillion in commitments that will presumably be paid from issuing more debt or collecting taxes. For every 1% (100 basis points) that the FED increases short term rates the impact is approximately $260 to $300 billion in additional interest. This assumes reasonably correlated increases from T-bills to T-notes and bonds.
Normalizing interest rates would suggest a 300 basis point hike in short term rates that would cost another $1 trillion per year that would have to come from selling more debt, or increasing taxes. It doesn’t take an accountant to understand that the national debt has become a self-perpetuating death spiral. I have touched upon this before, but the reality becomes more profound as Congress faces the debt ceiling once again and the need to borrow is a function of previous borrowing… among other government overheads. It is the Death Spiral.
While we are told FED policy is about the economy and monetary regulation, behind the scenes there are continuous discussions about impacting the Treasury. This is even more the case when considering that the FED has bought Treasury debt. If the FED raises interest rates, the value of its portfolio goes down. Talk about mixed incentives! So, does the FED devalue itself or overburden the Treasury?
For the moment, the FED is doing nothing, sending a signal to investors that the economy is insufficiently stable to sustain any interest rate increase. Bonds have jumped a full handle, but the Dow Jones Industrials barely budged. In truth, a 25 basis point increase in FED Funds would have been viewed as a positive; i.e. a return to normalcy. As it stands, there is no safe haven because all rates are well below the true inflation rate… even with the drop in energy.
It will probably take a day or two for Wall Street to view the FED’s conservatism in a positive light. On the other hand, some institutional investors may already be wondering if this is the time to bail… before reality grips equity markets and we experience another correction that would assuredly lead to a bear market. The FED and Treasury are not vested in stocks. It’s not their venue and not their problem.
The Great Inflation Myth
Understandably, inflation was driven by speculation and commodity hoarding. This was evidenced by the severe commodity price collapse coming into 2009… presumably after the recovery was in progress. Now, news headlines tell us housing is recovering and oil prices have collapsed.
Once again, inflation is in check because Uncle Sam needs to fool us into thinking raw commodities and homes are homogeneous; they’re not. There is a big difference between paying a mortgage and filling up a gas tank.
I have maintained that inflation played a dominant role in delaying any economic recovery. The pretense of a recovery is constructed from false statistics like unemployment that reflects improvement. The disclaimer is that people who have stopped looking for work… the chronically unemployed, are not counted. Further, people who are underemployed are not in the unemployment numbers. The real unemployment rate is double digits and a more appropriate measure of citizen wealth may be found in Food Stamps and other assistance programs. Out of 320 million people, 45 million receive Food Stamps - 12.87% of the entire population. According to the latest Census, 27.3% of the U.S. population is under 20 years old. This implies a far greater total dependency when considering that minors cannot file for Food Stamps by themselves.
The middle class has been pummeled by tax hikes and inflation to the point where they cannot assist in growing the economy. Corporations have increased bottom lines more as a percentage of top lines by cutting costs and scaling back. This is primary why GDP growth has remained anemic for so long. The good news is that gasoline prices have dropped almost to pre-crisis levels. In New Jersey, a gallon of regular gasoline has dipped below $2.00. Prospects for further declines as global capacity expands suggest we could return to the prices of the 1980s.
Speaking of the 1980s, Former FED Chairman Paul Volcker came face-to-face with inflation coming off the 1970s. He decided to wage war against inflation by hiking interest rates to unprecedented levels. Many economists predicted disaster as some rates hit high double digits, But disaster never materialized. Instead, investors poured money into Treasury Notes and Bonds.
The Treasury Bond monthly continuation chart from 1978 through 1997 shows how bonds dropped from over 100 to less than 56. For all purposes, principle values were cut in half from 1978 through most of 1981. Then, something strange happened. Everyone seemed to pour money into U.S. Treasury debt, causing a demand-driven drop in interest rates.
From the early 1980s up to 1987, Americans didn’t much care about the portfolio readjustment. But, high yields from 1982 through 1986 gave the Great Generation a big boost in purchasing power… not to mention the general population that was socking money away into long-term CDs, corporate debt, and Treasuries. This concerned the newly appointed FED Chairman, Alan Greenspan who was about to learn monetary policy the hard way. Following Paul Volcker’s play book, Greenspan begins to tighten leading up to the October 1987 crash… Oops!
Greenspan overlooked the evolving Savings & Loan Crisis that resulted from Congress’ dissolution of real estate tax benefits (IRS Code §62 & 63 passive write-offs against ordinary income). In usual fashion, Uncle Sam likes to say that the S&Ls were overextended. This was true, but there was nothing wrong with their exposure as long as real estate maintained its economic viability. When Congress changed the rules, the benefits of holding real estate instantly vanished, leaving an enormous vacuum that was filled by property abandonment. Thank you politicians and your economic advisors!
Does this sound familiar? Let’s see. In 2007 financial institutions were up to their eyeballs in leveraged sub-prime debt. President Bush did nothing to curb over exuberance as raw commodity speculation and a lack of any energy policy spiked gasoline prices, burdening sub-prime mortgage holders. I have expressed this many times in previous reports. The real kicker came when Barney Frank discredited Fannie Mae and Freddie Mac on international television. As these two government guaranteed mortgage consolidators imploded, so did Wall Street, Bank Street, and Main Street.
Rather than seek a private sector solution, Uncle Sam saw an opportunity to usurp the market in favor of a socialistic approach. First came the bailouts; then came the stimulus. As the FED tries to cope with an all-new phenomenon called a balance sheet, global stock markets have encountered a hiccup allegedly due to China’s economic slowdown. China has cooled from a roaring 8.5% GDP growth to only 4.5%... boo-hoo! Japan would kill for 4.5% as would the U.S. FED. The real problem is that China has been one of the driving forces that allowed foreign debt to expand. At the same time, China has been responsible for global commodity inflation.
The Great Adjustment
Even with Uncle Sam’s interference and FED meddling, the U.S. economy has managed to slowly creep back. I don’t see many economists acknowledging the Millennials as a factor in the economic comeback, but the Census Bureau tells us Millennials are the largest generation in history. Unlike the burden this population bulge presents for countries in the Middle East, our latest generation represents important human resources. They are a generation of consumers.
As Baby Boomers retire, they will become net with drawers from stocks, bonds, and annuities. The size of this withdrawal is monumental even if the DOW could achieve 20,000 and take other indices along for comparable gains. Absent this private sector event, our government will need to adjust the debt structure as it did in the 1980s. It will try to convert to shorter terms to avoid principle risk and reconstitute debt in an adjusted long-term rate. In the everyday world this is called a scam - it is tantamount to stealing. Politicians call it “policy.”
In the emerging presidential campaign the two sides present extremely different agendas. Bernie Sanders is pushing “democratic socialism.” This is defined as a democratically elected government that owns everything. How does that work? Bernie has no idea. In fact, there hasn’t been a single sound explanation of this concept. Moreover, Mr. Sanders receives his funding from private enterprise.
What’s wrong with that picture? If government owns everything and is the absolute employer, how could anyone fund a campaign against incumbents? Still, Bernie is very popular among young potential voters. Hillary is concerned about Bernie’s popularity. Her strategy is to follow Bernie’s lead.
The contrast is Donald Trump who wants to tax hedge funds and deport illegal immigrants. For the moment, Trump leads the pack as a businessman. His agenda is pushing private enterprise. How he does this without typical government collusion is another entire debate. Trust me…GOP contenders will bring this up sooner rather than later.
No matter who is elected, the economy will encounter a great adjustment. Governments must get out from under their debt overheads and realign public commitments. Unless interest rates provide a return, the debt market will become overly constrained. Prospects for growth will be limited and the Millennials will emerge from their socialistic propensity as hard line conservatives… just like the Flower Children morphed into Republicans. Who knew?
September 17, 2015
Philip Gotthelf
Commodity Futures Forecast
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