Thursday, January 29, 2015

FOMC Statement - January 28, 2015

The Federal Open Market Committee (FOMC) released its latest statement on monetary policy on January 28, 2015.  Since the Fed ended its QE program in October, most of the focus has been on interest rates.

The statement said the following:

"Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.  However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated."

All of this focus is on the federal funds rate (the overnight bank lending rate).  But despite these threats of higher rates from the Fed, long-term interest rates are falling.  Investors either don't believe what the Fed is saying or they really don't care.

I am expecting and preparing for a recession.  I don't know when it will come, but the Austrian Business Cycle Theory tells us that it should come.  The Fed has had six years of high monetary inflation and there is little question that this has generated bubbles and misallocated resources.  The bigger question is when this will fall apart.

Perhaps an even bigger question is how the Fed will react when the bubbles start to deflate.  Will it watch it happen or will it start another round of QE?  While we can't be sure, my bet would be on the latter.

Right now, I feel like Janet Yellen is a magician.  She is distracting everyone with one hand.  That is interest rates.  But nobody is paying attention to the other hand.  That hand is about to pull a rabbit out of the hat in the form of new money.

Again, the timing of this is impossible to predict, but we shouldn't be surprised when it happens.

Thursday, January 22, 2015

ECB Trying to Imitate the Fed

The European Central Bank (ECB) has announced its own version of quantitative easing (QE).  It will start buying 60 billion euros of assets each month, going well into 2016.  This will total at least 1.1 trillion euros, which is approximately 1.3 trillion dollars.

I see this as the ECB trying to imitate the Federal Reserve.  The Fed has quintupled the monetary base over the last 6 years, with its biggest round of monetary inflation coming to an end this past October.  Yet much of this money went into bank reserves and consumer price inflation has stayed relatively low.

It is almost as if the Fed has had a free lunch.  It has gotten away with its biggest round of monetary inflation ever with few consequences.  Meanwhile, the U.S. economy is looking better, especially when you compare it to Japan or Western Europe.

It might almost seem rational for the ECB to try to imitate the Fed.  Much of Western Europe is in recession or worse and the price inflation is low there as well.

Unfortunately for the Keynesian central bankers of Europe, things might not turn out the way they plan.  Mario Draghi, central banker and former Goldman Sachs guy (or do I repeat myself?), may not get off as easy as central bank officials in the U.S.

First, it is important to point out that things have not played out in the U.S. yet.  The economy is seemingly strong and much of it is because of the Fed's inflation.  But asset bubbles take some time to pop.  The popping of the oil bubble may just be the beginning.  Perhaps stocks are not far behind.

The point is, central bank inflation misallocates resources and it slows down productive growth.  At some point, these misallocated resources get exposed and the realignment usually means a recession, unless it is not too severe and other areas with strong productivity are able to offset it.

The second problem for Europe and the ECB is that Europe is not the same as the United States.  There is simply not as much real wealth.  The U.S. is a very entrepreneurial society and there is a lot of wealth from 200 plus years of capital accumulation.  Western Europe has been more of a hardcore welfare state and is relatively poorer in general.

When there is less in the way of real wealth and real savings, then things can't be covered up as long.  The people of Greece are finding this out the hard way right now.

When there is a large amount of government spending, coupled with central bank inflation, a wealthier society can withstand it better, at least for a period of time.  There is more real wealth to sustain things.

It is no different than a family.  If you have to take a pay cut and you are spending more than you are earning, you will be able to better withstand the situation if you have a lot of prior savings.  In terms of a country, I am not talking about government savings.  I am talking about real wealth that is owned by the individuals.

The ECB may find that its policies have almost no effect up front.  Meanwhile, they will be misallocating resources and hurting long-term wealth production.  It will wipe away what little savings are left there.  If much of Europe finds itself in recession, maybe the ECB will up the ante and create even more inflation.  But then it will just exacerbate the problem more and they may end up with a depressed economy and high price inflation at the same time.

Overall, it isn't going to be pretty for Western Europe in the long run.  The ECB is making things worse.  It is wasting real capital and real wealth.  If I were living in Western Europe right now, I would want to be in Switzerland, away from the euro.

Sunday, January 18, 2015

The Swiss Franc and PRPFX

The big financial news this past week was the announcement by the Swiss National Bank (SNB) that it would drop its peg to the euro.  The SNB announced this peg in September 2011, where it would not let the franc rise against the euro.  The peg was set at 1.2 francs per euro.

In order to maintain this peg, it meant that as the European Central Bank depreciated the euro by creating money out of thin air, the SNB had to essentially do the same thing.  The SNB, over the last 3 years, has had to buy up euros, mostly with newly created francs.

While this temporarily helped exporters in Switzerland, it hurt all consumers in Switzerland by making things more expensive.

This past week was the final straw, as the SNB realized that it wasn't up to the massive monetary inflation that would be necessary to keep up with euro, particularly with the anticipation that the European Central Bank is about to announce a massive monetary inflation scheme.

It is good news for most of the Swiss that the SNB has dropped this ridiculous peg.  The franc has been an historically strong currency, but its reputation was evaporating quickly before this past week.

The announcement will mean several companies and investors will be severely hurt or bankrupt, but that is because they were betting on the continued peg.  The "carry trade" - where investors would borrow francs at low rates and exchange them for other currencies that pay higher rates - was a popular thing, but it will now mean a lot of pain for those who tried it and now have to convert back to francs.

The SNB never should have attempted its policy, as it can now see.  But at least it is abandoning this bad policy, even though it will hurt some people in the short run.

PRPFX

My favorite mutual fund is PRPFX.  It somewhat mimics the permanent portfolio that was advocated by Harry Browne.  I recommend that investors put a minimum of half of their financial assets in a permanent portfolio setup.

I say that PRPFX "somewhat mimics" the permanent portfolio because it does stray from the original formula.  My biggest criticism of PRPFX, especially over the last few years, is its holdings of Swiss francs.  About 10% of the fund's assets are invested in Swiss assets.

This doesn't make a lot of sense to me because gold is in the portfolio and is supposed to protect your portfolio from dollar depreciation.  You shouldn't need to invest in foreign currencies.

This was made worse in 2011 when the SNB announced its peg to the euro.  I don't understand why the managers with PRPFX kept Swiss francs as part of the portfolio.  It may as well have invested in euros, at least up until this past week.

Well, things have just gotten a bit better.  It is no surprise that PRPFX did well last week with the SNB announcement.  I still think the fund should get out of the franc, as it is really speculation to buy foreign currencies.  Again, the significant gold portion should protect your portfolio against massive inflation.

At least now I feel a bit more comfortable recommending PRPFX.  While it is still far from perfect (nothing is perfect), it is a good option for investors looking for wealth protection and growth, without having to buy the individual pieces of a permanent portfolio.  It also does the rebalancing for you.

I don't expect any more major announcements from the SNB, but the market will have to find the new exchange rate for the franc.  There may be some more volatility in the short run.

Overall, this is good news for people living in Switzerland.  It is also good news for those invested (or wanting to invest) in PRPFX.

Wednesday, January 14, 2015

10-Year Yield Sinks

With retail sales numbers coming in weak earlier today, stocks were down significantly.  But the more interesting story is how low the 10-year yield has gone.  It closed at 1.84%.  It briefly dipped below 1.8% during trading.

I believe this is an indication of a coming recession.  I have been cautious to call a recession too soon and I still don't know how long this will take to play out.  But I am trying to warn my readers that they should prepare for a significant downturn in the economy.  You can never fully prepare, but it helps if you have an idea of what is coming.

The Fed stopped its massive QE program at the end of October.  We have had a couple of months of relatively stable money from the Fed.  It is rolling over maturing debt, but not adding to its balance sheet.

Yet long-term rates are dropping.  This means it is coming from investors, as opposed to the central bank.  This means that investors are locking in rates, even below 2% for 10 years.  The yield curve is flattening.

An inverted yield curve - where longer-term rates are lower than shorter-term rates - is typically a very good indicator of a coming recession.  In our present situation, short-term rates are near zero.  So we are unlikely to see an inverted yield curve.  For me, this flattening is good enough to indicate a substantial weakening in economic activity.

This should come as no surprise to those familiar with the Austrian Business Cycle Theory.  We have seen huge monetary inflation over the last 6 years and now it has stopped.  If the Fed doesn't start pumping more money soon, the malinvestment is going to become evident soon.  Resources have been misallocated, and without the new injections of money, the artificial bubbles will be revealed and will go bust.  This has already happened to oil.  It will probably happen to stocks.

Keep an eye on the 10-year yield.  It is good if you are getting a mortgage or refinancing.  It is probably not good if you are invested in stocks.

Saturday, January 10, 2015

Getting It Straight on Oil

As of this writing, the price of a barrel of crude oil is less than $50.  The price sunk quickly in the latter part of 2014 and nobody knows where it will find a bottom at this point.

There are a lot of misconceptions about what is happening and what it means, as so often happens with any economic subject.

There are basically four factors to consider in the pricing of oil.  There is the supply of oil.  There is the demand for oil.  There is the supply of dollars (or whatever currency you are pricing it in).  And there is the demand for dollars.

To be clear, when talking about the supply of oil or the supply of dollars, the supply expectations for the future are a big factor.  You could have no greater supply of oil today, but if there were new discoveries coming online and the oil production was expected to double next year, then the price would fall quickly just on the news.

It is the same with the dollar.  If the supply of dollars were currently steady, but people expected the Fed to start creating trillions of new dollars next year, then prices would start going up right away, all else being equal.  That is why markets move on Fed announcements, as opposed to just the Fed actions.

So what is driving the price of oil down?  In all likelihood, it is probably a combination of all of these things in something of a perfect storm.  The supply (and expected supply) of oil is going up due to the shale oil boom in the U.S.  Also, an announcement from OPEC, and Saudi Arabia in particular, that it would not cut production, helped trigger the downward price, although the price had already been moving down.

It would not be surprising if the demand for oil is down globally.  China has been slowing down a bit, not counting the stock market there.  Japan and much of Western Europe are in recession or worse.  So it makes sense that demand might be down for energy.

In terms of the dollar, the money supply has leveled off since the Fed ended its QE (money creation) program at the end of October.  This means that the money supply is expected to stay relatively flat in the near future, barring a major policy shift from the Fed.  This can also contribute to raising the demand for dollars.

Some might object to the dollar being a cause of declining oil prices because other prices are not going down.  Stocks are mostly booming (not counting the last couple of weeks) and consumer prices are not falling in most areas.  But here, it is important to understand the effects of monetary policy.  It is never uniform, which should be obvious based on recent history.

There was a tech stock boom in the late 1990s that went bust.  There was a housing boom in the 2000s that went bust.  These areas saw much of the monetary inflation rush into these sectors.  Therefore, they were also the sectors that crashed the hardest when it came time.  This is why I am very cautious about the current stock boom.

One thing that is important in all of economics is to not confuse cause and effect.  Low oil prices might be indicating a recession, but this doesn't mean it will cause a recession.  Oil prices started declining in the summer of 2008 before most people knew we were in a recession.  It is quite possible the same could be happening here.  Or it is possible that it is just the weak global demand from the many major countries in the world that are in recession.

There are some people out there who think that falling oil prices are a bad thing, but not because it is a possible warning sign of a coming recession.  They think it is bad because it is hurting the oil business in the U.S., which has some high paying jobs.  But this is bad economics.  We should celebrate falling oil prices, unless you happen to be an employee in that sector or a major investor.

If the price of oil dropped to one dollar per barrel, it would be great.  We could fill up our cars for almost nothing.  It would be bad in the short run for some investors and employees, but resources would have to be reallocated to be more efficient.  This would include some employees having to work in a different sector.

As an individual, you should take advantage of the low oil prices.  If you are like the average American, you should be saving about 50 dollars per month at the gas station.  Maybe you are saving more.  Take your savings and pay down debt or contribute to your savings/ investments.  The low prices may not last.

I am very cautious about the overall economy right now.  The Fed has tightened and I believe that much of the so-called recovery of the last 6 years has been artificial due to the loose monetary policy of the Fed.  The 10-year yield is just under 2% right now.  With oil also low, there are a lot of warning signals.  But as long as things hold up in the U.S. and oil prices stay down, take advantage of the situation and add to your savings.

Thursday, January 8, 2015

Economic Update - January 2015


It was an interesting end to 2014 with oil prices down as much as they are.  Almost nobody would have guessed just 6 months ago that crude oil would be near $50 per barrel.

We must be clear on what lower energy prices mean.  It is a benefit to the consumer, as it costs less to fill up a gas tank.  Let’s just hope that most Americans use this benefit to pay down debt or add to savings, instead of finding something else to spend it on.

The reason I say this is because, first of all, it may not last for long.  Second, it could be a sign that a recession is coming.

I understand that the lower prices may be partially due to higher supplies, or higher expected supplies.  But it seems likely that weakening demand is also a major factor.  Japan and much of Western Europe are already in recession or worse, so this would make sense.  The big question is whether there is weakening demand in the United States.

We shouldn’t confuse cause and effect here.  Lower oil prices won’t cause a recession.  Instead, they can be a warning sign of a looming recession.

There may be some oil companies and investors that lose a lot of money.  Maybe some people will lose jobs.  But this isn’t the point.  The point is that oil was a bubble that has popped.  Like most bubbles, we can assume that central bank monetary policy probably played a role in the bubble in the first place.

It just so happens that a popping oil bubble is good for most Americans because of the benefits of lower energy prices.  It won’t be good when other bubbles pop, particularly the bubble in the stock market.

The Fed has had a tight monetary policy since the end of October, despite the continued low interest rates.  The monetary base has leveled off.  This is going to lead to a bust at some point, especially if the Fed keeps a neutral monetary stance.

Long-term interest rates continue to stay low.  The 10-year yield is down to about 2%.  A flattening yield curve, even if not inverted, is another sign of a possible slow economy.

I continue to advocate a good majority of financial investments be in a permanent portfolio setup.  Even with interest rates low, the 25% in long-term government bonds is important due to the possibility of another recession.  Rates could go even lower, driving bond prices higher.

I am not saying that a recession is imminent, but I am saying it is a decent possibility.  You should be prepared.  Most people weren't prepared for what hit in 2008.  You should be prepared financially and mentally.  If you know what is coming, or at least know what is possible, then you will likely adapt easier when it hits.

Monday, January 5, 2015

Good-Bye Pennies and Nickels


The U.S. Mint has released its latest biennial report to Congress.  For all four major coins – pennies, nickels, dimes, and quarters – production costs fell in 2014.  The Mint says it “saved” $29 million in production costs as compared to last year, primarily due to lower copper prices.

The catch is that the Mint is still losing money on the production of pennies and nickels.  It now costs about $1.62 to make 20 nickels, or one dollar in face value.  It costs approximately $1.66 to make 100 pennies.

So while the prices of the metals used to make coins has dropped in recent times, they are still high enough to produce losses on the two coins with the smallest denomination.

To say that the Mint saved money is similar to cheering a reduction in deficit spending while the overall debt continues to increase.  The rate of loss is going lower in percentage terms, but the losses keep coming.

As of 2013, the Mint was losing $105 million annually to produce pennies and nickels.  This is mostly a drop in the bucket when compared to the annual federal budget, but it is still another little thing that adds up.

And these losses are not fixed.  If the prices of certain metals go up significantly, then the losses will accumulate quickly.

There are discussions about ditching pennies and nickels, but this proposal hasn’t gained a lot of traction up to this point.  The move would be highly opposed by certain special interests including metal alloy industries and Coinstar, which makes money when people trade in their change for cash.

The Mint could also change the metal composition in its coins, including dimes and quarters, to use more inexpensive metals, but this is not quite as easy as it sounds.  It would affect vending machines nationwide, requiring an upgrade to read the new coins based on the new weights.

Blame the Fed

Of course, the only reason this is an issue is because of monetary inflation.  As the money supply is increased by the Federal Reserve, our fiat dollars become worth less and less.  The purchasing power decreases with more dollars in circulation.  Therefore, most things will go up in price in nominal terms, particularly metals.

Over time, this adds up.  Since the Fed’s inception 100 years ago, the purchasing power of the dollar has declined over 95%.  Some things may get cheaper such as computers and other electronics due to increasing technology and production.  But in the case of most commodities, production and technology are not enough to offset the monetary inflation.  Prices will rise over time.  As metals such as zinc and copper rise in price over time, the value of the metal eventually exceeds the artificial values of 5 cents and 1 cent for nickels and pennies.

When metal prices began to soar in the mid-2000s, the metal value in nickels and pennies exceeded the monetary value of the coins.

Hoarding Pennies and Nickels

We can be sure that the days for pennies and nickels are numbered, at least in their current state.  If metal prices continue to rise, then losses for the U.S. Mint will continue to mount.  In other words, losses for taxpayers will continue to mount.

We will also see Gresham’s law take over.  This is where good money is driven out of circulation when there is an artificial government price control.  In this case, the government’s artificial price is putting a one-cent value on pennies and a five-cent value on nickels.

More people will begin to hoard pennies and nickels.  I can envision nickels going out of circulation faster because it is more cost effective and space effective to hoard nickels over pennies.

You could say that collecting pennies and nickels are the safest investment you can find.  They protect you from deflation and inflation.  If we have deflation, you can always just spend them based on the government’s monetary value.  And in a deflationary environment, the purchasing power of your money should increase.

If we have inflation, then the coins will increase in value based on the content of their metals.  They will end up trading just as we see “junk silver” traded today.  These silver coins are not really junk at all.  They are pre-1965 dimes, quarters, and half dollars that trade based on their silver content.

The same thing that happened to pre-1965 silver coins, which actually contain silver, is going to happen to pennies and nickels.

If the Fed keeps printing money, then we can say good-bye to pennies and nickels in their current state.  We can make a safe assumption that the Fed is going to continue to print money, whether it is done on a computer screen or outsourced to the Mint.