Gold News

What's a Boom with No Bust?

To reload an economic boom, you first need to get an economic bust...

AUSTRALIA's economic growth for the three months to 31 March came in at 0.6%, writes Greg Canavan for The Daily Reckoning Australia, just below expectations of 0.7% growth.

The annual rate of expansion slowed to 2.5%, the slowest growth rate since June 2011. We'd thought Wayne Swan would be out immediately telling everyone how good the numbers are, or more to the point, were...and he didn't disappoint. The all-important measure of national income, 'real net national disposable income', increased a robust 1.3% in the quarter. But with iron ore prices off significantly in the current quarter, you'll see that reversed on the release of the next set of accounts.

Not that it will stop Wayne Swan from selling the numbers before the unwinnable election, but the three months to March 31 were a long time ago. Since, we've had lower mining investment, weak retail sales, poor consumer sentiment and rising unemployment. So we'd expect that 2.5% annual growth rate to be even lower in three months' time, and we'd also expect national income to go backwards over the year.

Anyway, the market wasn't impressed with the numbers – or with Swan – as the Aussie Dollar sold off on the news. We think the Aussie Dollar is headed back to around 80 cents...the only question is how long it takes to get there.

But we didn't want to discuss the Australian economy today...or China, or mining. We wanted to look into the plumbing of the financial system and see how many leaks have sprung. It turns out they're all over the place.

US markets sprang a leak overnight with the main indices falling over 1.3%. Apparently it's due to concerns about the end of stimulus measures. But maybe the markets are just having a long overdue correction.

And there's water all over the place in Japan. Or, as one witty headline read following the recent announcement of Prime Minister Abe's craz-e-nomics policy, 'It's Raining Yen'.

Now, the Nikkei is leaking everywhere. After peaking at around 15,300 points on May 21, the index is now around 13,000. That's nearly a 15% decline in a few weeks. Maybe it's just a correction after a bubbling run up, but the market is looking very unsettled.

And it's having an effect on Australia too. Yen weakness/Aussie strength helped to drive the market higher ever since Abe got himself in the driver's seat last year.

But he's driven things a little too hard and now you're seeing Yen strength coincide with weakness in the Australian market. So if it is just a correction in the Nikkei and only momentary weakness in the Yen, you could well see our market turn around soon enough and start rallying again.

We're not sure what will happen tomorrow or next week, but we're pretty sure the whole financial system is screwed. And the latest comedy festival out of Japan is evidence of that. Yesterday, the Nikkei tanked around 4% while Abe spoke at a press conference. Confidence is waning. 

A few weeks ago, we nominated the day of Bernanke's 'maybe we'll taper maybe we won't' speech as the day the Fed lost control of the market. In case you're wondering, to 'taper' means to buy less government bonds and therefore monetise debt at a slightly less dramatic rate. Sounds innocuous, but it's become a big deal.

We don't really believe the Federal Reserve is serious about ending QE anytime soon. But they may have started to realise that QE is not the answer. It's not that they want to 'taper' because the economy is improving. They want to taper because QE makes the economy worse.

Two recent articles got us thinking on this point. A few weeks ago, hedge fund manager Andy Kessler wrote an op-ed in the Wall Street Journal saying that QE – Fed purchases of US Treasury bonds – was having a major negative impact on the shadow banking system.

We've written about this before. The shadow banking system uses Treasuries as money substitutes. That is, if you have a Treasury bond, it can act as collateral for a cash loan. It's known as a repurchase agreement, or repo. Here's how Kessler explains it:

"Repos are pretty simple. A 'borrower' puts up securities as collateral and receives cash from a 'lender' in exchange for an agreement to repurchase the security at a later date, maybe a day or a week (even years), of course at a slightly higher price. Usually the securities are US Treasuries or something liquid that can be easily disposed of in a default.

"But here's where it gets interesting. Since the repo lender owns a highly liquid security, the lender can do another repo with it, raising more cash to play with. This is known as rehypothecation, a fancy term for what basically creates a money multiplier similar to fractional reserve banking. Today, this means credit creation of two or three times for every piece of highly liquid security used in repos (down from four times in 2007).

"Just as the monetary base is commercial banking's gold, Treasury bonds are shadow banking's gold. Credit created by repos funds financial instruments (such as credit-card debt and mortgages) but also inventories, drilling projects, even fiber-optic buildouts. Hedge funds use repos for over half their funding and live for these riskier projects."

Kessler argues that the Fed is taking precious collateral out of the system, which is actually deflationary. A recent Bloomberg article, titled US 10-Year Note Repo Shortage Drives Lending Rates Negative supports this point of view.

On the other hand, QE does take assets out of the market, which pushes yields down across the board, which in turn should encourage borrowing and the creation of normal bank credit. So what the Fed takes out of the system in the form of Treasury securities, it hopes to more than replace via private credit creation.

But a recent 'investment outlook' by bond giant Pimco's Bill Gross argues that this is distorting the economy too. He argues that just as the notion of profit is crucial for the capitalist system to evolve, the notion of return or 'carry' is 'critical to our financial markets'. Put simply, 'carry' is the return you can expect to achieve over and above a risk free rate.

With rates across the board now so low, Gross argues that the potential for 'carry' is as low as it's ever been. Hence, there is very little incentive to take risk. He then brings this financial aspect back to the real economy:

"In addition, there are several other important coagulants that seem to block the financial system's arteries at zero-bound interest rates and unacceptably narrow 'carry' spreads:

1. Zero-bound yields deprive savers of their ability to generate income, which in turn limits consumption and economic growth.

2. Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient 'carry' to support employment infrastructures, then personnel layoffs quickly follow...

3. Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living...

4. When ROIs [return on investment] or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment...Look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks."

We don't know if this has suddenly dawned on Bernanke, and he's trying to 'taper' to help the economy or whether he genuinely believes in an improving economy.

But the fact is, in order to have a genuine economic recovery you need to have a genuine bust.

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

Follow Us

Facebook Youtube Twitter LinkedIn



Market Fundamentals