Gold News

Bad to Worse with the Federal Reserve

Would the US Fed know "normal" if it got up and bit it...?
 
FINANCIAL YEAR 2013 could best be summarised by Charles Dickens' immortal opening line in A Tale of Two Cities, writes Greg Canavan at The Daily Reckoning Australia...
"It was the best of times, it was the worst of times."
Indeed it was. The Australian share market rallied 17% during the financial year, but unless you were in the banks or other defensive industrials (or an index fund) those gains will seem foreign. The resource sector was a major drag and there were bombs going off all over the place at the junior end of the mining spectrum.
 
Which means this is probably the best place to put some speculative funds (if you have any left) for the 2014 Financial Year. It is rare for a sector to have a shocker for consecutive years, and chasing winners from the previous year is always fraught with danger.
 
Not that we have any particular sector insight over the next 12 months. But viewed dispassionately, we'd say that financials are expensive and resources cheap. That's not to say they won't remain so for a little longer.
 
In the eyes of investors, China has had a big fall from grace over the past 12 months. Much to their surprise, the Middle Kingdom won't be soaking up the world's metal resources as fast as they come out of the ground. As a consequence, junior miners are now starved of capital.
 
And what hurts the miners hurts the companies that service them. This morning, drilling services company Boart Longyear (ASX:BLY) came out with another profit warning, saying conditions had 'continued to soften' since the last update in May.
 
And China's all-important manufacturing PMI was out this morning, coming in at 50.1, in line with expectations but down from the May reading of 50.8. So the impression of a slowing China remains.
 
Meanwhile, the perception of the banks as defensive all-weather stocks continues to intensify. Despite the slowing economy of our major trading partner, bank earnings remain strong. Despite concerns over employment and consumer spending and worries over which political idiot will be running the show later this year, banks look like the safest bet of the lot.
 
But in the markets looks can be deceiving. While everyone is loving the big defensives and hating on miners – especially the gold miners – a great contrarian trade for 2014 would be to do the opposite. That is, short the banks and go long gold mining stocks. Let's see how it works out in 12 months' time.
 
In the meantime, there will be plenty of ups and downs to deal with. Because if there's one thing you can bet on in the market it's volatility, especially a market that's trying to deal with the threat of the Federal Reserve removing the monetary punchbowl at some point this year. 
 
But will it really? Is the US economy improving enough to justify interest rate normalisation? In our latest issue of Sound Money. Sound Investments, published last week, we argued that it was not. We made the case that it was impossible for the US economy to be able to handle tighter monetary policy because the structure of its economy has become completely dependent on easy money.
 
That is, when you run an 'easy money' policy for the best part of 15-20 years, the economy is going to develop industries and employment ('structure') around the provision of easy money. Take that away, and the economy will fall in a heap.
 
Global interest rates have more or less been in a long term, secular decline since the early 1980s. And like a see-saw, as interest rates declined, debt levels increased. The lower the interest rate the higher the debt levels.
 
Once interest rates hit zero, we saw QE come into effect to provide 'unconventional' monetary easing. Predictably, debt levels increased even more, led by a blowout in government borrowing. So now we have more debt in the world than ever before, and everyone thinks that the Federal Reserve is going to be able to normalise interest rates?
 
We can't see it happening. The Federal Reserve can try, but higher rates will very likely push the US economy into recession. This would impact unemployment and see the Federal Reserve reverse course and go back to talking QE, or some new form of it, up to investors.
 
But we're getting ahead of ourselves. Let's not forget that the Fed is still monetising a ridiculous amount of treasuries and mortgages each month. US$85 billion worth, to be exact. QE may or may not end anytime soon. The Fed doesn't really know. And for the first time in a long time, the market now knows that the Fed doesn't really know.
 
Which is not a particularly good development. When confidence in the Federal Reserve dries up, so does liquidity. It's not a good environment to make big bets with borrowed money. So the hedge funds pare back a bit. They sell out of emerging markets and other 'hot' sectors and reduce their leverage.
 
The threat of tighter US monetary policy actually impacts emerging markets first. Brazil's exchange, for example, is down around 35% from its peak in January. And it shouldn't come as a surprise that China's liquidity issues surfaced around the same time as US tightening talk emerged.
 
The world's reserve currency has long tentacles. The effect of higher US interest rates don't just impact the US, it impacts the world. So as much as the Federal Reserve might like to think they can slowly 'normalise' interest rates, there's much more to it than that.
 
They've spent 20 years abnormalising the global interest rate structure. They won't get out of it lightly.

Greg Canavan is editor and publisher of Sound Money, Sound Investments, a weekly financial report devoted to unearthing great value investments amid today's "money illusion" of fiat currency. Formerly editor of Australia's market-leading finance newsletter, Greg has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as LewRockwell.com 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