Central banks to become more creative...

Nov 12, 2014

New York, New York

Dear Diary,

We've been meaning to write about what hasn't happened yet.

Not that we claim any knowledge of tomorrow or the day after. But we can look at the present. And here's a guess about where it leads.

The middle classes - the voters - expressed themselves last week. They have been sorely used and they know it. The biggest money fabricating program of all time - QE - has done nothing for them. Instead, it has made their lot worse. Investment in new business output has gone down. Their meager savings produce no revenue. And good jobs - 'breadwinning jobs' - are few. For all the talk of an 'improving labor market' there is no sign of it in wages. The typical household has $5,000 less income than it had when the 21st century began.

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Plus, the whole world economy is weak. Just look at the prices of oil and steel...the two things a modern economy needs most. The oil price has collapsed West Texas rig...so completely that it brings into question the entire US oil industry. Modern fracking was born amid prices over $100 a barrel, which made it practical and profitable. Now, at $70 a barrel, the investment is no longer worthwhile. As for steel, Bloomberg is on the story:
    Iron ore capped the biggest weekly decline in more than five months amid expanding global surplus, with Vale SA's opening of a port in Malaysia highlighting rising supplies and investments by the world's largest shippers.

    Ore with 62 percent content delivered to Qingdao lost 4.7 percent this week to $75.84 a dry metric ton, according to data from Metal Bulletin Ltd. The decline completed three weeks of losses, deepening a bear market. Prices, which rose 0.6 percent today to snap a five-day losing streak, reached $75.38 yesterday, the lowest since September 2009.

While China's economy softens, Europe and Japan grow cold, dark and desperate. Last week, ECB chief Draghi announced a 1 trillion euro program to light a fire under the European economy. Mr. Kuroda got out his matches the week before, claiming potentially unlimited tinder.

Can the US resist the worldwide slump? Not likely. It is just a matter of time before either the US economy or US stock markets begin to wobble. We will surely see the Dow fall 1,000 points or more...or else we will hear that GDP growth has gone negative...or both. Then what?

Here is where the guesswork begins, but it seems almost a sure bet that the Yellen Fed will intervene, hoping to prevent a small problem from becoming a bigger one. Ever since the 1930s central bankers have learned that they will scarcely ever be criticized for over-reacting. But if they sit on their hands, they will be damned to Hell. And ever since Alan Greenspan's 1987 rescue, the Fed has backed up the stock market with whatever policy it deemed appropriate. Lower rates? More QE? They'll do 'whatever it takes.' Janet Yellen is also very much aware that the two previous Fed chairmen were both hailed for having saved the economy from destruction. She won't want to be the first to let it fail.

While we are guessing, we'll suppose that each rescue effort will be more costly and less effective than the one that preceded it. That's the way 'stimulus' works. Like looking at naughty pictures, the first are exciting and titillating. Later, they are just boring and sordid. Still, a vigorous new response from Ms. Yellen's will probably set off another produce another increase in asset prices. But then what?

Central bank activism - with more credit at lower rates - only works at all when people see little risk of default or rising rates. But that risk cannot be ignored forever. It is cyclical. It comes around, ferociously, after a long period of calm, apparent stability, over-optimism, over-priced equities, and artificially suppressed yields. When that happens, the central banks lose all their ability to coax stocks higher with low rates, because then low rates will be seen as a threat, not an opportunity.

At that point, and it could be months...or years...ahead, we are likely to see central banks become more creative. What else can they do? They will still be fully committed to 'saving' the economy. When their policy tools fail they will have to come up with something different. What? We see three things:

  1. Directly or indirectly, they will buy equities. Japan, as usual, is ahead of the curve.

  2. Governments will bring out large fiscal stimulus packages...probably aimed at infrastructure 'investments' which are supposed to be pay for themselves.

  3. These will be financed by some form of Direct Monetary Funding provided by the central bank. Instead of lending money, which will drive up government debt alarmingly, they will simply 'print' the needed funds.
All of these measures are either already in service or much discussed in the leading financial journals. What will they mean to stocks? Bonds? The dollar?

Stay tuned.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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