Central Banks: Going for Broke – All for the Debtors – June 6, 2014

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Central Banks: Going for Broke – All for the Debtors

Wednesday night, the ECB cut its main refinancing rate to 0.15%, its marginal lending rate to 0.40%, and its deposit rate to -0.10%. Draghi based the decision upon the increased risk of deflation in the eurozone – by that, we assume he’s referring to the eurozone periphery (the PIIGS). There, despite the ECB’s best efforts, the percentage of non-performing loans (defaults) has more than doubled since the PIIGS debt crisis began in 2008. Greece’s bad debts have recently spiked to 31.26% of all outstanding loans (before the crisis they were less than 5%). Ireland’s rate is currently 24.64%; Portugal, 10.96%; Italy, 10.0%; and Spain, 8.25%. Cutting rates, or lowering the cost of outstanding debts, may help to slow the default rate temporarily. However, with rates near zero, the ECB is planning to escalate its easing efforts to include asset purchases – affectionately known as QE.

MWM 14, 6-6 Box ScoresLet’s not forget that two years ago, when Draghi repeatedly assured investors that the eurozone funding crisis had been avoided, the EU economy was improving and confidence in the euro had been restored. It was just last year when things were so good that Draghi was planning to exit stimulus efforts altogether because inflation had returned. Of course the inflation part has always been true. The rest … not so much.

Preceding the ECB’s announcement, both China and Japan were exploring new ways to stimulate. The PBoC may widen its gaze to include asset purchases, while the BoJ may require pension fund operators to increase their allocations to Japanese stocks. Combined with a US non-farm payroll in May that beat expectations, markets (stocks and PIIGS debt) worldwide enjoyed a decent bounce at the expense of short sellers in what are still some of the lowest volumes seen in months, if not years. Incidentally, nearly all of the 217,000 jobs created in May were derived from birth/death model assumptions.

Away from stocks, US Treasuries slipped, but the euro rose against the dollar (the opposite of ECB intentions), while the precious metals managed a decent gain (see scores). Gold rallied above the $1,250 mark and held. We imagine that once the Fed capitulates on its tapering policy, much as the ECB has, gold could be in for a sizeable move higher. However, given the stock market’s behavior of late, it’s unlikely the Fed will change its policy stance before the next FOMC meeting June 18th. In the meantime, gold should stabilize on the events unfolding overseas.

At some point, it’s going to become obvious to investors (i.e., hedge fund managers) that central bankers are caught in the biggest liquidity trap of all time. The bankers’ need to print to stave off mass default is taking precedence over surging inflationary pressures – at least for now, until inflation overwhelms all else in the equation. Said a different way, the debt issues are making inflation or even hyperinflation as close to a guarantee as one can get.

It might pay for investors to recall Warren Buffet’s remark regarding monetary policy in 1995. He stated that by then it had gone “past the point of no return.” When one thinks about the trillions printed and borrowed since that time, just imagine where we are now – food for thought.

Best Regards,

David Burgess
VP Investment Management