charts092410Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Misdirection: Henning Nelms writes that, “Every performer needs to control the attention of his audience. But whereas actors and most entertainers are largely concerned with directing attention toward the point which happens to be important at the moment, conjurers are equally concerned with diverting attention away from some device. This is termed misdirection.” This is the art of illusion. And it’s the art practiced by the Federal Reserve today; the art of misdirection.

The public is expecting the following, based on a recent Federal Reserve communiqué: From the Mortgage-Backed Securities (MBS) on the Fed’s balance sheet, principle and interest payments are to be directed toward the purchase of Treasury bonds (monetization), which will maintain the current size of the Fed balance sheet, and, in the course of time, improve balance sheet quality as the MBSs are eliminated or phased out. The Fed has told the truth – that is occurring. But it’s not all that’s occurring.

The less obvious undercurrent is also found in the Fed’s active market involvement. This week, the Fed did in fact retire $361 million in MBSs from their balance sheet. But, rather than monetize a commensurate amount in Treasuries, which it told you it would do, it monetized $10.461 billion in Treasuries. That goes well beyond the scope of the promised MBS-to-Treasury conversion. In fact, it seems to us that this is full-tilt monetization that signals the arrival of the Quantitative Easing (QE) 2 program the market has been looking for. There is one set of actions the audience expects, and another that goes more or less unnoticed (misdirection in action). Keeping it quiet is what sings so loudly to us. The Fed has done a masterful job of diverting attention.

In reality, (as suggested in past weeks) QE 1 never ended. Fed monetization continues at a brisk pace. Bernanke is supporting the markets ahead of the election, all the while saying it isn’t necessary and won’t occur except under dire circumstances. For the month of September, the Fed is on track to monetize $30 billion via Treasury purchases. Does anyone notice? Does anyone care about this sleight of hand?

The issue in this case is not just one of performance and entertainment. There is purposeful misdirection that leads the public to believe one thing while reality lines up quite differently. What would occur if the market could discern the intent of Ben Bernanke, our modern day monetary wizard? How would market practitioners act if they knew a limitless supply of liquidity was being provided to ease the strains in the market? How would the dollar behave, how would gold behave? This is not so much a mastery of magic on Ben’s part as it is a cheap trick foisted on the world’s investors; propping up a perception of stability and viability. Seeing reality does at this point include the anticipation of curtains.

2. If at First You Don’t Succeed … Try, Try Again. Since the crisis hit in 2008, the economy has proved that it doesn’t respond to Fed easing. But that’s not stopping the Fed from stepping on the gas once again, as promised in the latest FOMC remarks last Tuesday. Not only is doing so fraudulent, as Dave McAlvany explained above, but it now seems to be a permanent fixture in the workings of our beleaguered economy. So the question now confronting analysts and economist is: how will the markets (and or economy) react to a constant (and increasing) supply of artificially created units of currency?

To give us some clue as to the future, I have provided two graphs. One charts the Nikkei 125, Japan’s stock index, and the other charts Gold in Japanese Yen terms. I’m not trying to pick on Japan here, but its fiscal and economic situation is one that closely resembles our own.

Following the breakup of the Japanese mania in 1989, the Japanese Central bank panicked and lowered its benchmark interest rate to 0% by roughly 1995 and kept it at that level ever since. The result, as shown in the charts, has been perpetual deterioration in the value of the Japanese stock market while gold, in yen terms, gained substantially (from January 1995: Nikkei down 55.26%, Gold in yen up 192%).

In our case, the Fed reached near-0% rates at the end of 2008, and since then both gold and the Dow have risen, with gold up 68% and the Dow up 33%. We suspect the reason we haven’t entered into a polarized situation like Japan’s has more to do with the strength in the bond (Treasury) market than anything else. But, given the Fed’s obvious contempt for the dollar, it’s only a matter of time till the bond market buckles under the pressure. That will usher in a near mirror image of Japan’s experience – right here in the U.S. In a nutshell, we have gone past the point of no return here; inflation is now an inevitable conclusion, and in a big way. Stay tuned…

Hope your weekend’s a good one.

David Burgess
VP Investment Management

David McAlvany
President and CEO