November was certainly a “game changer” of a month now, wasn't it? We saw the underdog win the Presidential election, and that brought a new thought in the markets. The Bond Vigilantes appear to be returning after a very long absence, and is a liquidity crisis in our future? These thoughts and more will be discussed in this month’s Review & Focus, so let’s not dawdle, and get right to them!
A Game Changer
The new President-Elect (PE), Donald Trump, has brought about a change of thinking in the markets that hasn't existed in over a decade, and that is that inflation is going to rise, and that tighter monetary policy will follow. Right now, the markets believe that the Federal Reserve Bank (Fed) will stay in front of rising inflation with rate hikes and, therefore, keep inflation from running away. In this scenario, the U.S. dollar is the winner, because it will not only enjoy a positive rate differential to the euro, yen, sterling and loonie, but also a positive rate differential vs. internal inflation.
In my opinion, that's a Goldilocks scenario folks, and one that is mostly likely not going to materialize. It's just not in history that a Central Bank is able to keep a lid on runaway inflation, and it usually gets caught behind the inflation 8-ball, and then scrambles to play catch-up. If that's the case—and I would bet on this being the case if I were a betting man—then the dollar will struggle to maintain the strength it built during the time when the markets thought all would be right on the night with inflation.
So, why do the markets believe that Trump's policies will be inflationary? Well, first of all, on the campaign trail, the PE made quite a few promises; to keep them all now will be nearly impossible. So, I'll pick out the ones I believe are the ones that will be at the top of his list for the first 100 days in office.
- Renegotiate the North American Free Trade Agreement (NAFTA) or withdraw from the deal
- Withdraw from the Trans-Pacific Partnership trade deal
- Label China a currency manipulator
- Identify all trading abuses that unfairly impact American workers, and direct the Secretary of Commerce and the U.S. Trade Representative to use every tool under American and international law to immediately end those abuses
- Establish tariffs to discourage companies from laying off workers in order to relocate to other countries and ship their products back to the U.S. tax-free
- Begin infrastructure projects throughout the country
- Cut taxes and simplify the tax code
So, on that list are some very inflationary policies, tax cuts, and the deficit spending that will go along with infrastructure projects. The real economic growth killer could be in the tariffs that the PE plans to begin to implement. Simply refer to the Smoot-Hawley Bill that implemented tariffs and basically sealed the deal for a depression in 1930. Or the Japanese Steel tariffs that President Bush implemented in 2001.
But, for now, the markets are of the belief that the Fed is in control, and that inflation and interest rates are going higher, and that has the dollar back on top of the hill as the king currency. Not since 2001 have we seen the dollar this strong and until we receive some clarity on what the PE's policies will be, I suspect the dollar will remain the king of the hill.
Have The Bond Vigilantes Returned?
Given the long discussion we just finished, one would think that the Bond Vigilantes would be knocking at the door. First though, let's talk about what a Bond Vigilante is…A bond vigilante is a bond market investor who protests monetary or fiscal policies he or she considers inflationary by selling bonds, thus increasing yields. In the bond market, prices move inversely to yields.
The U.S. Treasury 10-year yield has risen since the election result from 1.58% to 2.32% on November 18. That's quite an increase in such a short period of time, and would indicate that the Bond Vigilantes, who haven't been heard from in over a couple of decades, would be responsible for such a move.
Have you ever heard of CoCo bonds? Tier 1 contingent convertible or ‘CoCo’ bonds are designed to automatically convert from debt into equity in order to circumvent the messy and often protracted negotiations, which inevitably take place whenever such a conversion is called for.
But, haven't we seen these quick moves up in yield before only to have them prove to be nothing more than a false dawn? Yes, would be that answer. How many times in the past few years have we heard the cries of, “This is it! The end of the bond bull market is here!”? The years 2008, 2012, and 2014, come to mind for me as times when bond yields began to rise, only to fall back when inflation proved to be fleeting. I'm talking about the official inflation that the Fed uses to gauge the need to hike rates. Inflation is a personal thing, in my opinion, as each person buys things that the person next to them doesn't, and so on.
I, myself, was once caught up in this rising bond yield talk and wrote a white paper for the Sovereign Society back in 2008 about the popping of the bond bubble. But, that was before the Fed began their journey on the Bond Buying road known as Quantitative Easing (QE). With the Fed buying large portions of the annual Treasury auctions, there was nowhere for bond yields to go but down. In my presentations to audiences after the first round of QE by the Fed, I would have a slide of a man banging his head on his desk, and I would tell people that was me for calling for a pop of the bond bubble.
So, is it too early to say that inflation is going to become a problem? Will interest rates have to rise, along with bond yields, to end the great bond bull market once and for all? I do believe so given that we've seen this all fail to materialize a few times in the past. Keep your attention focused on the 10-year Treasury. It's the bond that's used to price mortgages and, thus, it is the most traded. If the 10-year Treasury yield rises past 2.50% in the coming weeks, then the rout on bonds could be on, and the Bond Vigilantes would be confirmed as having returned.
A Dollar Shortage?
I had a short piece on this thought of a Dollar Shortage in my Daily Pfennig® blog, and thought I would repeat it here, and then add more depth since I have more space here. So, here we go…
“Basically, there are economists out there telling the Fed that a rate hike would cause a dollar shortage, which would push the lack-of-liquidity envelope to the edge of the desk, and probably see it fall off, and then all hell would break loose in the world, if there was a lack of liquidity. Much like in 2008, when everyone wanted their money back, but this time we're starting from a hole in the ground, and there’s nothing we could do, save extreme money printing, helicopter money, and other drastic things that could cause social problems…
“So, now I hear you saying, “How in the world can there be a dollar shortage when the Fed printed more than $3 trillion in new dollars during the QE/bond-buying period?” Ok, grasshopper, here you go, stay with me on this: Basically, as the Fed was making money cheap, and easy to obtain, dollar denominated debt was created (Why not, right? Low rates to borrow at!). And, when debt/bonds are created, they are created, according to James Rickards, at a 20-fold pyramid. That means $60 trillion in new dollar denominated debt was created between 2009 and 2015 when QE stopped.
“So, guess what needs to continue for this entire new dollar denominated debt (triple D!) to carry on as if nothing bad has or will happen? Well, global growth needs to be running on all eight cylinders. And, since that's not even close to happening, and global growth is running on maybe four cylinders right now, as these bonds mature or even have interest payments, they need dollars to pay the bond holders. And, guess what? The debtors/issuers don't have the dollars to complete the deal, and if the cost of those dollars continues to rise (through rate hikes in the U.S.), the liquidity crisis will be staring at us through both barrels.”
In 2008, the liquidity crisis was very close to shutting down the entire financial system. And 2008, was worse than 1998, when the financial system also came close to shutting down due to a lack of liquidity. We saw it in 1998 and in 2008 and we see it now, with each time having larger numbers to deal with. It scares the bejeebers out of me, folks, and it's right there in front of everyone's faces. Fed Member Stanley Fischer denies that there's a problem brewing. He recently responded to a question regarding the proposed rate hike causing a liquidity problem by saying that he didn't see it that way, and that the markets should be getting ready for a rate hike.1
So, maybe I'm the boy crying wolf, again. And, maybe, I'm Paul Revere. Either way, wouldn't it make abundant sense to make certain that you have something set aside that's not dollars? You buy flood insurance in hopes that it never floods, right? And, you buy auto insurance in hopes that you never have an accident. Should the dollar become caught up in a potential liquidity crisis, you'll want to have already secured your protection against dollar weakness.
What To Do, What To Do?
As long as the dollar is playing king of the hill, and there's no clarity on what the policies of the PE will be, we have a couple of options as non-dollar investors. We can batten down the hatches and run for cover, and wait for an all-clear sign. Or, we can use the dollar's strength as an opportunity to purchase more currencies and metals at much cheaper prices. Or, we can look for a gem or two. Goldman Sachs recently issued a report saying that for 2017 they would be looking to own Russian rubles, South African rands, Brazilian reals, and Indian rupees.2 Now, those four currencies are still considered by many to be from emerging market economies and therefore may be subject to greater volatility than other currencies. Keep in mind though that these currencies may be offered through accounts that pay higher interest rates, which gives them what I call a “risk premium” that may help to offset some of this volatility. And I always tell people to only own currencies from emerging market economies with the speculative portion of your investment portfolio.
Well, it's that time of the year again—it's Christmas time! And, I'm doing much better this year health-wise than last year. I truly appreciate everyone that tells me they pray for my health, as I'm a big believer in the power of prayer. Cancer continues to live in my body, but like I said, I'm doing much better now than before.
Before I go, Pfennig tradition says that we get to say these special words to you:
I'm very thankful. I think about the late Jimmy V (Jim Valvano) and his famous speech before he passed away from cancer. He said, “To me, there are three things we all should do every day. We should do this every day of our lives. Number one is laugh. You should laugh every day. Number two is think. You should spend some time in thought. And number three is, you should have your emotions moved to tears, could be happiness or joy. But think about it. If you laugh, you think, and you cry, that's a full day. That's a heck of a day. You do that seven days a week, you're going to have something special.”
I live my life now to those thoughts. And now, it's time to get ready for Christmas. As I've said in past years, I'm someone that celebrates Christmas, and so, in hopes that you are not upset with me talking about Christmas, I will tell you that I'm like a little kid at Christmas; it's my second favorite time of year, and I can't wait!
As tradition dictates, I leave you with a poem each year at this time, and here it is:
May the light of faith, the warm of heart, and the love of family be your gifts this year.
Happy New Year, too!