Lately investors have been worried about
liquidity, specifically the central bank’s willingness (or
unwillingness) to continue providing it, and with good reason. Without
periodic injections of liquidity, investors eventually lose interest as
financial markets begin to languish. And in a financial economy like the
U.S., the death of a bull market means the death of the economic recovery.
Bull markets are to a large extent
liquidity driven affairs. Without an abundance of excess monetary liquidity
sloshing through the financial market, stocks and commodities have little
hope of developing the necessary ingredient of forward momentum. Momentum is
what attracts an ever-growing number of investors to participate in a bull
market, which in turn is what keeps the bull market going. When liquidity
dries up, momentum perishes and investors quickly lose interest. This, in a
nutshell, is how bull markets turn into bear markets, viz. the absence of
liquidity.
This week has seen two significant
central bank meetings: the FOMC met on Wednesday while the ECB met today to
discuss monetary policy. Both the U.S. and European central banks
disappointed investors who expected the banks to show their willingness to
provide more monetary stimulus.
The Dow Jones Industrial Average reacted
to this disappointment by falling some 200 points (intraday) over the course
of the last two days. The NYSE Broker/Dealer Index (XBD), which is much more
sensitive to future liquidity expectations, plummeted 9% since
Wednesday’s Fed meeting. The gold and silver stocks were also subject
to the widespread investor disappointment and were down both Wednesday and
Thursday. Although the damage has so far been fairly limited within the PM
stock group, volatility among individual mining shares has been increasing
since the central bank meetings (see HUI chart below).
Bull markets typically begin with a
massive dose of liquidity, just as they end whenever the liquidity stream
dries up. The reason why an increasing number of market participants have
been agitating for the world’s leading central banks to amp up the liquidity is obvious: the U.S.-led global
financial market recovery that began in 2009 appears to be slowly winding
down according to a number of monetary indicators.
One indication of how much liquidity has
diminished in just the last few months can be seen in the following chart.
The following graph shows the Treasury yield curve, which is calculated by
dividing the 10-year Treasury yield into the 3-month T-bill. On a very basic
level tells you gross profit margins of financial institutions. They borrow
short-term money and loan it out at long-term yields. A rising yield curve
– especially when above the 1% level – is generally regarded as
bullish for the financial market and economic outlook.
Since the first and second quantitative
easing (QE1 and QE2) programs of recent years the yield curve has been well
above 1%. But in recent months the yield curve has been falling, as you can
see here. The indicator is still reflective of an overall healthy monetary
trend, but the falling nature of the Treasury curve may suggest to the Fed
that it was high time for the Fed to give the market some sort of boost in
the short term…even if that “boost” was nothing more than
the promise of further stimulus down the road. The Fed’s latest failure
to do so is another reason why investors are understandably concerned about
the tenacity of the recovery and are questioning how much longer it can last
without central bank intervention.
The leaders of both the Fed and the ECB
threw out statements to the effect that they may intervene before the end of
this year, such an intervention isn’t likely. Fed chief Bernanke, like
his predecessor, relies on the stock market as a barometer to tell him when
intervention is seasonable. Barring an unforeseen market collapse by the end
of this year, another round of QE is unlikely in 2012.
Aside from the overall strength
projected by the major stock market indices, another important indicator is
giving Bernanke some assurance that he is okay to hold off on intervening.
The New Economy Index (NEI), which reflects the market performance of the
leading U.S. consumer and business companies, is at a new all-time high as of
this writing. This chart presents the picture of a bullish consumer retail
economic picture, one that Bernanke is surely watching. The last time the Fed
intervened with QE2, the NEI had preceded this by giving a “sell”
signal. No such sell signal has been made in the New Economy Index since 2010.
While it’s true that the consumer
retail economy is still in good shape, it is a mistake to use surface
measures of near-term economic strength like corporate profits and retail
sales to guide policy decisions. Undercurrents of deflation can still be seen
bubbling to the surface from time to time; moreover, the danger of an
economic conflagration in Europe – and the possibility of it spreading
to the U.S. – are reasons the Fed should relax its monetary policy
stance. Unfortunately, there is every reason for believing the Fed will once
again fall asleep at the wheel just as it did in the 2-3 years leading up to
the 2008 credit crisis.
The Fed isn’t solely to be blamed
here. It is a truism of history that both governments and central banks have
an inveterate tendency to underestimate the amount of monetary and fiscal
stimulus needed to resuscitate a flagging economy. Worse, governments often
make the wrong policy choices during the most critical times of an economic
crisis. Paul Johnson, in his 1991 book Modern
Times, made some insightful observations about the economic policies of
the Great Depression. He noted for instance,
“…the 1932 Revenue Act saw
the greatest taxation increase in U.S. history in peacetime, with the rate on
high incomes jumping from a quarter to 63 percent. This made nonsense of
[President] Hoover’s earlier tax cuts but by now Hoover had lost
control of Congress and was not in a position to pursue a coherent fiscal
policy.”
Sadly, history has a perverse way of
repeating itself and if that observation holds true we can expect to see
additional tax increases (in various forms) in the coming years as
governments try to deal with the problem of deflation.
Although QE1 and QE2 had a discernible
impact in lifting equity and commodity prices in the years since the 2008
credit crisis, the Fed’s decision to hold off on any further liquidity
increases will sooner or later feed into the deflationary undercurrents
within the global economy. The reluctance of banks and governments to provide
additional stimulus – whether in the form of monetary easing, lower
taxes and regulatory easing – will contribute to the downward velocity
of the declining long-wave cycle in the next couple of years. Gold, as the
ultimate safe haven at both ends of the long-wave, will eventually prove its
merit as a store of value in deflation. Before we arrive at that critical
juncture, however, there will undoubtedly be phases of volatility along the
way that temporarily obstruct gold’s forward progress – just as
we’ve seen since last September.
Although it may seem premature to assert
that the Fed has hit the proverbial “kill switch” on liquidity,
in the context of the long-wave deflation we’re in this isn’t an
exaggeration. By not maintaining an ample supply of liquidity, the Fed has
effectively numbered the days of the recovery. Whatever gains the market
makes from here will come primarily from a combination of investor
psychology, the peaking 4-year cycle plus the residual momentum from the
2009-2012 bull market between now and early 2013 (when the final “hard
down” phase of the 60-year cycle begins).
2014:
America’s Date With Destiny
Take a journey into the future with me
as we discover what the future may unfold in the fateful period leading up to
– and following – the 120-year cycle bottom in late 2014.
Picking up where I left off in my
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I expand on the Kress cycle narrative and explain how the 120-year Mega cycle
influences the market, the economy and other aspects of American life and
culture. My latest book, 2014:
America’s Date With Destiny, examines the most vital issues facing
America and the global economy in the 2-3 years ahead.
Clif Droke
2014: America’s Date With Destiny
Take a journey into the future with me as we
discover what the future may unfold in the fateful period leading up to
– and following – the 120-year cycle bottom in late 2014.
Picking up where I left off in my previous
work, The Stock Market Cycles, I expand on the Kress cycle narrative and
explain how the 120-year Mega cycle influences the market, the economy and
other aspects of American life and culture. My latest book, 2014:
America’s Date With Destiny, examines the most vital issues facing
America and the global economy in the 2-3 years ahead.
The new book explains that the credit crisis
of 2008 was merely the prelude in an intensifying global credit storm. If the
basis for my prediction continue true to form – namely the long-term
Kress cycles – the worst part of the crisis lies ahead in the years
2013-2014. The book is now available for sale at:
http://www.clifdroke.com/books/destiny.html
Order today to receive your autographed copy
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