Risk assets and financial markets around the world have been supported by
central bank action for several years. Performing financial alchemy on a scale
larger than has been seen in the history of mankind, central banks have hijacked
global financial markets. Mountains of liquidity, artificially low interest
rates, and the creation of future asset bubbles has been their calling card
for the past few years.
Unfortunately, time is starting to run out and these great Keynesian minds
are on the verge of encountering a series of problems. While central banks
can create fiat currency out of thin air, they cannot create real wealth. In
fact, central banks cannot print jobs, earnings growth, or an increase in wages.
Furthermore, in a paper put out by the New York Federal Reserve in 2012 and
covered by zerohedge.com ("Fed Confused Reality Doesn't Conform to Its Economic
Models, Shocked Its Models Predict Explosive Inflation") the Fed openly admits
that forward outcomes cannot be predicted with accuracy by their economic models.
Furthermore, one of the models known as the Smets and Wouters Model has predicted
significant inflation if interest rates were held near zero for more than 8
quarters.
For inquiring minds, I would forward readers to the zerohedge.com article
for a more in depth explanation. Ultimately the Federal Reserve is performing
a gigantic experiment in real time while admitting their economic models do
not accurately portray outcomes in the future. Nowhere can this be seen more
than in recent price action in U.S. Treasury prices.
Since mid-November of 2012, the 30 Year Treasury Bond has seen prices go down
by roughly 9% in value. When Treasury prices are falling, interest rates are
rising as there is an inverse relationship between bond prices and yields.
When longer term Treasury bonds are demonstrating rising interest rates it
is a signal that the bond market is expecting higher inflation levels out into
the future. The weekly chart of the 30 Year Treasury Bond is shown below.
As can clearly be seen above, prices have been coming down for several months
and we have initiated a price pattern with lower highs and lower lows. This
is not a bullish pattern by any means and should the 30 Year Treasury bond
take out key support around the 135 price level the Federal Reserve will be
in an awkward position.
The Fed's problem lies in the fact that the Federal Reserve is printing nearly
$85 billion dollars of fiat currency to purchase U.S. Treasury and agency bonds
and rates have still risen. It would only make sense that at some point, the
Federal Reserve will have to ratchet up their program to defend Treasury prices.
If the printing presses fire up fast and furiously to help put a floor under
Treasury bonds (cap rates), what is going to happen to commodity prices such
as oil? As shown below, the oil futures daily chart illustrates a coiled price
pattern that ultimately will lead to a strong move in price.
A move in oil prices above the $96 - $98 / barrel level will likely lead to
a powerful move higher in oil prices toward the $100 - $112 / barrel range.
Obviously a big move is coming and we could see a move lower just as easily.
I have no idea where price is going, but what I do know is that oil prices
are staged up for a fast, large move in price.
Interestingly enough, gold futures are also in a basing pattern after selling
off sharply earlier this year. Similar to oil futures, gold futures prices
are coiling up as well and could go either direction as shown below:
As can be seen above, gold futures are trading in a consolidation pattern
which could lead to a strong breakout in either direction. While the upside
seems more likely, it goes without saying that lower prices are always a possibility.
However, the point I would make to readers is that a large move in the near
future seems likely in both gold
and oil futures.
Gold is simply a hedge for inflation and acts as a senior currency, however
if inflation increases gold will protect owners from a reduction in purchasing
power. From an economic standpoint, oil and energy prices are far more important
than gold prices. If the Federal Reserve's Smets and Wouters Model is accurate
in its expectation of strong inflation pressure in the future, I would anticipate
seeing a strong move higher in both oil and gold prices.
However, the real point is that the Federal Reserve will likely find itself
in a precarious position in the future. On one hand, they have to print money
to backstop Treasury bonds through additional quantitative easing machinations.
On the other hand, the additional liquidity may start pouring into commodities
if inflationary pressures begin to mount.
Ultimately the Federal Reserve may attempt to hold down interest rates to
help the economy but if their activities cause energy prices to spike the U.S.
economy will begin to move toward recession quickly. In addition to that scenario,
it should leave many readers unsettled that it would appear Treasury rates
are rising while the Federal Reserve continues to print vast sums of fiat currency
to buy more government debt.
Ultimately, the Federal Reserve does not have a great answer about the future
since they publicly admit many of their models do a poor job of predicting
future economic conditions based on actions that they are taking. At the end
of the day, this is just one gigantic Keynesian experiment worldwide and the
outcome will follow historical trends.
It does not take an economic genius to understand that the vast amounts of
fiat currency created by the unprecedented recent actions of the Federal Reserve
will have to find a home somewhere. This process will likely manifest as dramatically
higher prices for a host of necessities in the future. In fact, the recent
parabolic rise in stock market prices can be viewed not as higher prices for
equities, but simply lower valued U.S. dollars.
Perhaps instead of concocting models with large names which simply do not
work, why doesn't the Federal Reserve open a few history books. Regardless
of what central bankers believe or what their models produce, history's version
of the outcome is simply unpleasant. Ultimately the Federal Reserve should
focus on the old adage that those who ignore history are doomed to repeat it.
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