Poor Infrastructure Costs Permian Producers $22.09/Barrel

By Jody Chudley

Jody Chudley

This post Poor Infrastructure Costs Permian Producers $22.09/Barrel appeared first on Daily Reckoning.

The ability of the American oil producers to grow production continues to amaze. Shale oil production in the Permian Basin keeps surging higher.

Unfortunately, the inability of American oil producers to plan for this production growth also continues to amaze. This production growth has now overwhelmed the pipeline and refinery capacity in the region.

Why does that matter?

It matters because all of this excess oil in the region has crushed the WTI Midland oil price — the price that Permian Basin producers receive for selling their oil.

Permian producers are missing out on billions of dollars of cash flow because they have grown too far, too fast.

The Oil Is Basically The Same — But The Prices Are Very Different

What we need to first understand is that there is no single price for oil.

In fact, there are many different prices for oil. Those price differences relate not just to the quality of the oil (heavy versus light), but also the location at which the oil is priced.

Today I want to talk about just three different oil prices, and give you two stocks that benefit from the spreads…

Brent Crude — Brent is a type of sweet light crude and is the primary price for oil globally. It is the global supply and demand fundamentals that dictate the price of Brent.

Nearly two thirds of oil transactions involve Brent pricing.

As I write this, Brent crude is trading for $75.27 per barrel which is the price that global producers are getting for the oil they sell.

West Texas Intermediate (WTI) — WTI (also a sweet light crude) is the main benchmark price for United States oil. When you see the price of oil being referred to on television it will most likely be WTI.

WTI relates to oil produced from wells in the United States and delivered to the major oil trading and storage hub of Cushing, Oklahoma.

As I write this, WTI is trading for $65.25 per barrel which is more than ten dollars less than Brent crude. That is a big difference — almost 15 percent.

That means that U.S. producers selling oil at Cushing are receiving $10 less per barrel than other producers around the world for an identical product.

That is bad, but others have it even worse…

WTI Midland — WTI Midland is the price for oil that is delivered to Midland, Texas. This is the main price for oil being produced in the Permian Basin which has been the main driver of “The Great American Oil Boom” over the past couple of years. Like West Texas Intermediate and Brent, this is a light sweet oil.

As I write this, WTI Midland is trading for $12.07 less per barrel than WTI (which is already trading for $10 per barrel less than Brent).

That means that Permian producers aren’t just receiving a selling price that is discounted from Brent, but are receiving a selling price that is further discounted from WTI.

As of today the three oil prices are:

  • Brent — $75.27 per barrel
  • WTI — $65.25 per barrel
  • WTI Midland — $53.18 per barrel

Because Permian producers have overwhelmed the Permian Basin’s infrastructure, companies are being forced to take more than a $20 per barrel discount to what global producers (and OPEC) are selling oil for.

With production costs that come in around $30 per barrel, Permian producers are turning profits of $23.18 per barrel today. If they were receiving Brent pricing, those per barrel profits would be $45.27 per barrel (a difference of $22.09).

That means that Permian producer cash flows are being cut in half by these big pricing differentials.

Sadly, this is an issue that is not going to go away any time soon. There isn’t expected to be enough pipeline capacity added until the end of 2019 which means American producers are going to lose out on billions of dollars of cash flow over that time.

This is exactly the same thing that happened in the Bakken a few years ago when production growth far exceeded pipeline capacity. I can’t believe the industry has made exactly the same mistake in the Permian just a couple of years later.

One Company’s Nightmare Is Another Company’s Dream

Not all Permian producers will be impacted in the same manner. Some companies have hedged away some or much of the risk of these differentials blowing out. Some have hedged little.

All will be negatively impacted to some degree.

For refiners who purchase oil from this region, this low Midland WTI price is terrific news — a virtual license to print money. These refiners get to purchase their raw crude oil input product at low Midland WTI prices and then sell their finished products (gasoline, etc.) at a price that is based off of global Brent pricing.

That makes for extremely wide profit margins.

Without a doubt the refiner that benefits the most from low Midland WTI prices is Delek (DK) with HollyFrontier (HFC) being a strong second. Delek can generate an extra $75 million in cash flow from each $1 per barrel that the Midland WTI price drops below WTI. And that is on top of the benefit that Delek receives from WTI trading at a discount to Brent.

I’m sure these refiners are licking their chops because it looks like the next 18 months are going to involve some very fat profit margins.

Here’s to looking through the windshield,

Jody Chudley
Financial Analyst, The Daily Edge

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Trouble Brewing in Emerging Markets

By James Rickards

Jim Rickards

This post Trouble Brewing in Emerging Markets appeared first on Daily Reckoning.

Emerging markets, EMs, have had an amazing run over the past two years. Moving in lock step with U.S. stock markets, the leading EM stock ETF has produced gains of over 50% since early 2016.

But just as U.S. stocks have run into higher volatility and major drawdowns in recent months, EM stocks have also encountered head winds. A major reversal of EM stock gains is emerging.

Your correspondent in front of the ruins of Al-Khazneh (the “Treasury”) in the ancient city of Petra in a remote part of the Jordanian desert. These ruins were featured in the Indiana Jones film series. I spend about 30% of my time in overseas travel, and about half of that in emerging markets, from China to Africa to South America. Emerging markets have seen rising asset prices since 2009 as global investors sought higher yields than were available in developed markets. Now that the U.S. is raising interest rates, an outflow of hot money from the emerging markets back to the U.S. may lead to a global credit crisis.

The reason U.S. stocks and EM stocks have moved together is not difficult to discern. Both asset classes are what economists call “risky” assets, in contrast to “safe” assets such as developed-market government bonds or even “risk-free” assets such as short-term U.S. Treasury bills.

(Of course, no asset is truly risk free. The U.S. credit rating suffered a downgrade in 2011 and may be downgraded again later this year).

These distinctions between risky and risk-free assets are used by portfolio managers to construct diversified portfolios that attempt to optimize total returns on a risk-adjusted basis — that is, taking into account volatility, return and liquidity.

The difficulty is that major institutional investors such as banks, insurance companies and pension funds have return targets they must meet in order to have a profitable and competitive business. These return targets come from promises to insurance policy holders, retirees or stockholders. Naturally, portfolio managers are expected to take more risk in order to earn higher returns.

Developed-market government bonds have been unattractive to many portfolio managers for the past decade. These bonds offered negative returns in the cases of Japan, Germany and Sweden. Returns were not much higher in the U.S. and Canada.

Pension managers and insurance companies in particular expect their portfolios to meet return targets of 6–8% in order to pay promised benefits. With government bond rates stuck near zero, these portfolio managers went elsewhere in search of higher returns.

Many low-yielding developed-economy government bonds were purchased by the central banks of the issuing countries as part of money printing programs intended to drive down yields and force investors into risky assets such as stocks and real estate.

This effort on the part of central banks to reduce yields on safe assets and force investors into risky assets, known as the “portfolio channel” method, was supposed to produce a “wealth effect.”

In theory, investors would drive up stock prices, which would encourage consumer confidence and consumer spending and ultimately result in a return to trend economic growth of 3% or higher.

The wealth effect never materialized. Consumer confidence was boosted by higher stock prices but consumers never increased their spending to any significant extent. Instead, they paid down debt as a way to repair their personal balance sheets after the historic losses of 2007–08.

Instead of producing more consumption, the portfolio channel effect only produced asset bubbles in U.S. and emerging-markets stocks. Investors chased the stock market higher as a way to meet their investment return targets.

The same was true in emerging markets. EMs also borrowed heavily in dollars at low rates to finance the expansion of their manufacturing and export capacities. U.S. and EM stocks enjoyed a “Goldilocks” moment the past two years. Institutional investors purchased these assets for higher yields.

The purchases drove up prices, which attracted more buying. The feedback loop continued as higher prices encouraged more buying, which led to higher prices, and so on.

The persistence of this feedback loop practically eliminated volatility, as stocks seemed only to rise and never fall. Computers interpreted this absence of volatility as a sign that these markets were less risky, since volatility is a standard measure of risk in prevailing risk-management models.

Using “risk parity” approaches, the computers then bought even more equities because they seemed to offer an optimal combination of high return and low risk, the Holy Grail of investment management.

Now lately this entire process has been thrown into reverse. The three bears have returned home and Goldilocks has jumped out the window and fled into the forest.

The primary cause of this reversal is central bank tightening. This already exists in the U.S. and is coming soon to the U.K. and the eurozone. Japan may be a few years behind the rest of the developed world but it is also working toward policy normalization.

The result is that yields on low-risk developed-economy government bonds suddenly look relatively attractive to institutional investors compared with the drawdowns and increased volatility of U.S. and EM stocks.

The Great Unwind has begun.

Hot money has been heading out of stocks and moving in the direction of government bonds, where higher risk-adjusted returns await.


With this market backdrop in mind, what are the prospects for emerging markets in the months ahead?

Outflows from EM stocks have just begun and are set to accelerate dramatically in the months ahead.

This could lead to a full-blown emerging-market debt crisis with some potential to morph into a global liquidity crisis of the kind last seen in 2008, possibly worse.

Some of the main drivers of this outflow from EMs are:

  • China has begun cracking down on excessive leverage, zombie companies and shadow banking. The result will be a slowdown in growth in the world’s second- largest economy as the Communist Party tries to bring a credit bubble in for a soft landing. If they fail, the result will be worse than a slowdown; it could be a made- in-China credit crisis
  • President Trump has launched a trade …read more

    From:: Daily Reckoning

An Urgent Warning for the Fed

By Brian Maher

This post An Urgent Warning for the Fed appeared first on Daily Reckoning.

The Federal Reserve is unwinding its balance sheet.

At the same time, the Treasury is issuing gorgeous amounts of debt to pay for the Trump tax cuts.

Are the two policies — seemingly disconnected — combining to create a dollar liquidity crisis?

Today we identify hidden linkages… connect far-flung dots… and unearth potential seeds of mischief.

We first set the scene…

The Fed inflated its balance sheet by a cosmic $3.4 trillion between 2008–2015.

And its ultra-low interest rates made dollars available nearly free of charge.

Several emerging-market governments, corporations and banks rose to the bait.

And they created their own mountains of debt with borrowed dollars.

In fact, the world conjured new dollar-denominated debt with even greater gusto than the Fed conjured dollars.

Over $60 trillion of fresh debt sprang into being during this time — much of it overseas.

“This huge debt pyramid was fine,” says Jim Rickards — “as long as global growth was solid and dollars were flowing out of the U.S. and into emerging markets.”

But global growth slipped in 2018’s first quarter — growth even ran negative in Japan.

And the outflowing tide that once swept dollars into emerging markets… is now receding.

The dollar is surging.

A rising dollar increases the burden of the dollar-denominated debt emerging markets took on in the heady days of near-zero interest rates.

Rising U.S. Treasury yields also attract greater investor interest… which draws investment away from riskier emerging markets.

In turn, fewer dollars are available to service the rising costs of emerging-market debt.

That way trouble lies…

Bloomberg informs us that dollar-denominated debt is now becoming “one of the weakest links in the global financial system.”

It should therefore not surprise that emerging markets have come in for hard sledding.

The MSCI Emerging Markets Index has since fallen over 10% after peaking in January.

January, the calendar confirms, arrived three months after the Fed began tackling its balance sheet in October.


Not according to Urjit Patel, governor of India’s Central Bank:

Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet.

The Fed’s shrinking balance sheet is reducing dollar availability.

And emerging markets are feeling the blade.

But earlier we raised the issue of the Trump tax cuts.

How in blue blazes do the tax cuts tie in with the Fed’s balance sheet… and a possible emerging-market crisis?

It is time to connect dots…

Taxes have been cut.

But government spending — to state it charitably — has not.

February’s bipartisan budget deal lifts spending an additional $300 billion over the next two years.

To make good the shortage, the Treasury is issuing vast amounts of debt.

Through 2019, it is on track to sell $1.2 trillion worth of Treasuries to cover the projected deficit.

And every dollar pouring into U.S. Treasury debt… is one dollar unavailable for overseas duty.

Combine the shrinking balance sheet with the dollar-hoarding Treasury issuances… and the result is a global dollar shortage.

The aforesaid Mr. Patel calls the business a “double whammy.”

And he believes the Federal Reserve is sound asleep.

Wake up, he tells Jerome Powell.

And take your wingtips off the monetary brake — or else:

… the Fed has not adjusted to, or even explicitly recognized, the previously unexpected rise in U.S. government debt issuance. It must now do so…

Given the rapid rise in the size of the U.S. deficit, the Fed must respond by slowing plans to shrink its balance sheet. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.

Mr. Patel adds the Fed should “damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher U.S. government borrowing.”

Our agents inform us the Fed has no plans to heed Mr. Patel’s counsel at this time.

But the prospect of a crisis in the dollar bond markets is enough to send Jim Rickards under the bed in terror:

It raises the prospect of a new liquidity crisis and financial panic worse than 2008… There are not enough dollars to go around. The losses will be enormous… We are closer to the stage (last seen in September 2008) where “everybody wants her money back.” When that happens, there’s never enough money.

And so the Fed could bumble its way into another crisis — if the foregoing analysis holds together.

“The paths of error are many,” said Aristotle, “the path of right doing is one.”

Given its record…

Do you think it more likely the Fed will select the right path… or one of the many paths of error?


Brian Maher
Managing editor, The Daily Reckoning

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Small Stocks Are Set For BIG Gains

By Zach Scheidt


This post Small Stocks Are Set For BIG Gains appeared first on Daily Reckoning.

Stocks are making another set of new highs this week much to the delight of investors across the country.

What’s that? You thought the market was still in a correction?

You must be looking at the wrong chart…

Because today — and actually for more than two weeks — stocks have been making new all-time highs.

See for yourself!

The Small Stock Market That’s Notching Big Gains

When investors hear about the “stock market” on a particular day, most think about the Dow Jones Industrial Average (or simply the “Dow”). The Dow is an average of 30 of the biggest U.S. stocks.

As you probably know, this measure of the market is full of flaws.

First of all, 30 stocks is a small sampling of the roughly 3,600 companies listed on U.S. stock exchanges at the end of last year. Plus, as a price-weighted index, the Dow gives an arbitrary heavy weighting to stocks with high prices.

In short, the Dow is a horrible way to measure how the market is doing. And it’s not helpful to compare your own returns to the Dow’s gain or loss.

A second index people compare returns to is the S&P 500 index.

This measure is a little better because the index covers a wider group of 500 different stocks. So the S&P 500 gives us a better picture of how the whole market is doing.

But there are still some problems.

Namely, the S&P 500 only looks at the biggest companies on U.S. exchanges. And the index is weighted based on the market cap. So big companies have much more influence on the market than smaller companies.

For instance, Apple Inc. (AAPL) with a $960 billion market cap, has more than 100 times more influence on the market than tiny Foot Locker (FL) which only has a $6.5 billion market cap.

I’m assuming you don’t invest 100 times as much of your money in Apple as you do in shares of a smaller company.

Here’s a stock market chart that may be different from the stock market chart you see on the nightly news:

This is the Russell 2000 small cap index. It’s an index made up of 2,000 smaller companies listed on the U.S. exchanges. And as you can see, this small-cap index hit a new high yesterday after recovering nicely from the volatility earlier this year.

The Best Shopping Mall for Growth

As an investor, I’m always looking for ways to grow the value of my account.

There are times when it makes sense to look at big companies with solid balance sheets and established businesses. That’s because these companies typically have stable outlooks and can have less risk.

But smaller companies can have some tremendous advantages when it comes to growth opportunities.

For starters, small companies have more room to grow simply because of the fact that they’re small!

Think about it for a second…

Apple Inc. had $247 billion in revenue over the last year. How likely is it that Apple will double its revenue in the next year? Or even in the next five years?

Apple has pretty much saturated the market for smartphones, computers and tablets. Sure, the company will continue to roll out new products to its customers. But you can’t expect a huge percentage gain in sales because of the huge base Apple already has.

But a smaller company like Peabody Energy (BTU) is completely different.

This is just one example, but Peabody is a niche natural gas player in the U.S. With annual revenue of just $1.5 billion, it wouldn’t be too hard for the company to drill some new wells or to realize higher prices on its natural gas production — and quickly double its revenue!

Small companies have more potential for growth simply because they haven’t saturated their market yet.

And in the U.S., small-cap stocks have some other great advantages over their large-cap counterparts.

For instance, most large-cap stocks are currently facing the headwind of a strong dollar.

A strong U.S. dollar makes it harder for companies with international sales to compete. That’s because it’s more expensive for international clients to buy products with weaker euros, yen or other currencies.

But as a general rule, small-cap stocks do business here in the United States. And the strong U.S. economy and the strong U.S. dollar makes it easier for customers to purchase the products and services small-cap companies are offering.

That’s why we’re seeing such strength in the Russell 2000 index, even while the S&P 500 is struggling to get back to where it was trading before the February pullback.

That’s why today, I’m spending a lot of time looking through the smaller stocks listed in the Russell 2000 index and finding some of our best opportunities in smaller names that are off the beaten path.

You can easily do a Google search to find small cap opportunities in specific sectors of the market. In particular, I’ve been looking for small retail companies with strong brand loyalty, technology companies with new ideas, and small cap banks that are benefiting from deregulation.

There are plenty of opportunities in today’s market if you look beyond the headlines. So don’t let the “weak” market or the media’s fear tactics keep you from generating attractive profits.

Here’s to growing and protecting your wealth!

Zach Scheidt

Zach Scheidt
Editor, The Daily Edge

1Where Have All the Public Companies Gone?, Bloomberg

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A Recession Is Coming… And the Fed Can’t Stop It

By James Rickards

Second-longest economic expansion

This post A Recession Is Coming… And the Fed Can’t Stop It appeared first on Daily Reckoning.

Is the Fed ready for the next recession?

The answer is no.

Extensive research shows that it takes between 300 and 500 basis points of interest rate cuts by the Fed to pull the U.S. economy out of a recession. (One basis point is 1/100th of 1 percentage point, so 500 basis points of rate reduction means the Fed would have to cut rates 5 percentage points.)

Right now the Fed’s target rate for fed funds, the so-called “policy rate,” is 1.75%. How do you cut rates 3–5% when you’re starting at 1.75%? You can’t.

Negative interest rates won’t save the day. Negative rates have been tried in Japan, the eurozone, Sweden and Switzerland, and the evidence is that they don’t work to stimulate the economy.

The idea of negative rates is that they’re an inducement to spend money; if you don’t spend it, the bank takes it from your account — the opposite of paying interest. Yet the evidence is that people save more with negative rates in order to meet their lifetime goals for retirement, health care, education, etc.

If the bank is taking money from your account, you have to save more to meet your goals. That slows down spending or what neo-Keynesians call aggregate demand. This is just one more example of how actual human behavior deviates from egghead theories.

The bottom line is that zero means zero. If a recession started tomorrow, the Fed could cut rates 1.75% before they hit zero. Then they would be out of bullets.

What about more quantitative easing, or “QE”? The Fed ended QE in late 2014 after three rounds known as QE1, QE2 and QE3 from 2008–2014. What about QE4 in a new recession?

The problem is that the Fed never cleaned up the mess from QE1, 2 and 3, so their capacity to run QE4 is in doubt.

From 2008–2014, over the course of QE1, 2 and 3, the Fed grew its balance sheet from $800 billion to $4.4 trillion. That added $3.6 trillion of newly printed money, which the Fed used to purchase long-term assets in an effort to suppress interest rates across the yield curve.

The plan was that lower long-term interest rates would force investors into riskier assets such as stocks and real estate. Ben Bernanke called this manipulation the “portfolio channel” effect.

These higher valuations for stocks and real estate would then create a “wealth effect” that would encourage more spending. The higher valuations would also provide collateral for more borrowing. This combination of more spending and lending was supposed to get the economy on a sustainable path of higher growth.

This theory was another failure by the eggheads.

The wealth effect never emerged, and the return of high leverage never returned in the U.S. either. (There is a lot more leverage overseas in emerging-market dollar-denominated debt, but that’s not what the Fed was hoping for. The EM dollar-debt bomb is another accident waiting to happen that I’ll explore in a future commentary.)

The only part of the Bernanke plan that worked was achieving higher asset values, but those values now look dangerously like bubbles waiting to burst. Thanks, Ben.

The problem now is that all of that leverage is still on the Fed’s balance sheet. The $3.6 trillion of new money was never mopped up by the Fed; it’s still there in the form of bank reserves. The Fed has begun a program of balance sheet normalization, but that program is not far along. The Fed’s balance sheet is still over $4 trillion.

That makes it highly problematic for the Fed to start QE4. When they started QE1 in 2008, the balance sheet was $800 billion. If they started a new QE program today, the they would be starting from a much higher base.

The question is whether the Fed could take their balance sheet to $5 trillion or $6 trillion in the course of QE4 or QE5?

In answering that question, it helps to bear in mind the Fed only has $40 billion in capital. With current assets of $4.4 billion, the Fed is leveraged 110-to-1. That’s enough leverage to make Bernie Madoff blush.

To be fair to the Fed, their leverage would be much lower if their gold certificates issued by the Treasury were marked to market. That’s a story for another day, but it does say something significant about the future role of gold in the monetary system.

Modern Monetary Theory (MMT) led by left-wing academics like Stephanie Kelton see no problem with the Fed printing as much money as it wants to monetize Treasury debt. MMT is almost certainly incorrect about this.

There’s an invisible confidence boundary where everyday Americans will suddenly lose confidence in Fed liabilities (aka “dollars”) in a hypersynchronous phase transition. No one knows exactly where the boundary is, but no one wants to find out the hard way.

It’s out there, possibly at the $5 trillion level. The Fed seems to agree (although they won’t say so). Otherwise they would not be trying to reduce their balance sheet today.

So if a recession hit tomorrow, the Fed would not be able to save the day with rate cuts, because they’d hit the zero bound before they could cut enough to make a difference. They would not be able to save the day with QE4, because they’re already overleveraged.

What can the Fed do?

All they can do is raise rates (slowly), reduce the balance sheet (slowly) and pray that a recession does not hit before they get things back to “normal,” probably around 2021. What are the odds of the Fed being able to pull this off before the next recession hits?

Not very good.

Have a look at the chart below. It shows the length of all economic expansions since the end of World War II.

The current expansion is shown with the orange bar. It started in June 2009 and has continued until today. It is the second-longest expansion since 1945, currently at 107 months. It is longer than the Reagan-Bush …read more

From:: Daily Reckoning

Uh-oh: Unemployment Falls Below 4%

By Brian Maher

Unemployement rate and recessions

This post Uh-oh: Unemployment Falls Below 4% appeared first on Daily Reckoning.

Bad news frightens us — but good news terrifies us.

The May jobs report came out Friday.

It revealed the unemployment rate has sunk to a booming 3.8%.

For only the second occasion since 1969… the unemployment rate has slipped below 4%.

(Well are we aware that official unemployment numbers do not necessarily reflect the actual unemployment rate. For simplicity’s sake, we defer to official numbers today.)

CNN reports the latest numbers are “another sign of the strong economy and tight labor market.”

“New milestones in jobs report signal a bustling economy,” assures The New York Times.

Meantime, Goldman Sachs believes the unemployment rate could plumb 3.5% by next year.

Markets reacted in grand style today — the Dow Jones was up over 200 points this morning.

But today we graze against the grain of consensus… knock conventional wisdom from its horse… and illustrate perils lying in wait…

The last time unemployment dropped below 4% was April 2000 — the peak of the dot-com derangement.

The economy was in recession by March 2001… less than one year later.

But that is one isolated instance, comes your reply.

You say we pick a cherry to confirm our thesis.

You demand more evidence.

And more evidence you will have…

Prior to April 2000, unemployment last slipped below 4% in December 1969.

What followed?

The economy dropped into recession that same month… where it remained until November 1970.

The recession of 1969–70 ended what was then the longest economic expansion in U.S. history.

At 108 months and counting, we now wallow in the second-longest economic expansion in U.S. history.

Does today’s 3.8% unemployment rate mean the show is drawing to an end?

We still have only cited two examples of circumstantial evidence, you counter — the jury is not convinced.

But let us call a certain Nicole Smith to the witness stand…

Ms. Smith is chief economist at Georgetown University’s Center on Education and the Workforce.

Her testimony reveals:

If we look historically at other times when the unemployment rate has fallen below 4%, it’s times where it was the boom phase just before recession or just after a major war period…

What we find is that the low unemployment rate is often associated with a boom phase just before a recession. It’s almost a precursor for a recession or a precursor for another slumping economy.

Into the court record goes Exhibit A…

That is a chart giving the history since 1950.

On each occasion the unemployment rate fell below 4%, it reveals, recession soon followed.

The evidence, smoke billowing from the gun barrel:

Now, it is true… we have been treated to recessions when unemployment has remained above 4%.

But the chart proves nonetheless:

On each occasion that the unemployment rate sank beneath 4%… recession was soon on tap.

To remind, it now rests at 3.8%.

But why should recession rapidly follow peak employment?

Extremely low unemployment is often associated with an “overheating” economy.

This overly excited economic engine, our monetary authorities have historically concluded, requires a good cooling off.

They must therefore increase interest rates to bring the business under control.

But they often end up throwing the engine into reverse.

As the following chart informs us, each recession since 1950 was preceded by rising interest rates

US Fed Funds Rate and Recession

Note the rising rates surrounding those periods of 4% unemployment or less:

The early 1950s… the late 1950s… 1969… and 2000.

And note the gray bars of recession forming shortly thereafter.

The Federal Reserve has been increasing interest rates since December 2015.

It will likely increase rates once again in shortly over one week — the market odds presently stand at 91%.

But as Jim Rickards has hollered repeatedly, the Fed is “tightening into weakness.”

GDP has only grown at an average 2.16% annual rate for the past eight years.

At the going rate, 2018 growth will remain below 3%.

Is this the indicator of an overheating economy?

And Jim says the low unemployment rate is a statistical phantom, an illusion:

Official unemployment statistics are highly misleading. They do not count approximately 10 million able-bodied working-age adults who have simply given up on work.

Adjusted for those “missing workers,” the real unemployment rate is about 10%, a depression-level figure.

Jim believes the Fed will have to drop its rate hikes once it realizes the economic patient can’t take the bitter medicine.

But will it be in time to ward off recession?

History says no.

And given today’s ironically disconcerting unemployment number… is recession far behind?

“It is always dawnest before the dark,” says our co-founder Bill Bonner.

We offer no specific forecast.

But given the massive distortions of the current expansion…

We suspect it could be a long night that follows…


Brian Maher
Managing editor, The Daily Reckoning

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The Federal Reserve Dilemma: No Good Choices

By James Rickards

This post The Federal Reserve Dilemma: No Good Choices appeared first on Daily Reckoning.

Beginning in December 2015, Janet Yellen put the Fed on a path to raise interest rates 0.25% every March, June, September and December, a tempo of 1% per year through 2019, until the Fed “normalizes” interest rates around 3%.

The only exception to this 1%-per-year tempo is when the Fed takes a “pause” in hiking rates because one part of its dual mandate of job creation and price stability is not being met. Yellen raised rates in a weak economy, and now Jay Powell has done the same.

I’ve warned repeatedly that the Fed is tightening into weakness. Why is it doing so?

I’ve said repeatedly but can’t say enough, is that the Fed is preparing for the next crisis. The evidence is clear that it takes 3% to 4% in rate cuts to pull the U.S. out of a recession. The Fed cannot cut rates even 3% when the fed funds rate is less than 2%.

So, the Fed is in a desperate race to raise rates before a recession arrives so they can cut rates to cure the recession.

How does balance sheet normalization fit in?

Having pushed the balance sheet to $4.5 trillion in the last crisis, the Fed needs to reduce the balance sheet now so they can expand it again up to $4.5 trillion in QE4 if necessary.

Reducing the balance sheet is a precautionary step in case a recession arrives before rates reach 3%. In that case, the Fed would cut rates as far as they could until rates hit zero, and then revert to QE. (The Fed has shown no inclination to use negative rates, and the evidence from Europe, Sweden and Japan is that negative rates don’t work anyway).

The Fed does not have an unlimited capacity to monetize debt. The constraint is not legal, but psychological. There is an invisible confidence boundary on the size of the Fed’s balance sheet. The Fed cannot cross this boundary without destroying confidence in the central bank and the dollar.

Whether that boundary is $5 trillion or $6 trillion is unknowable. A central bank will find out the hard way instantaneously when they cross it. At that point, it’s too late to regain trust.

In short, the Fed is tightening monetary conditions now so they can ease conditions in the next crisis without destroying confidence in the dollar.

The Fed’s conundrum is whether they can tighten monetary conditions now without causing the recession they are preparing to cure. The evidence of the past ten years shows the answer to that conundrum is “no.”

The likely outcomes and the Fed’s real choices are the following:

In one scenario, the double dose of tightening from rate hikes and QT slows the economy, deflates asset bubbles in stocks, strengthens the dollar, and imports deflation. As these trends become evident, disinflation could tip into mild deflation.

Job creation could dry up as employers rein in costs. A stock market correction will turn into a bear market with major indices dropping 30% or more from 2018 highs.

All of these trends would be exacerbated by a global slowdown due to the trade war, concerns about U.S. debt levels, and reduced immigration. A technical recession will ensue. This would not be the end of the world. But it would be the end of one of the longest expansions and longest bull markets in stocks ever.

The other scenario is a more complex process with a far more catastrophic outcome. In this scenario, the Fed repeats two historic blunders. The first blunder occurred in 1928 when the Fed tried to deflate an asset bubble in stocks. The second blunder was in 1937 when the Fed tightened policy too early during a period of prolonged weakness.

Until December 2017, the Fed rejected the idea that it could identify and deflate asset bubbles. This policy was based on the experience of 1928 when Fed efforts to deflate a stock bubble led to the stock market crash of October 1929 and the Great Depression.

The Fed’s preference was to let bubbles pop on their own and then clean up the mess with monetary ease if needed.

However, the popping of the mortgage bubble in 2007 was far more dangerous and the policy response far more radical that the Fed expected going into that episode.

Given the continued fragility of the financial system, the Fed began to re-think its clean-up policy and chose a more nuanced stance toward deflating bubbles.

This new view (really a reprise of the 1928 view) emerged in the minutes of the Federal Open Market Committee, the Fed’s rate policy arm, for November 1, 2017, and was echoed in the public remarks of Fed officials in the days following this FOMC meeting.

This newfound concern about asset bubbles played out in the FOMC’s decision to raise rates at their December 13, 2017 meeting despite continued worries about disinflation.

As if to validate the Fed’s new approach, U.S. stock markets soon suffered a sharp 11% correction during February 2 – 8, 2018; a mild preview of what happens when the Fed tries to deflate asset bubbles. The Fed’s attempted finesse in financial markets could well result in a market crash as bad or worse than 1929.

The impact of such a market crash will not be confined to the U.S. In fact, a stronger dollar resulting from tight monetary policy could precipitate a crisis in emerging markets dollar-denominated debt that transmutes into a global liquidity crisis through now well-known contagion channels.

The second Fed blunder was an effort to normalize rate policy in 1937 after eight years of ease during the worst of the Great Depression beginning in 1929. Today’s policy normalization is almost an exact replay.

Economic performance from 2007 to 2018 is best understood as a depression, not in the sense of continual declining GDP, but rather actual growth that is depressed relative to potential growth even without outright declines.

It is understandable that the Fed wishes to resume what it regards as normal monetary policy after a decade of abnormal …read more

From:: Daily Reckoning

A Bold Prediction Comes True

By Brian Maher


This post A Bold Prediction Comes True appeared first on Daily Reckoning.

Two weeks ago yesterday we dared the wrathful gods… and tempted fate with a rare prediction.

From The Daily Reckoning, dated 17 May:

May 31 is the date of the next drop… We do not forecast a cataclysm — but a substantially negative May 31. So you can go ahead and put us down for it. The S&P will sink May 31.

If wrong, we boasted, we would eat every word we wrote that day — without salt.

May 31 has come… May 31 has gone.

And our prediction?

We are pleased beyond description today — we’ve been spared a dreadful dish of unseasoned prose.

The S&P sank 19 points yesterday, precisely as predicted… at least to an inch or two.

Three at most.

The Dow Jones fared even worse percentagewise — down 252 crimson points on the day.

Nor was the wreckage limited to the abovementioned.

The Nasdaq and the Russell both ended deeply in red territory.

Incidentally, all three indexes roared back today… and made good most of yesterday’s losses.

Why were we so confident the market would fall yesterday?

The answer arrives in three words:

The Federal Reserve.

It is now hard at the job of quantitative tightening — the reverse of quantitative easing.

Year to date, the Fed had unloaded $117 billion worth of assets before yesterday.

And the S&P lost a combined 4.7% on the specific days these jettisonings occurred.

The reproduced evidence, coming by way of Martingale_Macro:

And yesterday witnessed the largest single balance sheet reduction since the business began last October.

Nearly $29 billion worth of maturing bonds were scheduled to roll off the Fed’s balance sheet yesterday.

Did you hear about it in the financial media?

You did not of course — it went entirely unreported.

It was, nonetheless, the specific basis of our May 17 crystal gazing.

And with the pleasure of repeating ourselves… we were correct.

But do we accept an undeserved laurel?

Did markets sink yesterday for another reason, entirely unrelated to the Fed’s balance sheet?

The Trump administration announced tariffs on steel and aluminum imports from the European Union, Canada and Mexico.

These tariffs were met by immediate threats of retaliation.

Recall, prospects of a global trade war kindled February’s market “correction” — at least in part.

And yesterday those fears bubbled again to the surface.

But we will permit no rain to fall on our triumphant parade today.

No, no, the Fed and its balance sheet alone account for yesterday — and we consider the case jolly well closed.

If you disagree… drive on!

We jest of course.

The tariff announcement may well have been sufficient — or perhaps it was a combination of both.

Or something else entirely.

Every time we think we have the market by the tail… we soon discover otherwise.

But let us now face the horizon…

The Fed is on pace to reduce its balance sheet $420 billion by year’s end… and plans to trim another $600 billion next year.

And another $600 billion the year following.

It does not believe its trimmings will affect markets.

We have our evidence to the contrary — albeit circumstantial — as argued above.

Nor will Jim Rickards guzzle the moonshine:

The Fed wants you to think that QT will not have any impact. Fed leadership speaks in code and has a word for this, which you’ll hear called “background.” The Fed wants this to run on background…

This is complete nonsense.

Contradictions coming from the Fed’s happy talk want us to believe that QT is not a contractionary policy, but it is.

They’ve spent eight years saying that quantitative easing was stimulative. Now they want the public to believe that a change to quantitative tightening is not going to slow the economy.

And so the Fed maintains its thumbless grasp of economic cause and effect.

We’ll be keeping a sharp eye on the Fed’s next substantial rollover date.

Will we crowd our luck with another bold market prediction that day?

No, we had better not — the gods are vengeful.


Brian Maher
Managing editor, The Daily Reckoning

The post A Bold Prediction Comes True appeared first on Daily Reckoning.

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From:: Daily Reckoning

What History Teaches About Interest Rates

By Jacob Johnson


This post What History Teaches About Interest Rates appeared first on Daily Reckoning.

“At no point in the history of the world has the interest on money been so low as it is now.”

Who can dispute the good Sen. Henry M. Teller of Colorado?

For lo eight years, the Federal Reserve has waged a ceaseless warfare upon interest rates.

Economic law, history, logic itself, stagger under the onslaughts.

We suspect that economic reality will one day prevail.

This fear haunts our days… and poisons our nights. But let us check the date on the senator’s declaration…

Kind heaven, can it be?

We are reliably informed that Sen. Teller’s comment entered the congressional minutes on Jan. 12… 1895.

1895 — some 19 years before the Federal Reserve drew its first ghastly breath!

Were interest rates 122 years ago the lowest in world history? And are low interest rates the historical norm… rather than the exception?

The chart below — giving 5,000 years of interest rate history — shows the justice in Teller’s argument.

Please direct your attention to anno Domini 1895:

Rates had never been lower in all of history.

They would only sink lower on two subsequent occasions — the dark, depressed days of the early 1930s — and the present day, dark and depressed in its own right.

A closer inspection of the chart reveals another capital fact…

Absent one instance at the beginning of the 20th century and a roaring exception during the mid-to-late 20th century, long-term interest rates have trended lower for the better part of 500 years.

Could the sharply steepening interest rates that began in the late 1940s be a historical one-off… a Mt. Everest set among the level plains?

Analyst Lance Roberts argues that periods of sharply rising interest rates like that period are history’s exceptions — lovely exceptions.

Why lovely?


Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time.

In this view, rates rose steeply at the dawn of the 20th century because rapid industrialization and dizzying technological advances had entered the scenery.

Likewise, Roberts argues the massive post-World War II economic expansion resulted in the second great spike in interest rates:

There have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing”… It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed.

Let the record show that rates peaked in 1981… and have declined steadily ever since. If rising interest rates indicate a rising economy, does that mean our best days are in back of us?

And was this post-World War II period of dramatic and exceptional growth… itself the exception?

“Investors have often talked about the global economy since the crisis as reflecting a ‘new normal’ of slow growth and low inflation,” begins New York Times senior economic correspondent Neil Irwin.

“But just maybe,” he concludes, “we have really returned to the old normal.”


Very low rates have often persisted for decades upon decades, pretty much whenever inflation is quiescent, as it is now… The real aberration looks like the 7.3% average experienced in the United States from 1970–2007.

“We’re returning to normal, and it’s just taken time for people to realize that,” adds Bryan Taylor, chief economist of Global Financial Data.

Today’s 10-year Treasury note yields a relatively slender 2.84%, for example.

But British consols — the world’s low-risk bonds of the day — yielded an even slimmer 2.48% in 1898.

This was, of course, shortly before the steep interest rate rise of the following three decades.

Granted, drawing meaningful comparisons between historical eras can be a snare, a chimera, the errand of a fool if done carelessly.

But maybe today’s low rates aren’t as outrageous as originally strikes the eye.

Paul Schmelzing professes economics at Harvard. He’s also a visiting scholar at the Bank of England, for whom he conducted a study of interest rates throughout history.

Over seven centuries, Schmelzing identifies nine “real rate depression cycles.”

These cycles feature a secular decline of real interest rates, followed by reversals. The first eight cycles tell fantastic tales…

These cycles often pivoted around such events as the Black Death of the mid-14th century… the Thirty Years’ War of the 17th century… World War II.


The world is currently immersed in history’s ninth rate depression cycle, which began in the mid-’80s.

It is here where our tale gathers pace…

Schmelzing’s research reveals that the present cycle is the second longest of the entire 700-year record… and the second most intense.

The only longer-lasting cycle came in the 15th century.

Only one previous cycle — also from the same epoch — exceeded the current cycle in intensity.

By almost any measure, today’s rate depression cycle is a thing of historic grandeur. The steep downward slope on the extreme right of the chart gives the flavor of its severity:


Schmelzing’s researches show that the real rate for the entire 700-year history is 4.78%.

Meantime, the real rate for the past 200 years averages 2.6%.

And so “relative to both historical benchmarks,” says Schmelzing, “the current market environment thus remains severely depressed.”

That is, real rates are well below historical norms.

And if the term “reversion to the mean” has any currency… rates could accelerate… quickly.

History shows that when rates do regain their bounce, they do so with malice.

We note that 10-year Treasury yields have gained roughly one full percentage point over the past year.

Could the cycle be ending?

It is premature to say.

But if the world is near the end of the current 34-year rate depression cycle, it could be in for a harsh lesson in mean reversion.


The evidence from eight previous “real rate depressions” is that turnarounds from such environments, when they occur, have typically been both quick and sizeable… Most …read more

From:: Daily Reckoning

Just How Low Are Today’s Interest Rates?

By Brian Maher

This post Just How Low Are Today’s Interest Rates? appeared first on Daily Reckoning.

“How is your wife?” someone supposedly asked Winston Churchill.

The reply, oozing Churchillian wit from every pore:

Compared to what?

Today’s interest rates are low.

But today we consider the “real” question:

Interest rates are low… compared to what?

The Federal Reserve has been lifting the nominal fed funds target rate since December 2015.

It currently rests between 1.50% and 1.75%.

That is, nominal rates remain low.

Now crane your neck… and glance rearward to the disco-filled days of 1979…

Nominal interest rates averaged a Himalayan 12.5% or thereabouts.

That is, the nominal interest rate was some 8.5 times higher in 1979.

But could it be that today’s puny 1.50–1.75% rate… is “really” higher than 1979’s 12.5%?

A preposterous question, you thunder.

But come sit down before the facts…

The real interest rate is the nominal interest rate minus the inflation rate.

Assume the nominal interest rate is 3%, for example.

Further assume that inflation runs at 1%.

In this instance, the real rate is 2% (3 – 1 = 2).

There is a reason why it is called the real interest rate.

It penetrates numerical mists. It scatters statistical fogs.

It clarifies.

Nominal interest rates averaged 12.5% in 1979.

Inflation ran to 13.3%.

So let us apply some English major math to arrive at the real interest rate in 1979…

We take 1979’s average nominal interest rate (12.5%) and subtract the inflation rate (13.3%).

We then come to the arresting conclusion that the real interest rate was not 12.5%… but negative 0.8% (12.5 – 13.3 = -0.8).

Once again:

The average nominal interest rate was 12.5%.

But the real interest rate was -0.8%.

We can only conclude that real interest rates can be negative despite a high nominal rate.

As Jim Rickards explains:

Negative real rates exist when the rate of inflation is higher than the nominal interest rate. This condition can exist at any level of nominal rates. For example, inflation of 3% with nominal rates of 2.5% produces a negative real rate of 0.5%.

Likewise, inflation of 4% with nominal rates of 3.5% produces the same negative real rate of 0.5%.

Now roll the film forward to today…

Today’s nominal rate is between 1.50% and 1.75%.

Meantime, (official) consumer price inflation goes at about 2%.

Again, if we want the real rate, we must subtract inflation from the nominal rate.

What do we find upon doing so?

We find that today’s real interest rate lies somewhere between -0.5% and -0.25%.

That is, despite today’s vastly lower nominal rate (12.5% versus 1.75%)… today’s real interest rate is actually higher than 1979’s -0.8%.

Shocking — but the facts are the facts.

We must once again conclude that the nominal interest rate lacks all meaning absent the inflation rate.

Yet the difference between nominal rates and real rates scarcely rates a mention in the financial media.

But as Jim Rickards notes, “Real rates are what determine investment decisions.”

A 10-year Treasury bond yielding 6% may draw your interest, for example.

But what if inflation averaged 7% over the same period?

Inflation would devour your 6% yield — and then some.

You would require an 8% yield to keep ahead of inflation.

But let us take a leap forward…

It now appears the Fed has cracked its blessed 2% inflation target.

And it is planning a steady calendar of rate hikes until it reaches 3% by late next year.

We have our doubts it will arrive at the destination.

Another market “correction” could easily knock it off course.

And the economy is long past due for a recession.

Can the current “expansion” peg along for another year and one half?

We are far from certain.

Mr. Powell and his merry band would certainly return to lowering rates in case of recession.

But go ahead and assume a nominal 3% rate at the end of 2019.

Assume further — as the Fed currently does — that inflation will average 2% in 2019.

The math reveals a real rate of only 1%.

Meantime, the nation’s average long-term real interest rate is about 3%.

Even if nominal interest rates rise, real interest rates would therefore remain substantially below normal.

And it could be a long time before they return to normal.

That is, if they ever return to normal…


Brian Maher
Managing editor, The Daily Reckoning

The post Just How Low Are Today’s Interest Rates? appeared first on Daily Reckoning.

…read more

From:: Daily Reckoning