Capitalism Is Broken

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The announcement came rolling from the Eccles Building at 2 p.m. Eastern…

No rate hike today.

Jerome Powell has decided to sit on his hands — for now.

In his very words:

It’s important that monetary policy not overreact to any one data point… The FOMC will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.

That is precisely why the next move will be a rate cut.

We have reckoned lots lately about the inverted yield curve… and the recessionary menace it represents.

The 10-year versus 3-month yield curve recently inverted to its lowest level since April 2007.

Meantime, 10-year Treasury yields hover at two-year lows — 2.04%. One Bloomberg opinion piece instructs us to prepare for 1% yields.

As the old-timers know… the bond market gives a truer economic forecast than the chronically dizzied stock market.

Meantime, the New York Fed’s recession model reveals a 30% probability of recession within the next year.

It last gave those same odds in July 2007 — merely five months before the Great Recession was underway.

JP Morgan places the odds of recession in the second half of this year at 40%.

And Morgan Stanley gives a 60% likelihood of recession within the next year — the highest since the financial crisis.

Yes, the Federal Reserve will soon be cutting rates.

One clue?

Conspicuously absent from today’s statement was the word “patient.” Thus Mr. Powell telegraphs that he is ready to move.

Federal funds futures presently give nearly 90% odds of a July rate cut.

The market further expects as many as three rate cuts by this time next year — perhaps four.

We are compelled to restate the blindingly obvious:

The Federal Reserve has lost its race with Old Man Time.

The opening whistle blew in December 2015… when Janet Yellen came off the blocks with a 0.25% rate hike.

If the Federal Reserve could cross the 4% finishing line in time, it could tackle the next recession with a full barrel of steam.

Alas… it never made it past 2.50%.

The Federal Reserve cannot return to “normal.”

The stock market will yell blue murder and take to violent rebellion if it tried — as happened last December.

No, Wall Street has Mr. Powell in its hip pocket — as it had Janet Yellen, as it had Ben Bernanke, as it had Alan Greenspan before him.

But it is not only the Federal Reserve…

Last year the world’s major central banks were pledging to “normalize.”

But now they are in panicked retreat…

All have taken to their heels, hoofing 180 degrees the other way.

For example:

Both the Bank of Japan and European Central Bank are now gabbling openly about rate cuts and/or additional quantitative easing.

“It’s all in the open now. Front and center. The new global easing cycle has begun before the last one ended.”

This is the considered judgment of Sven Henrich, he of NorthmanTrader.

We must agree.

Yet the central banks have only themselves to blame…

They grabbed hold of the poisoned apple during the financial crisis.

They gulped… and took the first fateful nibble. It proved nectar to the stock market.

Encouraged by the results, they soon munched the full dose… and later went plowing through the entire tainted orchard:

Zero interest rates, QE 1, 2 and 3 — Operation Twist — the lot of it.

Even with trade war raging and recession hovering, stocks are within 1% of record heights.

And so the banks are too far gone in sin to turn back now.

Their greatest casualty?

Capitalism itself.

Henrich on the wages of central bank sin:

Let’s call a spade a spade: Equity markets and capitalism are broken. Neither can function on any sort of growth trajectory without the helping hand of monetary stimulus. Global growth figures, expectations and projections are collapsing all around us and markets are held up with promises of more easy money, in fact are jumping from central bank speech to central bank speech while bond markets scream slowdown.

We fear Mr. Henrich is correct.

We further fear capitalism will get another good round pummeling in the years to come…

The Federal Reserve’s false fireworks will land as duds against the next recession.

Cries will then go out for the artificial savior of government spending — Modern Monetary Theory (MMT).

Free college tuition… universal Medicare… jobs for all… a $15 minimum wage…a possible Green New Deal…

These and more will be in prospect.

Politicians will go running through the Treasury as a bull runs through a china shop… and leave the nation’s finances a shambles.

Only then — too late — will they discover that debt and deficits matter after all…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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REVEALED: How Far Stocks Will Fall

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How far might markets plunge next time around?

And will you be able to recover your losses rapidly?

Answers — possibilities, rather — shortly.

And is one of Wall Street’s oldest chestnuts of investment wisdom tragically wrong?

This question too we will tackle.

But first to that vicious den of sin and iniquity — the stock market.

The Dow Jones roared 353 points today. The S&P rallied 28 points and the Nasdaq… 109.

For reasons we turn to the president’s comments this morning:

Had a very good telephone conversation with President Xi of China. We will be having an extended meeting next week at the G-20 in Japan. Our respective teams will begin talks prior to our meeting.

That G-20 meeting transpires June 28-29.

We shall see.

But how much value can you expect the stock market to shed in the next bear market?

The United States economy has endured recession every five years since World War II — on average.

Yet the present economic expansion runs to 10 years. It will be crowned history’s longest next month.

How much longer will the gods of chance be put off, cried down, ridiculed and shooed away?

10-year Treasury yields have slipped beneath 3-month Treasury yields.

This yield curve inversion has preceded each and every recession 50 years running.

And last week the yield curve inverted to its steepest degree since April 2007.

Meantime, Morgan Stanley’s Business Conditions Index just endured its largest-ever monthly plummet.

It presently languishes at its lowest level since December 2008 — the teeth of the financial crisis.

In Morgan Stanley’s telling, the American economy may already be sunk in recession.

But today or 18 months from today… a bear market will likely come dragging in on recession’s coattails.

Thus we arrive at the inevitable question:

How much value might the stock market lose in the next bear market?

Financial journalist Mark Hulbert interrogated the history since 1900 (based on data from research firm Ned Davis).

Investors have withstood 36 bear markets in these 119 years.

Hulbert then zeroed in on stock market valuations.

In particular, to the cyclically adjusted P/E ratio (CAPE) hatched by Yale man (and Nobel winner) Robert Shiller.

At 30.2, CAPE is mountain-high — that is, stocks are vastly expensive by history’s standards.

Today’s valuations rise even above 1929’s — and put 2008’s in the shade.

Only during the dot-com delirium were stocks dearer than today.

Chart

Hulbert’s research reveals bear markets tend to greater severity when stock valuations are elevated.

And so given today’s wild valuations, how far might the Dow Jones drop next time?

The answer, says Hulbert… is 35.3%:

A simple econometric model whose inputs are past bear markets and CAPE values predicts that, if a bear market were to begin from current levels, the Dow would tumble 35.3%. Though that’s less severe than the 2007–09 bear market, it still would sink the Dow below 17,000. 

In fairness…

Hulbert concedes his findings do not rise to the 95% confidence level he seeks. But can you safely throw them aside?

Assume the Dow Jones does go tumbling 35.3% — beneath 17,000.

Worry not, says Wall Street.

Hold on for the long pull. Buy and hold is the way.

The stock market always comes back, the learned gentlemen assure us.

The magic of annually compounding returns will ultimately leave you in easy waters.

But have another guess, says analyst Lance Roberts of Real Investment Advice…

Perhaps you seek 10% compounding annual returns for five years.

Ten percent is handsome — but not extravagant.

Assume 10% is precisely what you receive the first three years. But you lose 10% the fourth.

What then happens to your gorgeous five-year 10% compounding?

You would need to haul in a ludicrous 30% return the fifth year… to catch up.

Chart

Roberts:

The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required.

If you are approaching retirement — or already in retirement — can you afford to stagger 10%?

Or 20%?

You must further consider today’s extreme valuations.

The higher the valuation… the lower returns you can expect over the next several years.

At today’s valuation extremes…

Would you be better off placing $3,000 into the stock market each year — or wedging it under your mattress?

Roberts has given the numbers a good, hard soaking. At 20x valuations, he finds…

Your stock market money would finally exceed your snoozing cash… in twenty-two years.

22 years!

“Historically, it has taken roughly 22 years to resolve a period of overvaluation,” affirms Roberts, adding:

Given the last major overvaluation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.

And recall — today’s CAPE is 30.2%. Perhaps stocks must wait even longer to break ahead.

But can you afford to wait?

Regards,

Brian Maher
for The Daily Reckoning

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The Perfect Storm

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What are the three elements of the perfect political and market storm I see coming together this fall?

The first is an effort by the Democratic House of Representatives to impeach President Trump. The second is the socialist-progressive tilt in the 2020 presidential election field. The third is the fallout from the Mueller report and the Russia collusion hoax — what I and others called “Spygate.”

These components are independent of each other but are at high risk of convergence in the coming months.  Let’s look more closely at the individual elements of impeachment, electoral chaos and Spygate that comprise this new storm with no name.

The first storm is impeachment. Impeachment of a president by the House of Representatives is just the first step in removing a president from office. The second step is a trial in the Senate requiring a two-thirds majority (67 votes) to remove the president. Two presidents have been impeached, but neither was removed. Nixon resigned before he could be impeached.

If the House impeaches Trump, the outcome will be the same. The Senate is firmly under Republican control (53 votes) and there’s no way Democrats can get 20 Republicans to defect to get the needed 67 votes needed. So House impeachment proceedings are just for show.

But it can be a very damaging show and create huge uncertainty for markets. There are powerful progressive forces in Congress and among top Democratic donors who are fanatical about impeaching Trump and will not be satisfied with anything less. One poll shows that 75% of Democratic voters favor impeachment (including almost 100% of the activist progressive base).

Speaker of the House Nancy Pelosi and House Majority Leader Steny Hoyer have both poured cold water on impeachment talk. They feel it’s a distraction from Democratic efforts to enact their legislative agenda. But some of the party’s biggest private money donors, including Tom Steyer, are also demanding impeachment.

If Steyer does not get an impeachment process, he looks to support primary challenges to sitting Democrats who don’t join the impeachment effort. This could jeopardize Pelosi’s speakership in a new Congress. So Pelosi could come under heavy pressure to go along with impeachment.

The final outcome is irrelevant; what matters is the process itself. Impeachment fever is not likely to last long into 2020, because at that point the election will not be far away. Voters will turn their backs on impeachment and insist that disputes about Donald Trump be settled at the ballot box. That’s why you can expect impeachment fever to come to a head by the fall of 2019. And that will create a lot of uncertainty for markets.

The second storm is the 2020 election.

Trump is on track to win reelection in 2020. My models estimate his chance of victory is 63% today and it will get higher as Election Day approaches. The only occurrence that will derail Trump is a recession.

The odds of a recession before the 2020 election are below 40% in my view and will get smaller with time. Meanwhile, Trump will keep up the pressure on the Fed not to raise interest rates and will ensure that the U.S.-China trade war comes in for a soft landing.

This may sound like a rosy scenario for the economy. But it’s not so rosy for the Democrats. Every piece of good economic news will cause Democrats to dial up their political hit jobs on Trump. Each one will try to outdo the next.

There are now 24 declared candidates for the 2020 Democratic presidential nomination. That’s more than the Democrats have ever had before. Currently Joe Biden and Bernie Sanders are out in front. Biden is considered the most moderate of the candidates.

But I don’t expect Joe Biden to stay in front for long, and I don’t believe he’ll win the nomination. But the only way for a Democrat to stay in the race is to stake out the most extreme progressive positions. This applies to reparations for slavery, free health care, free child care, free tuition, higher taxes, more regulation and the Green New Deal.

If Biden does fall away, then the choices are back to Sanders, Elizabeth Warren or maybe Kamala Harris. But one is more radical than the next. So, you could have a shock effect where all of a sudden it looks like the Democratic nominee is going to be a real socialist. And that would rattle markets.

This toxic combination of infighting among candidates and bitter partisanship aimed at Trump will be another source of market uncertainty and volatility until Election Day in 2020 and perhaps beyond.

But the third storm is the most dangerous and unpredictable storm of all: Spygate. It involves accountability for those involved in an attempted coup d’état aimed at President Trump.

The Mueller report lays to rest any allegations of collusion, conspiracy or obstruction of justice involving Trump and the Russians. There is simply no evidence to support the collusion and conspiracy theories and insufficient evidence to support an obstruction theory. The case against Trump is closed.

Now Trump moves from defense to offense, and the real investigation begins.

Who authorized a counterintelligence investigation of the Trump campaign to begin with? Did surveillance of the Trump campaign by the U.S. intelligence community (CIA, NSA and FBI) begin before search warrants were obtained? On what basis? Was this surveillance legal or illegal?

These are just a few of the many questions that will be investigated and answered in the coming months.

These criminal referrals will be taken seriously by Attorney General William Barr along with other criminal referrals coming from Congress. Barr will take a hard look at possible criminal acts by John Brennan (CIA director), James Comey (FBI director) and James Clapper (director of national intelligence) among many others.

At the same time Lindsey Graham, Republican senator from South Carolina, will hold hearings in the Senate Judiciary Committee about the origins of spying on the Trump campaign and lies to the FISA court. These may be the most important hearings of their kind since Watergate.

Trump will be running for reelection against this backdrop of revelations of wrongdoing by his political opponents in the last election. Actual indictments and arrests of former FBI or CIA officials will cause immense political turmoil. Such charges may be fully justified (and needed to restore credibility). They will certainly energize the Trump base.

But they are just as likely to infuriate the Democratic base. Cries of “revenge” and “witch hunt” will be coming from the Democrats this time instead of Republicans. Markets will be caught in the crossfire.

How do these three storms — impeachment, the 2020 election and Spygate — converge to create the perfect storm?

By November 2019, the impeachment process should be well underway in the form of targeted House hearings. The 2020 Democratic debates (starting in June 2019) will be red-hot. Trump’s counterattacks on the FBI and CIA should be reaching a fever pitch based on real revelations and actual indictments.

The impeachment process and Trump’s revenge represent diametrically opposing views of what happened in 2016. The Democrats will continue to call Trump “unfit for office.” Trump will continue to complain that the Obama administration and the deep state conspired to derail and delegitimize him.

The 2020 candidates will have to take a stand (even though they may prefer to discuss policy issues). There will be nowhere to hide. The bitterness, rancor and leaking will be out of control.

Any one of these storms would create enough uncertainty for investors to sell stocks, raise cash and move to the sidelines. The combination of all three will make them run for the hills. That’s my warning to investors.

The next six months will present unprecedented challenges for investors. Markets will have to wrestle with fights over impeachment, election attacks and Spygate. Trump will be trying to improve his odds with Fed appointments and an end to the trade wars. Democrats will be trying to derail Trump with investigations, accusations and leaks.

Some of this will be normal political crossfire, but some of it will be deadly serious, including arrests of former senior government officials and revelations of an attempted coup aimed at the president.

A perfect storm with no name is coming. The only safe harbors will be gold, cash and Treasury notes. And make sure you have a life preserver handy.

Regards,

Jim Rickards
for The Daily Reckoning

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Rickards: “Perfect Storm” Is Coming

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People often refer to the “perfect storm.” A perfect storm is generally understood as two or more events that are independent but converge to produce an outcome much worse than either event alone.

The term is an overused cliché, and as a writer I avoid clichés whenever possible. But though rare, perfect storms do exist. The most common example is the devastating 1991 storm popularized by the book and movie of the same name, although it was initially known as the “Halloween storm.”

In that case, three separate weather dynamics all converged in one place on one day to produce a perfect storm. The odds of all three coming together at once were less than one in 100,000. That’s less than once in 270 years. That’s a perfect storm.

Do metaphorical perfect storms happen in politics and capital markets?

The answer is yes, provided the conditions of the perfect storm definition are satisfied. The multiple events that make up the true perfect storm must be independent and rare and come to converge in an almost impossible way.

Unfortunately, a political and market perfect storm is now on the way and may strike as early as Halloween 2019, marking a new “Halloween storm.” Get ready.

Today I’ll be discussing the components making up this perfect storm, and how I see them all coming together at the same time.

In my 40-plus years in banking and capital markets, I have lived through a number of financial fiascos that arguably qualify as perfect storms. Here’s a partial list:

  • 1970: Penn Central bankruptcy, the largest in history at that time
  • 1973–74: Arab oil embargo
  • 1977–80: U.S. hyperinflation
  • 1982–85: Latin American debt crisis
  • 1987: One-day 22% stock market crash
  • 1988–92: Savings and loan (S&L) crisis
  • 1994: Mexican tequila crisis
  • 1997: Asian financial crisis
  • 1998: Russia/Long Term Capital Management (LTCM) crisis
  • 2000:Dot-com crash
  • 2007: Mortgage market collapse
  • 2008: Lehman Bros./AIG financial panic.

I was not just a bystander at these events. From 1977–85, I worked at Citibank and dealt with inflation, currencies and Latin America from a front-row seat.

From 1985–93 I worked for a major government bond dealer that financed S&Ls and traded their mortgages.

From 1994–99, I was at LTCM and dealt in all the major international markets. I negotiated the LTCM rescue by Wall Street in September 1998.

In 1999–2000 I ran a tech startup, and in 2007–08 I was an investment banker and financial threat adviser to the CIA.

That’s a lot of action for one career, but it also makes the point that financial perfect storms happen more frequently than standard models expect.

Here’s what I learned: Every one of these episodes was preceded by mass complacency or euphoria.

Before the Arab oil embargo, we expected cheap oil forever. Before the Latin American debt crisis, countries like Brazil and Argentina were “the land of the future.”

No one worried about a stock market crash in 1987 because we had “portfolio insurance.” The S&Ls could not get in trouble because they had FSLIC (Federal Savings and Loan Insurance Corp.) insurance.

Mexico could not get in trouble because it had oil. Asia could not get in trouble because it had cheap labor, high growth and “fixed” exchange rates.

Russia would not go broke because it was a “nuclear power.” LTCM would not go broke because it had two Nobel Prize winners. Dot-coms would not go broke because they attracted “eyeballs.”

Mortgages were solid because we had never seen a simultaneous nationwide decline in home values. Lehman Bros. was “too big to fail.” AIG was the Rock of Gibraltar.

In short, the fiascoes I witnessed were “not supposed to happen.” They all did. The worst panics are always preceded by a sense that nothing can go wrong.

We are there again. Stocks are approaching all-time highs again. The bond bust hasn’t happened. Mortgage interest rates are near the lows of the early 1960s. Exchange rate volatility is low.

Unemployment is at 50-year lows. Real wages are rising (at least a little). There are more job openings than job seekers. ISIS is defeated. Brexit is on indefinite hold.

It’s all good. What, me worry?

I saw a recent poll asking investors when they thought a market crash might happen. Something like 80% of the respondents answered not anytime soon.

I cannot imagine a better setup for catastrophe. No one ever sees disaster coming. That’s the point.

I believe a perfect storm is coming. It’s hard to foresee the full magnitude of it, but it will likely be dramatic. It will have a major impact on markets. How it impacts you depends on how far in advance you see it coming.

What are the three specific elements of the new perfect storm I see coming for markets? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

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The Coming Gold Breakout

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I read headlines all day and focus extensively, if not exclusively, on gold. If gold is the best form of money (it is), and if gold had unique properties as money (it does; it’s the only form of money that is not also debt), then gold is well worth the focus.

With that said, it’s hard to surprise me on the subject. After a while, you think you’ve seen it all. Yet, there are exceptions. This headline stopped me in my tracks: “Bank of Russia may consider gold-backed cryptocurrency.”

The idea itself is not exactly new. I first suggested that Russia might be acquiring gold with a view to a new gold-backed currency at a financial war game hosted by the Pentagon at a top-secret laboratory in 2009.

Jim Rickards

Your correspondent at the Homestake Mine in Lead, South Dakota. Homestake was one of the largest and most productive gold mines in U.S. history, and was the foundation of the Hearst family fortune. Global gold output has flatlined in recent years while demand for gold remains strong.

In my upcoming book, Aftermath, I describe a more sophisticated monetary arrangement among Russia, China, Iran and other nations to use a gold-backed cryptocurrency for international settlements.

Still, theory is one thing, reality is another. Here was a real central bank taking real steps toward a gold-backed cryptocurrency. Of course, the announcement came with lots of caveats about the need to stick to hard currencies. This gold initiative involves review of a report, not a live plan at this stage.

Still, it was a significant moment in the move away from the hegemony of the U.S. dollar as the dominant global reserve currency toward another system that included gold.

By itself, this announcement is not a reason to load up on gold. In fact, the spot price of gold barely budged on the news. Gold prices are far more likely to be affected by strength or weakness of the U.S. dollar, real interest rates, inflation prospects and geopolitical stress.

But, the announcement is highly significant in another way. It signals that the demand for physical gold by major central banks is here to stay. Whether a new gold-backed cryptocurrency emerges next year or five years from now does not alter the fact that you need gold to have a gold-backed currency.

Neither Russia nor China has all the gold it needs for that purpose yet. Therefore, demand for physical gold will remain strong even as supply has flatlined.

This creates an asymmetric trading pattern where gold has good potential to rise, but only limited prospects of a material fall. Those are the best kinds of markets for trading and investment. Taking into account both these fundamental and technical factors, what is the outlook for the dollar price of gold and gold mining stocks in the near term?

Right now, the evidence is telling us that the dollar price of gold is poised to breakout to the upside after a prolonged period of range-bound trading.

Chart 1 below illustrates recent price action in gold and shows why the prospects are good for near-term price appreciation.

After a rally from $1,215 per ounce in late November 2018 to $1,293 per ounce in early January 2019, gold remained in a tight trading range.

Over the past five months, gold has traded between about $1,270 and $1,345 per ounce (as of yesterday after gold’s big run over the past week).

That’s a range of about 2.8% above and below a mid-point of $1,305 per ounce. A 2.8% range is not unusual when governments try to peg two currencies to each other. In effect, gold has been pegged to the dollar at $1,305 per ounce.

Chart 1

Chart 1

However, this trading range exhibits another pattern called “lower highs.” Each spike at the high end of the range is slightly lower than the one before. Conversely, the bottom in each gyration has been more tightly bunched forming a kind of floor under gold prices.

The combination of a strong floor and declining highs results in a compression of the trading range. What this pattern presages is a breakout. Of course, the question is whether gold will breakout to the downside or the upside. This week we saw gold break higher, to $1,345.

The evidence is strong that gold is poised for a sustained upside breakout. The reason for the floor around $1,270 per ounce has to do with fundamental supply and demand. Russia and China continue to buy gold at a prodigious rate.

Russia has been buying between 15 and 25 metric tonnes per month, sometimes more, for over ten years. Russia’s gold reserves now stand at 2,183 metric tonnes, over 25% of the U.S. total with a far smaller economy. China is less transparent in its gold buying but also has over 2,000 metric tonnes, perhaps much more.

Neither Russia nor China have their targeted amount of gold yet, which would be 4,000 metric tonnes for Russia and 8,000 metric tonnes for China to achieve strategic gold parity with the U.S.

Iran and Turkey have also embarked on major gold accumulation efforts.

What all of these gold buying strategies have in common is a desire to escape from dollar hegemony and the imposition of dollar-based sanctions by the U.S. The practical implication for gold investors is a firm floor under gold prices since Russia and China can be relied upon to buy any dips.

The primary factor that has been keeping a lid on gold prices is the strong dollar. The dollar itself has been propped up by the Fed’s policy of raising interest rates and reducing money supply, so-called “quantitative tightening” or QT. These tight money policies have amplified disinflationary trends and pushed the Fed further away from its 2% inflation goal.

However, the Fed reversed course on rate hikes last December and has announced it will end QT next September. These actions will make gold more attractive to dollar investors and lead to a dollar devaluation when measured in gold.

The price of gold in euros, yen and yuan could go even higher since the ECB, Bank of Japan and People’s Bank of China will still be trying to devalue against the dollar as part of the ongoing currency wars. The only way all major currencies can devalue at the same time is against gold, since they cannot simultaneously devalue against each other.

A situation in which there is a solid floor on the dollar price of gold and a need to devalue the dollar means only one thing – higher dollar prices for gold. A breakout to the upside is the next move for gold.

Regards,

Jim Rickards
for The Daily Reckoning

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About Today’s Jobs Report…

This post About Today’s Jobs Report… appeared first on Daily Reckoning.

The May unemployment report came rolling from the United States Department of Labor this morning.

In the highly technical vernacular of the trade… it was a “miss.”

And not by a nose, not by a hair, not by a whisker.

Economists as a group divined 175,000 May jobs.

What was the actual number?

Seventy-five thousand — fully 100,000 beneath consensus — and the lousiest figure since February.

Each one of 77 Wall Street analysts — each one — heaved up a greater estimate.

But unlike February, they cannot foist blame upon winter weather or a government shutdown.

Thus our faith in experts staggers yet again… and fast approaches our faith in weathermen, crystal gazers, salesmen of pre-owned automobiles and congressmen of the United States.

But our faith in the lunacy of the existing financial system is infinitely confirmed…

Wall Street vs. Main Street

In a healthful and functioning order, the stock market is a plausible approximation of prevailing economic conditions.

A poor unemployment report should send panicked shudders through the stock market.

It indicates a wobbled economy. Rough business is likely ahead. And companies can expect a reduced profit.

Stocks should — in consequence — fall tumbling on the news.

But ours is not a healthful and functioning order. It is rather an Alice in Wonderland order.

Up is down. Down is up. Good news is bad news.

And bad news is good news…

Bad news for Main Street is good news for Wall Street, that is.

Wall Street thrives on Main Street’s bad news as doctors thrive on fractured legs… as dentists thrive on toothaches… as embalmers thrive on murders.

And this morning’s jobs report constitutes good news for Wall Street.

It merely forms additional evidence the Federal Reserve will be slashing interest rates soon.

And low interest rates are the helium that lifted stocks to such gaudy and obscene heights lo these many years.

Stocks Soar on Today’s Weak Jobs Report

The Dow Jones was so heavily floored by this morning’s jobs report it went up 300 points by 11 a.m.

The other major indexes were similarly flabbergasted.

The S&P was up 35 points and the Nasdaq up 130 by the same 11 a.m.

All three indexes composed themselves somewhat by day’s end.

The Dow Jones ended the day 263 points in green territory. The S&P gained 30 points, while the Nasdaq added 126.

Yet as we documented Wednesday, the economy is going backward… and recessionary warnings flash in all directions.

Meantime, all reasonable estimates place second-quarter GDP growth under 2%.

But because the Federal Reserve promises yet additional levitating gases, the stock market has record heights once again in view.

“The Disconnect Between the Economy and Stocks is at Record Highs”

Thus the gentlemen of Zero Hedge declare, “The disconnect between the economy and stocks is at record highs.”

JJ Kinahan — chief market strategist at TD Ameritrade — here affirms the “bad news is good news” theory:

The market’s got a conundrum here. That’s a bad report. Just on the report itself, I think people would want to sell the market. However, the fact that it really makes the case for a rate cut, I think is why you’re seeing the market hang in there.

Affirms Mike Loewengart — vice president of investment strategy at E-Trade:

This is the type of [jobs report] the doves will really take to as it supports the argument for cutting rates beyond politics or trade issues…

Luke Tilley, chief economist at Wilmington Trust, adds:

I think that this is a true slowdown in hiring right now… The market signals are obviously screaming for the Fed to reduce rates.

Wall Street has Jerome Powell by the ear.

When Wall Street screams for lower interest rates, lower interest rates it will have.

Odds of Rate Cuts Approach 100%

The market presently gives 84% odds that the Federal Reserve will cut rates at least 25 basis points by July. By September those odds increase to 95%.

By January, they rise to 99%… with the heaviest betting on two rate cuts.

Investors further expect at least three rate cuts by next June.

But as we have detailed at length… you can expect recession within three months of the inevitable rate cut — whenever it may fall.

Yes, the next destination is recession.

The route may twist, the route may meander, the route may even temporarily turn back on itself.

But it terminates in recession nonetheless.

The “New Normal”

The No. 2 man at the Federal Reserve would nonetheless have us put away all talk of recession.

Mr. John Williams insists diminished growth is merely the “new normal”:

I know this talk of slowing growth is causing uncertainty, some hand-wringing and even fear of recession. But slower growth shouldn’t necessarily come as a surprise. Instead, it’s the “new normal” we should expect.

But with the highest respect to Mr. Williams… why shouldn’t we expect more?

The United States government borrowed in excess of $10 trillion over the prior decade.

$10 trillion is plenty handsome. Yet that $10 trillion of debt yielded only $3 trillion of real GDP.

Or to switch the figures some, the nation’s debt increases roughly $100 billion per month.

But GDP only increases some $40 billion per month.

We have gotten plenty of buck, that is. But not half so much bang to go with it.

The nation’s debt-to-GDP ratio already exceeds 100% — its highest since WWII.

The standard formula says deficits should decline during economic expansions. Come the inevitable recession, the government then has a full war chest to throw at it.

But a decade into the current expansion… the Treasury is depleted.

Trillion-dollar deficits extend to the horizon.

And the debt-to-GDP ratio is projected at 115% within three years.

Meantime, the Federal Reserve expects long-term GDP growth of 1.9%.

It is a bleak calculus — growing debt twinned with sagging growth.

The Mills of the Gods 

As we have argued previously, time equalizes as nothing else.

Scales balance, that which goes up comes down, that which goes down comes up…

The mighty fall, mountains crumble, the meek inherit the Earth.

We suspect strongly that stock market and economy will meet again on fair ground.

We further suspect it is stock market that will fall to the level of economy. Not the other way.

The mills of the gods may grind slowly, as Greek philosopher Sextus Empiricus noted.

But as he warned…

They grind exceedingly fine…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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A Tour of the Future

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Sharp, bracing winds have scattered the fog. The horizon is now visible… and the future drifts into focus.

Yes, we have the future in sight.

Today we report the way ahead.

We begin where we stand — upon creaking and groaning floorboards…

Recessionary Warnings in all Directions

Manufacturing surveys indicate global manufacturing contracted in May… for an unprecedented 13th-consecutive month.

The Manufacturing PMI (Purchasing Managers’ Index) surveys indicate manufacturing crawls at its slowest rate since September 2009.

United States factory orders expanded merely 1.0% in May — the lowest rate since President Trump took the throne.

The Cass Freight Index — a broad measure of domestic shipping activity and a plausible thermometer of economic health — has dropped 3.2% since last April.

Meantime, the bond market flashes warnings of a lean season ahead.

Ten-year Treasury yields have dropped to their lowest levels in two years, to 2.12%.

And the yield curve has inverted. An inverted yield curve nearly always precedes recession.

Thus we stand upon our precarious perch, wary of the shifting, sandy foundations beneath us.

But it is the future we have in mind today…

Morgan Stanley: 60% Chance of Recession Within One Year

The professional optimists of the Federal Reserve’s Atlanta branch office expect Q2 GDP to ring in at a slender 1.3%.

J.P. Morgan has lowered its own sights from 2.25% to 1%.

It also projects 10-year Treasury yields will sink to 1.75% by year’s end… and 1.65% by next March.

JP Morgan also — incidentally — places the odds of recession in the second half of this year at 40%.

It placed those same odds at 25% one month prior.

Morgan Stanley has also revised its Q2 GDP forecast from 1.0%… to a pale and sickly 0.6%.

It further gives a 60% likelihood of recession within the next year — its highest percentage since the financial crisis.

Of course, the Federal Reserve looms large in our vision…

Rate Cuts A2re Coming

The current rate hike cycle is ended. The Federal Reserve will next slash interest rates.

Its Federal Open Market Committee gathers in two weeks’ time.

As Craig Hemke of Sprott Money News notes, two options rise before the august ladies and gentlemen of the committee.

Neither is desirable:

1. Admit defeat and immediately cut the fed funds rate by up to 50 basis points.

2. Stall. And if they do this, bonds will rally even higher as the bond market will anticipate an even more dramatic global economic collapse.

The market votes heavily for Option 1.

Federal funds futures currently give nearly 70% odds of at least one rate cut by July.

By September these odds rise to over 90%, and by next January… to over 98%.

Some crystal gazers even hazard three rate cuts by this year’s end alone.

The Trigger for Recession

But as we have noted repeatedly… the next rate cut is a phony cure.

It is fool’s gold, a snare, a desert mirage.

The past three recessions ensued within 90 days of the first rate cut that ended a hiking cycle.

Affirms Zero Hedge:

While many analysts will caution that it is the Fed’s rate hikes that ultimately catalyze the next recession… it may come as a surprise to many that the last three recessions all took place [within] three months of the first rate cut after a hiking cycle!

We have every reason to expect the trend continues uninterrupted.

We further allow the possibility that the economy has already slipped into recession.

Recessions are often only identified several months after they commence — or longer.

Early next year, the bean counters may well point to Q2 2019.

Regardless, the recessionary straws are swaying in the stiffening breeze. Even Jerome Powell spots them.

“It’s Time to Rethink Long-run Strategies”

Mr. Powell realizes the standard rate cuts will fizzle woefully… like July Fourth sparklers that fail to spark.

So he will be on hand with more potent pyrotechnics.

From comments this week:

It’s time to rethink long-run strategies… Perhaps it is time to retire the term “unconventional” when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in the future… The next time policy rates hit the lower bound and there will be a next time it will not be a surprise.

Quantitative easing. Zero interest rates. Negative interest rates.

These and more tricks he doubtless has in mind.

And did you catch this bit?

“Perhaps it is time to retire the term “unconventional” when referring to tools that were used in the crisis.”

Just so.

Central banks have inflicted these “unconventional” tools upon the world’s citizens for 10 years — to varying degrees.

But if these gaudy and flashy devices met their advertising… why is the economy plunging into recession at all?

It is true, they have lit up the stock exchanges. But they fell as duds upon Main Street.

Why should they dazzle the crowd now?

They worked one primary effect:

To drill the world trillions of dollars deeper into debt.

Global debt has doubled post-financial crisis… as has the United States national debt.

Yet we return to the future…

Prepare for the Cannons of Fiscal “Stimulus”

We observe that the Federal Reserve’s punchless old fireworks have failed.

That is when the national authorities will haul out the cannons…

They will load them full of Modern Monetary Theory (MMT) — or “QE for the people.”

Rolling barrages of fiscal “stimulus” they will send raining down onto Main Street.

If a Democratic commander in chief is barking the orders at the time, he may load a Green New Deal into the breeches.

Free college tuition… universal Medicare… jobs for all… a $15 minimum wage.

All these and more it will promise — and save the world into the bargain.

The False Miracle of Debt

Like most crank ideas, these fevered schemes will fail in grand and spectacular style.

The false miracle of debt is their common delusion.

All debt-based consumption steals from the future to gratify the present. It is tomorrow’s consumption pulled forward.

It depletes the capital stock… and leaves the future empty.

It signs a perpetual check against an overdrawn future.

Mark Jeftovic of the Guerrilla Capitalism blog on MMT, which can extend to a Green New Deal:

Think of an MMT crisis as an economic black hole sucking all value from further and further future generations into a gravitational vortex of the present moment, where all value collapses in on itself and disappears forever.

Thus we conclude our tour of the horizon.

Mercifully, we can see no farther…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

The post A Tour of the Future appeared first on Daily Reckoning.

Wall Street and the New Cold War

This post Wall Street and the New Cold War appeared first on Daily Reckoning.

The stock market seems to rise or fall almost daily based on the latest news from the front lines of the trade wars.

When Trump threatens new tariffs and China threatens to retaliate in kind, stocks fall. When Trump delays the tariffs and China agrees to resume negotiations, stocks rise. And so it goes. It has been this way since January 2018 when the trade war began.

The latest dust-up came late last week when Trump threatened tariffs against Mexico if it doesn’t do more to curb illegal immigration to the U.S. Markets sold off on Friday as a result, bringing a terrible May to an end. Largely due to the trade war, the stock market had its worst May in seven years.

From the start, Wall Street underestimated the impact of the trade war. First they said Trump was bluffing. Then the analysts said that Trump and Xi would put their differences aside and make an historic deal.

All of these analyses were wrong. The trade war was problematic from the start and is growing worse today.

China will lose the trade war. The reasons are obvious. Foreign trade is a much larger percentage of Chinese GDP than it is for the U.S., so a trade war was always bound to have more impact on China than the U.S.

And if China tries to match the U.S. in tariffs dollar for dollar, they run out of headroom at $150 billion while the U.S. can keep going up to $500 billion and inflict far more pain on China.

Other forms of Chinese retaliation are mostly nonstarters. They cannot dump U.S. Treasuries without hurting their own reserve position and risking an account freeze by the U.S. China cannot turn up the pressure by stealing intellectual property because they’re already doing that to the greatest extent possible.

China’s latest threat is to ban exports of “rare earths” to the U.S. and its allies. Rare earths are essential for the production of plasma screens, fiber optics, lasers and other high-tech applications. Electric vehicles, mobile phones and telecommunications systems would be impossible to build without them. China is responsible for 90% of global production, which makes them a potent weapon in the U.S.-China trade wars.

“Rare” earths aren’t actually that rare. They are plentiful in quantity. The problem is that they are found in extremely low concentrations. This means a huge amount of ore and expensive mining processes are needed to extract even a small amount of these vital substances.

So rare earths are one weapon China possesses.

But over time, Western powers can replace rare earths purchased from China. There could be major manufacturing disruption in the meantime, it’s true. But it would not be the end of the world.

The U.S. will win the trade war and either China will open its markets and buy more U.S. goods or the Chinese economy will slow significantly.

But while the trade war is important, it’s not the main event.

The trade war is part of a much larger struggle between China and the U.S. for hegemony in Asia and the Western Pacific.

They are locked in a new cold war being fought on many fronts. These include trade; technology; rights of passage in the Taiwan Strait and the South China Sea; and alliances in South Asia, where China’s Belt and Road Initiative is promising billions of dollars for infrastructure development.

The U.S. is responding with arms deals and bilateral trade deals to counter Chinese influence. Even if a modest trade deal is worked out with China this summer, it will not put an end to the larger struggle now underway.

What are the implications?

If the Chinese view the trade war as just one step in a protracted cold war, which I believe they do, then we’re in for a long period of contracting growth that will not be confined to China but will affect the entire world.

That seems the most likely outcome for now. Get set for slower growth and perhaps stagflation. It could be like the late 1970s all over again.

Slowly, Wall Street is taking the trade wars seriously. But it is still missing its larger implications of a new cold war.

This new cold war could last for decades and it will affect the entire global economy. Let’s just hope it doesn’t turn into a shooting war.

Below, I show you why it could. Read on.

Regards,

Jim Rickards
for The Daily Reckoning

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The True “Green Revolution”

This post The True “Green Revolution” appeared first on Daily Reckoning.

An increasing number of states that have legalized medical-use marijuana, adult-use marijuana, or some combination of the two. But many in the mainstream media, and on Wall Street, continue to believe investing in pot is about getting high.

It’s time to set the record straight because investing in cannabis has absolutely nothing to do with getting high!

Today I’ll be discussing my top three reasons why every investor should allocate at least a small portion of their investable assets to the cannabis industry.

The reasons I believe you should invest in the green revolution are as follows:

  1. The U.S. cannabis market is massive
  1. There are many known catalysts with unknown timelines (a good thing!)
  1. Positive sentiment will lead to a U.S. infrastructure buildout

So without further ado, let me show you why cannabis is where you should put your money…

According to the research firm Euromonitor – the American cannabis market will grow from an estimated $5.4 billion in 2015 to an impressive $20 billion by next year.

And Euromonitor’s optimistic views aren’t out of line with the views of other research firms.

Market research firm Cowen has gone on record with its view that the American market could reach $75 billion by 2030.

Now, while early investors will no doubt make enormous fortunes if the cannabis industry grows to $75 billion over 11 years, I believe the market could grow even larger.

You see, most industry observers are only considering the uses of cannabis that we know of today. But like the internet in the mid-1990s, it’s just too soon to know how the cannabis industry will mature and ultimately unfold.

It’s even possible that we haven’t even identified the most profitable use for cannabis.

While cannabis users may love the plant for its healing, therapeutic, or relaxing effects, investors should recognize it as an untapped gold mine!

The bottom line is we’re in the very early days of a new industry that has tens of millions of potential customers in the U.S. alone, and billions-of-dollars in sales just waiting to be scooped up.

While anyone who pays even a little attention to the stock market knows about the green revolution unfolding in the U.S, I’m laser-focused on identifying investment opportunities. That way I can share them with my readers before they’re highlighted in The Wall Street Journal or on CNBC.

You see, to maximize your investment returns, you must be adequately invested before the story is shared with the investing masses on the front-page of every newspaper in America. That means investors need to identify industry catalysts, and then put their money to work in select companies before those catalysts are made public.

Look, we know with near 100% certainty that the U.S. government will eventually decriminalize the use of cannabis. And we know that banking reform will liberalize existing rules against cannabis.

Now, when banking reform is passed, the floodgates will burst open with banks wanting to lend cannabis companies money, and institutional investors wishing to snap up stock as quickly as possible (more on this below).

The bottom line is the catalysts are coming.

Investors that wait for the dust to clear, legislation to pass, and CNBC to report on the enormous stakes that significant institutions have taken in the United States’ multistate cannabis operators will be forced to pay a sky-high price for shares.

By focusing on the most successful U.S. cannabis companies and investing ahead of the crowd that is waiting for the legislative all-clear signal, you will be pre-positioned when the masses are only beginning to invest.

When it comes to Wall Street, sentiment is enough to move markets. And while it may seem like there’s a world of difference between Wall Street and the Washington, D.C., beltway, there isn’t. Politicians, like Wall Street analysts, are heavily influenced by public sentiment.

In April, a new Hill-HarrisX poll was released showing that 84% of Americans now support some form of marijuana legalization. It doesn’t take a high-ranking political operative to figure out that when 84% of voters support something, you can bet politicians are paying attention.

The dramatic rise in public opinion surrounding cannabis also explains why virtually every serious Democratic candidate for the 2020 elections supports marijuana legalization. Many Republicans are also on board.

Yes, investing in cannabis is going to resemble the wild west over the next 1-2 years. But it’s that lack of certainty and regulation that actually provides marijuana investors with massive profit potential.

Below, I show you why you should invest in the “true” Green Revolution. And I’m not talking about green energy. Read on.

Invest in the True Green Revolution

Twenty years ago, the only people making money from marijuana were stone-cold criminals.

These guys smuggled narcotics across a national border, made deals with cartels and sold drugs on the street. And every dime they made had to be laundered through phony businesses to keep the heat off their backs.

Today, I can make quick and easy money from marijuana, sitting at my computer in my pajamas. And it’s all 100% legal. No drug mules, no police — just a click of a button.

Now, before you get the wrong idea, I’m not talking about selling pot, using it or even living in one of the growing number of pot-friendly states. You can do this from anywhere in the U.S. All you need is a laptop and access to a trading account. I’m talking about the growing sector of the stock market that’s dedicated to legal pot.

I’m talking about medical marijuana companies, legal growers and even gardening companies who are getting in on the marijuana-growing boom.

Yes, I believe cannabis — specifically U.S.-focused cannabis companies — are set to explode higher in 2019 and beyond. I don’t know if you were investing in the mid-1990s but I was and it was a magical time.

Companies like Netscape, AltaVista, CMGI, and WebMD captured the imaginations of investors, and Wall Street rewarded these companies and others like them with multi-billion-dollar valuations.

Now, there’s no denying that the internet revolution was a once-in-a-lifetime event. And when technology stocks came crashing to the ground in mid-2000, I assumed that was it. I’d never see an investment opportunity that massive ever again.

But I was wrong.

You see, we are facing the end of cannabis prohibition in the United States. And like the internet revolution, this too is a once-in-a-lifetime investment event.

Unfortunately, many investors hear the word marijuana and immediately shut down. They’ve grown up listening to how horrible cannabis is, and viewing it as a dangerous drug with no medical value. They can’t handle the idea of investing in a product that is both federally illegal and responsible for landing thousands of Americans in prison.

Simply put, many on Wall Street will miss out on this investment opportunity because they’re either incapable or unwilling to look beyond today’s federal cannabis policy which is tragically out of step with popular opinion and position their portfolio for where federal policy will be in the near future.

Now, I want you to try and wrap your head around a few numbers.

Legal U.S. recreational and medical cannabis generated $10.4 billion in 2018. However, that only represents sales made in state-legal cannabis enterprises. If we account for the estimated black market demand, that figure jumps up to an astounding number somewhere between $50 billion and $55 billion!

With bipartisan federal and state-level political support for cannabis legalization, public opinion that is already heavily in favor of reform, and support from the banking, alcohol and tobacco, professional sports, and banking industries — there’s no question that full-scale federal legalization is right around the corner.

Now, it’s no secret that the biggest challenge facing the legal U.S. cannabis industry today is access to banking services.

You see, because cannabis remains illegal under the Federal Controlled Substances Act, banks and credit unions are understandably scared to do business with or extend credit and banking services to state-licensed cannabis companies.

And without access to banking services, state-licensed cannabis companies are forced to operate on a cash-only basis.

While cannabis is illegal at the federal level, any bank providing traditional banking services to a legal cannabis company could be accused of money laundering and aiding and abetting federally-illegal operations.

The takeaway is that without a cannabis-related banking solution at the federal level, most U.S. cannabis companies will be forced to remain predominantly cash-only operations.

But that’s changing.

Senator Jeff Merkely (D-OR) and Rep. Ed Perlmutter (D-CO) introduced the Secure and Fair Enforcement (SAFE) Banking Act in May 2017 to both legitimize the burgeoning cannabis industry, and to establish a framework of banking rules for cannabis companies operating under state-legal guidelines.

Unfortunately, the 2017 version of the SAFE Banking Act failed to see the light of a committee hearing.

But on February 13, 2018, the House Financial Services’ Subcommittee on Consumer Protection and Financial Institutions held the first ever congressional hearing on the issue of cannabis banking.

And an underpublicized Congressional subcommittee held a hearing this March on providing safe harbor via the SAFE Banking Act of 2019 for banks wanting to work with legal cannabis businesses in the U.S.

A vote on the SAFE Banking Act of 2019 could happen by the end of June. The fact that it managed to get this critical piece of legislation in front of the House Financial Services subcommittee is a HUGE positive for the cannabis industry.

And with public opinion blowing heavily toward legalization at the federal level, our elected leaders in Congress finally realize they must come out from the shadows and do their job!

Just the fact that legislation is finally being discussed is a momentous step in the right direction.

Here’s what Rep. Denny Heck (D-WA) said following the hearing:

“We listened to hours of testimony today about the dangerous position we put store owners and employees in by forcing them to do all of their business in cash. We can fix this. We don’t have to force them to operate in a way that makes it difficult to secure and track their funds. Regardless of our views of marijuana use, the voters have decided in states all over this country that they want recreational and medicinal markets. To continue to do nothing to protect public safety would be negligence.”

I’ll continue to monitor any developments with the SAFE Banking Act. I’m very excited about any future developments in the legalization of cannabis at the federal level. Again, there could be a vote by the end of June.

Abraham Lincoln famously said,

“We the people are the rightful masters of both Congress and the courts.”

And I believe the day is finally coming when the views of most Americans will be heard, and the cannabis industry will be permitted to emerge from the shadows and dark alleyways and operate in full government-sponsored daylight.

The pieces are in place for cannabis to emerge as the next great growth sector. And the fact that marijuana is still illegal at the Federal level in the U.S. provides traders with a significant catalyst to invest around.

America’s budding pot market is the BEST way for an average American to get rich right now.

There is a so much momentum building, from the individual states to the halls of Washington, D.C.

Right now, most mainstream investors don’t know how to read the signals. But it won’t be long before they catch on — which is why I recommend you move on this opportunity right now.

Don’t miss out!

Regards,

James Altucher
for The Daily Reckoning

The post The True “Green Revolution” appeared first on Daily Reckoning.

Beware the “Adjusted” Yield Curve

This post Beware the “Adjusted” Yield Curve appeared first on Daily Reckoning.

Yesterday we furrowed our brow against the latest inversion of the “yield curve.”

The 10-year Treasury yield has slipped beneath the 3-month Treasury yield — to its deepest point since the financial crisis, in fact.

Inverted yield curves precede recessions nearly as reliably as days precede nights, horses precede carts… lies precede elections.

The 10-year Treasury yield has dropped beneath the 3-month Treasury yield on six occasions spanning 50 years.

Recession was the invariable consequence — a perfect 1,000% batter’s average.

But an inverted yield curve is no immediate menace.

It may invert one year or more before uncaging its furies.

But today we revise our initial projections — as we account for the “adjusted” yield curve.

The “adjusted” yield curve indicates recession may be far closer to hand than we suggested yesterday.

When then might you expect the blow to land?

Now… you realize we cannot spill the jar of jelly beans straight away. You must first suffer through today’s market update…

Markets plugged the leaking today.

The Dow Jones gained 43 points on the day. The S&P scratched out six. The Nasdaq, meantime, added 20 points.

Gold — safe haven gold — gained nearly $7 today.

But to return to the “adjusted” yield curve… and the onset of the next recession.

The Nominal vs. the Real

We must first recognize the contrast between the nominal and the real.

The world of appearance, that is — and the deeper reality within.

For example… nominal interest rates may differ substantially from real interest rates.

Nominal rates do not account for inflation.

Real interest rates (the nominal rate minus inflation) do.

That is why a nominal rate near zero may in fact exceed a nominal rate of 12.5%…

Nominal interest rates averaged 12.5% in 1979. Yet inflation ran to 13.3%.

To arrive at the real interest rate…

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).

Today’s nominal rate is between 2.25% and 2.50%. Meantime, (official) consumer price inflation goes at about 2%.

Thus we find that today’s real interest rate lies somewhere between 0.25% and 0.50%.

That is, despite today’s vastly lower nominal rate (12.5% versus 2.50%)… today’s real interest rate is actually higher than 1979’s negative 0.8%.

The Standard Yield Curve vs. The “Adjusted” Yield Curve

After this fashion, the standard yield curve may differ substantially from the “adjusted” yield curve.

Michael Wilson is chief investment officer for Morgan Stanley.

He has applied a similar treatment to distinguish the adjusted yield curve from the standard yield curve.

The standard yield curve — Wilson insists — does not take in enough territory.

It fails to account for the effects of quantitative easing (QE) and subsequent quantitative tightening (QT).

The adjusted yield curve does.

It reveals that QE loosened financial conditions far more than standard models indicated.

It further reveals that QT tightened conditions vastly more than officially recognized.

The adjusted curve takes aboard the Federal Reserve’s estimate that every $200 billion of QT equals an additional rate hike… for example.

The standard yield curve does not.

Thus the adjusted yield curve reveals a sharply more negative yield curve than the standard.

Here, in graphic detail, the adjusted yield curve plotted against the standard yield curve:

Image

The red line represents the standard 10-year/3-month yield curve.

The dark-blue line represents the adjusted yield curve — that is, adjusted for QE and QT.

The adjusted yield curve rose steepest in 2013, when QE was in full roar.

But then it began a flattening process…

QT Drastically Flattened the Adjusted Curve

The Federal Reserve announced the end of quantitative easing in late 2014.

And Ms. Yellen began jawboning rates higher with “forward guidance” — insinuating that higher rates were on the way in 2015.

Thus financial conditions began to bite… and the adjusted yield curve began to even out.

By the time QT was in full swing, the adjusted curve flattened drastically. The standard curve — which did not account for QT’s constraining effects — failed to match its intensity.

Explains Zero Hedge:

The adjusted curve shows record steepness in 2013 as the QE program peaked, which makes sense as it took record monetary support to get the economy going again after the great recession. The amount of flattening thereafter is commensurate with a significant amount of monetary tightening that is perhaps underappreciated by the average investor.

Now our tale acquires pace — and mercifully — its point.

The Adjusted Yield Curve Inverted Long Before the Standard

After years of flattening out, the standard yield curve finally inverted in March.

Prior to March, it last inverted since 2007 — when it presented an omen of crisis.

But since March, the standard curve bounced in and out of negative territory.

The recession warning it flashed was therefore dimmed and faint — until veering steeply negative this week.

But the adjusted yield curve did not invert in March…

It inverted last November — four months prior. And it has remained negative to this day.

Wilson:

Adjusting the yield curve for QE and QT shows an inversion began at the end of last year and persisted ever since.

Thus it gives no false or fleeting alarm — as the standard March inversion may have represented.

We refer you once again to the above chart.

Note how deeply the adjusted yield curve runs beneath the standard curve.

A “Far More Immediate Menace”

Meantime, evidence reveals recession ensues 311 days — on average — after the 3-month/10-year yield curve inverts.

But if the adjusted curve inverted last November… we are presented with a far more immediate menace.

Here Wilson sharpens the business to a painful point, sharp as any thorn:

Economic risk is greater than most investors may think… The adjusted yield curve inverted last November and has remained in negative territory ever since, surpassing the minimum time required for a valid meaningful economic slowdown signal. It also suggests the “shot clock” started six months ago, putting us “in the zone” for a recession watch.

If recession commences 311 days after the curve inverts — on average — some 180 days have already lapsed.

And so the countdown calendar must be rolled forward.

Perhaps four–five months remain… until the fearful threshold is crossed.

If the present expansion can peg along until July, it will become the longest expansion on record.

But if the adjusted yield curve tells an accurate tale, celebration will be brief…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

The post Beware the “Adjusted” Yield Curve appeared first on Daily Reckoning.