What Is Coming Down the Pipe..............YIKES!

Monetization and Debt Will Only Bring Inflation

• March 3, 2011

Many ask, what will happen when quantitative easing ends? China doesn’t want to accumulate more Treasury and Agency bonds and we find the buying from London and the Cayman Islands questionable at best. We have always suspected that the real buyers in part from those locations were the Fed. Quite frankly we believe that QE2 is much further ahead in issuance than we are told. Remember they actually began adding liquidity last June. Problems as a result of such creation of money and credit have been the leveraged unnatural elevation of the stock market. All the funds normally devoted to cleaning up the Treasury/Agency market by banks and institutions have allowed these entities to dis-intermediate their funds to the stock market and commodities. This process has allowed the artificial inflation of prices in stocks and commodities, which in time will become problematic. The Fed knew that the course they were taking would result in just what we have seen and the minute markets see that easing is going to end they would end their participation. One of the key reasons of the treasury bail out was to keep the stock market up. The mirage of wealth had to be maintained since wealth in real estate for the most part had been destroyed. The multiyear bond bull market also looked like it could be coming to an end as real interest rates began to climb some six months ago. QE2 has again fostered risk taking in the form of leverage. We might also add that many other governments have done the same thing and that means when forcing liquidity ends every market will fall simultaneously.
The result of Fed and bipartisan policies has been price inflation in commodities and particularly food prices. Higher costs have spread worldwide and will continue to do so for the next two years or more. Our conclusions on extending QE2 to QE3 are simple. It is not going to end. If it were to end the bottoms would fall out of everything except gold and silver. Central banks have deliberately chosen higher inflation rather than face reality. That decision is going to cost them dearly. Inflation can be contained but that comes with a price, less money and credit, higher interest rates and deflationary depression. As you can see they are trapped in a box and they cannot get out, worse yet, they are well aware that there is no escape.
There will be Treasury debt to be sold perpetually with deficits of $1.6 trillion. Congress talks in terms of cutting $60 billion and the administration wants to add $50 billion. That is virtually no effort at all, as the deficit nears 11% of GDP. Truly a banana republic number. The liquidity created by the Fed to create depth to the Treasury market is little more than a mirage with side effects. The monetization has to bring inflation. It in no way solves the out of control debt creation that has to be adjusted at the White House and in Congress and that has not happened and it looks like it isn’t going to happen. The excesses are worsening not getting better. QE1 and QE2 have created terrible distortions and only delayed higher interest rates that are naturally underway in the real market. We have just observed a quick bond market rally, but will it last? We find it hard to believe that it will under these nervous conditions, as other sovereigns withdraw from purchasing. These conditions have to drive yields higher with very negative consequences. Big players at some point will come to the realization that the debt situation is no longer manageable and recognize that there has to be a purging process. When that process finally begins markets will go starkly negative.
The budget for next year plans for the fourth consecutive deficit of $1.65 trillion or more. This is the official estimate. In reality the deficit is considerably higher. Officially that is 44% of projected federal spending. We see lots of figures that put government debt between 85% and 103% of GDP. These are very significant numbers, because they indicate that that total effort has to be devoted to servicing debt and growth can’t continue. That is why we saw five fading quarters of GDP growth to 3% to 3-1/4%. QE2, plus stimulus, will only bring 2% to 2-1/4% this time in what we have called the law of diminishing returns. Simply, the focus of debt service does not help GDP growth. It is like putting out an endless fire comparable to being in hell. A QE3 plus the same stimulus will only produce an official 1% GDP growth, when in reality the figure will be minus 1-1/2%. Without the boost real GDP growth would be minus 3%. Are you getting the message? It is a façade and it won’t work. If we throw in municipal and state debt, personal and corporate debt, we are really in trouble. If we look across the pond we see England and Europe experiencing the same problems, because they have done the same thing although in a smaller way. By the end of the year the US will have reached debt of more than 100% of GDP. How far can this go? We don’t know, but the day of reckoning is not far away. We might add, what will happen when corporate America can no longer keep two sets of books, particularly the financial sector? What is interesting is that government, Wall Street, the BIS, the FASB and the financial media never mention the existence of such a practice, which renders financial reports bogus and irrelevant.
It is quite obvious that QE2 and the stimulus are not getting the desired results. That is understandable considering that nothing they can do can resurrect the economy. The insiders are well aware of that. The system will fold when they want it too. Their problem is they know we are waiting for them to pull the plug, so we can then react and spoil their plans. Thinking people now realize that the entire stimulus isn’t and hasn’t worked. There have been no spending cuts and there won’t be. What they are doing has not worked and won’t work; it is a perpetual stalling for time. In late 2009 it was announced that the recession was over, yet, unemployment has improved only slightly. A commission was set up to reduce budget deficits and their recommendations were essentially ignored. Goodness, who would want to cut spending $1 trillion a year for four years? The disintegration is underway and it is only a matter of time before the wheels come flying off the economy. There is absolutely no discipline or any effort to seriously save the system.
Earlier Japan and now China have been financing the US. The Japanese have been in a depression since 1992 and as long as they keep doing what they are doing they will sink further. China is now in the position that Japan has been in for so long. The sale of US debt by either the Japanese or Chinese in any meaningful way would sink all three economies and the world economy would join in for the ride. You might call it mutually assured destruction. What has happened is that on a net basis both have cut back or stopped buying US obligations. They and others are non-buyers or sellers of US debt. China has recently sold about $50 billion in US debt. The question is will they continue to do so and our answer is probably yes. That means the Fed has to be the buyer and that can only be accomplished via monetization followed by inflation.


The US deficit increases exponentially each year into the trillions of dollars. In the meantime Wall Street, banking and others have been bailed out of their grievous mistakes. The solution has been more government spending, some $850 billion a year and quantitative easing. The Fed creates money out of thin air, and buys Treasury and Agency securities. In fact the Fed owns 25% more of the Treasuries and Agencies than China and they in time probably will end up owning them all. In fact we believe that the Fed already owns $1.5 trillion of that paper. The US and the Fed will have no buyers in the end and only default can follow. Foreigners are well aware of what is going on and that is why the US 10-year T-note’s yield has risen from 2.05% to 2.20% and recently to 3.74%. That is quite a leap. We see 4% to 4-1/4% by year end and 5% to 5-1/2% by the end of 2012. The bull market in Treasuries is over and in time the entire game will be over. It is called the ultimate Ponzi scheme and it will not work. That is why you have to have gold and silver related assets; they are the only real money.
We have great reservations concerning the Fed’s balance sheet because of derivatives and swaps, and who knows what else they are up too. The balance sheet has expanded almost $225 billion over the past 16 weeks, as global central bank assets have catapulted $1.5 trillion yoy, which means the Fed is not the only central bank printing money and credit under the euphemism quantitative easing. Over the past two years the increase has been $2.6 trillion, or 40% to $9.3 trillion. The result has been the bailout of financial companies in the US and Europe and presently the continued flow of funds to these institutions and the funding of sovereign debt. These policies have created a false sense of security, bought time, and extended the false façade of healthy markets and economies. As the strong underflow of deflation persists, governments and central banks instill re-inflation, because if they do not do so their seemingly healthy financial and economic environment will collapse. This conceptual pursuit has in its process allowed great flows of capital to flow into stock markets thereby raising equity prices, which in turn has produced false confidence. Be as it may this papering over of systemic problems will not permanently allow the instability lurking just below the surface.
Such developments have again raised the level of leveraged speculation. The banks, hedge funds and other financial institutions have avoided sovereign debt, because that is being managed by the Fed, and have launched another wild spate of speculation. You would have thought they would have had learned their lessons almost three years ago. There is no question the world is awash in liquidity, which is very dangerous and disastrous for currencies versus gold and silver. At the same time North Africa and the Middle East are enveloped in turmoil and who knows where it could lead next. At the same time food prices hit new highs and availability becomes more difficult, as commodity prices keep rising as investors begin a flight to quality. We now have price inflation as well as monetary inflation. Most professionals and investors disregard these dull problems at their peril.
We don’t have to remind you of what is happening in Libya and could happen in Saudi Arabia. That realization is finally being reflected in a small way in US and foreign markets. The potential for future problems is enormous, especially in oil production. In the meantime the seduction of speculation holds forth. This time the players could be very wrong and the losses unmanageable.
The Saudi’s are terrified, so much so that they increased social spending by $36 billion including a 15% pay increase, which will prove to be additionally expensive. Incidentally, you can expect other nations worldwide to copy the Saudi lead of short-term expediency.
We are sure China and the US are watching the Middle East with great trepidation. It could only be a matter of time before they and many other nations experience the same dilemma. There should be monetary tightening, but there won’t be. The Fed certainly doesn’t care about inflation. Their concept is to keep the economy rolling along. In fact we expect easing and inflation to accelerate, assisting the rise in gold and silver prices. Further monetization is on the way and you can plan on that. There is no other way to keep the system going. Batten down the hatches there are violent storms ahead.