Real estate rates are finally asserting themselves and the leveraged play known as the carry trade is finally coming to a conclusion. Inflation is about to race ahead as the budget and current account deficits spin out of control. We won't see the reign of real interest rates until Sir Alan Greenspan leaves office. We doubt he will increase interest rates more than 3/4's of an additional point prior to his departure. Thus, the profligacy will last until next February. We have no idea at this point what his successor will do.
Measured tightening via higher interest rates is being offset by monetary creation, excessive credit creation via the banking system and now persistent inflation. The only way to cease the madness is to allow real interest rates to move considerably higher. This will allow the system to be purged. In addition, using bogus official figures, a move in inflation from 2 to 3.3% has offset about 75% of the 1-3/4% increase in Fed rates over the past nine months. As we said in previous issues, Sir Alan is 9 to 12 months behind the curve and he has been there for several years, This, needless to say, does not instill confidence in the so-called science of macro policy, which is no more than guess and by golly. Economics like the stock market is not a science – it is an art form. Sir Alan has blown it and he knows it. Unfortunately, the world won't realize it until he is gone.
The way we figure it we'll get another 3/4% increase in Fed funds' rates by yearend. Next year you can figure on an increase of 3 to 3-3/4%. That would put the 10-year US Treasury note at 7-1/2% to 8-1/4% and that would put 30-year fixed mortgage notes at 8-1/2 to 9-1/4%. Those numbers could pull the system into some sort of balance, dependent on political, monetary, fiscal, financial, economic and world events, a tall order for an art form. If the elitists really wanted to purge the system the 10-year Treasury note would go to 12-1/2%, or higher. Yes, we would have depression, but that is what the system will have sooner or later anyway. Between now and the end of 2006, the budget deficit and current account deficits will get worse and gold and silver will trade much higher as inflation soars.
European socialists have again abused their system by abandoning the stability pact and creating the possibility of political, fiscal and economic failure. If fiscal conservatism is not followed and European governments follow the lead of George and the neocons, Congress and the Fed, they will be every bit as doomed as the US is. The barometer will be when the euro price of an ounce of gold trades convincingly above 350. That is on the short term. On the long term, higher gold prices versus the euro and the dollar are a lock. Owning euros or euro treasuries probably will be tenable until the end of 2006, and then everything has to be in gold. In the meantime, the euro will trade to $1.60 to $1.65, but when that is attained you have to see where the euro stands versus gold. The euros 15% gold backing will help, but it won't save it versus gold. As the price of gold breaks out in euros it will attract more gold buying in euros. Gold will have already broken out over $500 an ounce in dollars. As this unfolds, gold will also attract money from all currencies and the next phase of the bull market in gold will have begun.
It deeply disturbs us every day that we are told Iran is our enemy and that they are preparing WMD, when they are interested in using nuclear power like so many other nations have. The problem really is that in June Iran is preparing to open an oil exchange that will trade oil in euros as well as dollars. That probably will bring about the demise of the dollar as the world's reserve currency. That is why our President and his accomplices want to attack and destroy Iran.
Little has really changed over the past few months. The Dow has yet to correct. The S&P is weaker and the Nasdaq Index has broken down. The dollar rally is about over and the euro shorts are beginning to cover. The underlying problems in the US economy are still there. The fiscal deficit, the current account deficit, tremendous individual and government debt, war in the Middle East, high oil, gas and commodity prices, a real estate bubble and higher interest rates with higher rates in the works. Due to systemic problems, a lower dollar will not give any assistance to the trade deficit until the Dollar Index hits 65 to 70. It is currently close to 84. Higher interest rates at current levels will not appreciably bite into the economy. A Greenspan compromise will see rates 3/4% higher by January. That will affect the general economy only slightly. It will begin the beginning of a profound effect on the real estate market. If our forecast is correct, you will see the 30-year fixed mortgage at 6-3/4% to 7% by the end of the year. That will cause a leveling in housing prices and a flat to 10% correction dependent on the housing circumstances. By the end of 2006 we see a 10-year treasury note at 7-3/4% to 8-1/4% and a 30-year mortgage rate of 8-3/4% to 9-1/4%. Rates will not be rising to slow the economy, they will be rising to dampen inflation and support a falling dollar. As problems become manifest, gold will break out on its own. It will still be influenced by the fall in the dollar, but will be influenced by other negative domestic events, the housing collapse being one of them. Gold will also begin to appreciate against other currencies, especially the euro. Scandals will get bigger and more damaging. We may well have a Selective Service Draft and an extension of warfare in other theaters. Every world economic and monetary depression has had wars to divert the attention of the masses, why should this planned fiasco be any different?
We are here to interpret for you. We are here to tell you what is really going on, not what our government, Wall Street and our media want you to know. Ultimately higher interest rates are going to cause lots of damage. In the long run higher rates will bankrupt millions of Americans and thousands of companies. It will result in capital flight out of the dollar into other currencies and gold. It will collapse the dollar and eventually other currencies. Unemployment will easily exceed 30%. We will have a depression, the result of not tackling our problems some 16 years ago. Our budget and current account deficits will worsen. Those who believe higher interest rates will help the economy or strengthen the dollar are sadly mistaken. The Fed cannot control inflation unless interest rates are raised 10% or more. Unfortunately, they will eventually be forced to do that. Higher rates will crush consumers. There will be few home equity loans and cash outs and refinancing will be a part of history. There will be little savings; debts will have to be paid. Consumer spending is at least 75% of GDP. Less consumption means less tax revenue. The collapse of the housing bubble will be even more devastating than the collapse of the stock market in 2000. The losses will be relative, but the loss of your home is more devastating. Unemployment will be awful. Construction, all forms of finance jobs, travel, retailing, entertainment and sports will take the brunt of the hit this time, Today we have enormous debt that did not exist in the 1930s and that will make this depression much worse. Our government has created a police state so we believe as we get deeply into the depression there is a good chance that America could experience a second revolution. We hope not, but it sure looks to be headed that way.
We are beginning to see aggressive professional selling in commercial real estate as prices hit records. The sellers are old-line real estate families, pension funds and Calpers, the California Public Employees Retirement System. Calpers has sold $6.5 billion in office buildings and shopping centers in the last three months, which is half of their real estate investments. It is in the process of selling most of the rest. Interest rates are rising and the pros are heading for cover. The average price of an apartment building rose 26% in 2004, while industrial properties were up 21%. Office buildings rose 6% and retail properties 14%. In Houston and San Francisco prices had been in the pits for eight years. They soared 55% and 41% respectively. Volume jumped 50% from 2003, topping out at $182 billion. In January and February $29 billion in commercial property hit the market, double last year's offerings for that period.
We hear complaints from our State Department that Venezuela is upsetting and destabilizing South America via its weapons purchases, yet Washington has reversed a 15-year policy authorizing the sale of F-16 fighter jets to Pakistan. India has warned it will destabilize the volatile region. There are two sets of rules, one for the US and one for everyone else. Pakistan can buy the upgraded F-16 and F-18 in unlimited quantities. There are deep-seated rivalries and religious animosities between these two nuclear giants. George and the neocons just stepped on the accelerator. This will push India further into the Russian, China, Iran, Brazil, and Venezuela camp. This is very bad foreign policy. Bush believes the planes will give leverage over Pakistan in regard to Kashmir, we do not think so. Former Senator Larry Pressler (R-SD), who sponsored the 1985 law that ultimately forced the cancellation of the original F-16 sale in 1990, called the decision “an atrocity” that goes against “everything the Bush administration has stood for.”
AIG's ties with former CEO Maurice Greenberg are being severed. The head of the Greenberg crime family and exalted member of the Council on Foreign Relations, will testify before prosecutors in the office of Eliot Spitzer, New York A.G. We expect him to take the Fifth Amendment. This is a wide range investigation, which includes offshore companies that own millions of dollars of AIG stock. Again, let's hope Eliot opens action on AIG's rigging of the silver market. He has all the evidence. One disgrace after another, despite recommendations by Army investigators, commanders have decided not to prosecute 17 American implicated in the death of three prisoners in Iraq and Afghanistan in 2003 and 2004. The charges included murder, conspiracy, and negligent homicide. One received a reprimand and another was discharged. The total deaths of prisoners is 31 and 36 soldiers were involved. Most murders were by having been beaten to death or by asphyxia. We would not want to be captured by Iraqis. We can imagine the payback.
The following statistics are as of March 25, 2005, last Friday. We published early so they were not included. Remember, they'll be a second set later in the report for this week.
The two-year US Treasury yields surged 16 basis points to 3.85%, the highest level since August 2001. The ten-year raised 9 PB to 4.60%.
M3 declined $11.8 billion to $9.49 trillion. Year-to-date M3 has expanded at a 1.3% rate, with M3 less money funds growing at a 4.9% rate. It is up 8.6% over 52 weeks.
Here is the hook. This is how A. Greenspan is deceiving investors. Bank credit has expanded a stunning $293.7 billion during the first 11 weeks of the year (20.6% annualized), in what is demonstrating all the characteristics of a classic credit blow off. Securities credit is up $118.7 billion, or 29% annualized y-t-d. Real estate loans have expanded at a 17.1% rate during the first 11 weeks of 2005 to $2.04 trillion, and were up $337.9 billion, or 14.7% over the past 52 weeks. Consumer loans rose $2.8 billion and securities loans were up $11.7 billion.
Total commercial paper dipped $1.4 billion and it is up 11.0% y-t-d. Fed foreign holdings of Treasury, agency debt raised $3.7 billion to $1.389 trillion. Custody holdings are up $52.9 billion, or 17.2% annualized. Despite the short week, $11 billion worth of ABS were issued. Y-T-D issuance of $144 billion is 8% ahead of comparable 2004. At $91 billion, y-t-d home equity ABS issuance is 23% above year ago levels.
Japanese private investors are cooling to US Treasuries. Their total net purchases of foreign bonds thus for this year has reached $63 billion, the largest three month decline since March 2003. About half those sales were in US Treasuries. As we said in the last issue, once the private Japanese investor slows his buying of US Treasuries or stocks, yields will go straight up.
Credit and liquidity are financing asset bubbles and inflation. The nature of perceived financial or asset wealth is about to change. Interest rates are rising. That means that the unprecedented leveraging and speculation and derivative excesses are in for some dramatic changes and they won't be good changes. Euro dollar rates for June 06 imply a 10-year US Treasury yield of 6%. We see it at 6-1/4% to 6-3/4%. After yearend there will be an acceleration of rates as foreign buying of Treasuries and agencies falter, the last of the carry trade covers and derivative players get caught offside again. Oil will still be selling higher than $40.00 a barrel and auto and truck sales will continue to slide putting GM and Ford in a difficult position. The financial backdrop is changing. We should have been into deep recession by now, but for the madness of Sir Alan Greenspan. He may have bought us four years, but the price we will pay for his foolishness will be steep and harsh. Over the second half of the year growth will slow quickly. Corporate earnings will only be up 5 to 10% this year, not 22% like last year. Official unemployment will move higher as well as inflation and gold and silver prices. You had best get your house in order. This is the beginning of the long ride down.
Systemic corruption in the financial world is endemic. The headliners are AIG, JP Morgan/Chase, Citigroup, Morgan Stanley and Deutsche Bank, all involved in suppressing the gold and silver markets. Then there is Fannie Mae and Freddie Mac who we believe is already bankrupt. One thing they all have in common, besides being criminals, is that they are in derivatives big time and that will be injurious to their financial health eventually. Important stocks that are in strong distribution are GM, Ford, GE, Citigroup, Delphi, Lucent, JPM and AIG. We are looking for a quick test of 9,500 on the Dow soon. This should be the beginning of the end of the bear market rally.
This is exactly what we predicted would happen seven years ago. Swiss biotechnology company, Signet AG said it mistakenly sold to farmers an experimental corn seed genetically engineered to resist bugs that was never approved by regulators, bolstering claims that the industry tighten government security. We ask, how do you sell hundreds of tons of seeds and not know what you are shipping? That is ridiculous. Worse yet, hundreds of tons of unapproved corn were planted in open fields for four years before Syngenta acknowledged what they had done. They have spread this GM garbage all over Europe, which has banned it. On March 25, 2005, the World Economic update was held at the Council on Foreign Relations and the following are some of the salient ideas that came from that forum. The host, Maurice R. Greenberg, was unable to attend because he was preparing for a deposition with NY AG Eliot Spitzer. The panel was composed of several eminent economists, which included Stephen Roach and Jim Grant.
China has about $450 billion in dollar assets and Hong Kong, we might add, has about $180 billion, or a total of $630 billion. If the dollar drops by 33%, that is a loss of 14% of GDP or about $210 billion. This will be a massive loss for the Chinese. There is also growing hostility again on US-China trade tensions, especially in light of the surge of Chinese textile imports during the first two months of this year. They are causing major new unemployment. There is going to be a lot of China-bashing this year. This raises risk to the stability of their dynamic growth. We might add that legislation for 28% tariffs on Chinese goods just might get passed as the situation deteriorates. Incidentally, tariffs in a rising interest rate environment would prove devastating not only for the US but also for the entire world economy.
In addition, there is no question all small nations have or will slowly move out of the dollar. Big nations will as well, but they have to be very careful not to start an avalanche. No matter, the downward pressure on the dollar over time will be relentless. Jim Grant said it is in everyone's interest in Asia that the dollar not collapse, but it is in no one's individual interest that they not take action ahead of the others. In fact, it is everyone's individual interest to act first. So, I think that the serial uttering of this heretical word diversification and the quick denial is a verbal leading indicator of a major shift in thought in Asia. And, it is not such a subtle thought; it is why have every egg in one basket? The marginal cost of production of a dollar bill is essentially nothing. That money has no cost to produce and a relatively new idea in the history of the world. Since 1971, that idea has become current and acceptable.
Stephen Roach said, look we had a small hiccup in 1987 that I would call certainly at the time, disorderly. It occurred against the backdrop of a US current account deficit, which widened all the way to 3.4% of GDP. Isn't that amazing? Today's problem, as you alluded to, is twice as bad as that. Right now the current account deficit is 5.6%, but it is headed up to 6.5% for reasons that have been eluded to here.
All we are getting is spin. When you have an unprecedented external imbalance, by definition the odds of a disruptive adjustment are high. And, macro cannot tell you when and it cannot give you the bolt from out of the blue, which can disturb it. But, when you have this massive deficit, the likes of which we have and the dependence we have on external financing, it takes less to stir up the pot than would be case if we were closer to balance. That is the price we pay for this.
Who knows what the bolt out of the blue is? You know, some dumb piece of legislation gets passed in Washington that is protectionist, or some other central banks, you know, announce they are going to bail out, or, you know, there is as you know, an LTCM type problem because, you know, some levered players have played the trade too much and they implode, or lo and behold, we wake up and find out the America's productivity miracle has been a scam and its over. (We believe that is true. We are surprised Roach dared to go this far in the house of the conspiracy.) Have no idea what it would be. But the price we pay for these excessive deficits is that the risk of a disorderly adjustment by definition is higher. None other than Paul Volcker is on record according to Council (CFR) Chairman Peter Peterson, who built this wonderful building for us, saying that there will be a 75% chance of a dollar crisis in the next three years.
Richard Haass closed the meeting making excuses for fellow Council members who were responsible for such a deplorable situation. This was the first time the Council has ever had such an open forum and they thought it was quite successful because no one was foolish enough to expose what the Council is really up to. Haass' closing remarks were: “This is an important time for the Council and these issues that we are working on, the issues that we talked about today, but this issue is also of war and peace and the rest. These are not abstract issues, foreign policy, national security matters in ways that I believe it hasn't mattered in a long time. I've been in business for about 30 years and I cannot think of a moment when there has been as many pressing difficult issues crammed on the plate at the same time as there are now. Everything we talked about today, if there are changes in the dollar, will have strategic consequences. And, if there are strategic developments, those could have dollar consequences.” The smoke screen continues but the Council is very concerned, otherwise they would have never had the open forum. We are headed toward big trouble and everyone at the top knows it.
Researches at Bridgewater Associates, which manages more than $100 billion of institutional and hedge fund money, has been issuing warnings in its daily reports that the dollar's outlook is grim. They bring to their clients attention that if the yuan is revalued it will not need as many dollar-denominated assets to keep its currency from gaining value, nor will its competitors for export markets. If enough investors follow Bridgewater's lead, the dollar will lose value rapidly, which means there is little sense in buying or holding dollars. Fundamental economic factors need not worsen any further. In currency crises, perception very quickly becomes reality. Bridgewater says the dollar is already beyond the point of no return. In order to keep the dollar at its current value, private investors will have to buy more American securities as central banks desert them. Before private investors will act, they need to see a higher return from American assets relative to assets carrying similar risks abroad. If the returns move higher to accommodate these private investors, the economy will slow and then falter. As rates rise, the economy is choked off. Bridgewater predicts a further decline in the dollar of 30%, especially against Asian currencies, and a rise in American long-term rates of one-half to one full percentage point. If that doesn't happen and rates remain relatively the same and budget deficits are cut, there will be a standoff. That still leaves the balance of payments defects, inflation and a sea of liquidity. If the FED tightens, everything goes down except gold and silver. Congress and the President will not cut the deficit, so that is out. That means interest rates are going higher.
Fifteen years ago hedge funds managed less than $40 billion and today the figures are close to $1 trillion. Assets in mutual funds grew from $1 trillion to $1.8 trillion. There are now 3,307 hedge funds, up 74% from 1,903 in 1999. As opposed to mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and short the market. Hedge funds play both sides of the markets.
These funds have had a huge impact on the markets. They now account for 50% of all activity in major markets such as the NYSE and the LSE. Wall Street made $25 billion catering to hedge funds. Hedge funds are unregulated and they use mega leverage to double or triple their bets.
SEC registration begins in 2006 and managers are none too happy about it. These funds are the ultimate gambling vehicle and the SEC says they want to find if anyone involved in these funds are felons, especially when the incentives for investors to bet the house are so huge.