Over the past 12 months I’ve written extensively at TSI about the myths surrounding US bank reserves and the relationship between bank lending and bank reserves. For example, I’ve explained that bank reserves cannot be loaned into the economy and that in the real world — as opposed to the world described in economics textbooks — banks do NOT expand credit by ‘piggybacking’ on their reserves. As part of these bank-reserve writings I addressed the reasoning behind the Fed’s decision to start paying interest on reserves, reaching the conclusion that the decision had been taken to enable the Fed Funds Rate (FFR) to be hiked in the future without contracting the supplies of reserves and money. Last week there was confirmation from the horse’s mouth that my conclusion was correct, as well as some other interesting information on how an eventual tightening of US monetary policy will proceed.

As implied above, the Fed confirmed last week that when it finally gets around to moving the FFR upward, it will do so primarily by adjusting the interest rate it pays on excess reserve balances. If not for the existence of this relatively new policy tool, the only way that the FFR could be hiked would be via the traditional method involving reductions in the supplies of reserves and money. Moreover, considering the immense quantity of excess reserves now in the banking system, there would need to be a large reduction in the supply of reserves just to achieve a 0.25% increase in the FFR. Trying to shift the FFR upward via the traditional method would therefore quickly ignite a financial crisis.

The other interesting information conveyed by the Fed last week is that the size of its balance sheet will be reduced by ceasing to reinvest repayments of principal on the securities it holds. For example, if the Fed currently owns a bond with 3 years remaining duration, then — assuming that it has embarked on a policy normalisation route — it will not reinvest the proceeds when the bond’s principal is repaid in three years’ time. Instead, the principal repayment will bring about a reduction in the Fed’s balance sheet and a reduction in the money supply.

This means that the Fed plans to reduce the size of its balance sheet — and tighten monetary policy — at a snail’s pace.

The following chart is very interesting. I found it in John Mauldin’s latest “Thoughts from the Frontline” letter, although it was created by the Boston Consulting Group. It compares the cost of manufacturing in the top 25 exporting countries.

According to this chart, Australia is now the most expensive country to manufacture stuff. Manufacturing costs in Australia are now 30% higher than in the US, almost 20% higher than in Japan, almost 10% higher than in Germany, and about 5% higher than in Switzerland. The cost of manufacturing in the US is now slightly below the average — at around the same level as South Korea, Russia, Taiwan and Poland. This means that the Fed is almost half way to its goal of reducing US living standards to the point where the average factory worker in the US can compete on a cost basis with the average factory worker in Indonesia.

The above comment is only partly tongue-in-cheek. Many pro-free-market commentators discuss the decline in US living standards as if it were an unintended consequence of the Fed’s policies, but there is nothing unintended about it. It is a deliberate objective. The Fed will never come out and say “we are doing what we can to reduce living standards”, but a policy that is designed to boost asset prices, support capital-consuming businesses and promote investments that would never see the light of day in the absence of artificially low interest rates, all while minimising “wage inflation”, is also designed to reduce real wages and, therefore, to reduce living standards. The Fed surely doesn’t want to reduce US living standards to Indonesian levels, but that’s the direction in which its efforts are deliberately pointed.

I’ve explained in TSI commentaries that the root of the problem is unswerving commitment to bad economic theory. Under the Keynesian theories that all central bankers religiously follow, wealth is something that just exists. There is no careful and deep consideration given to how the wealth came to be and why some countries managed to accumulate a lot of wealth while other countries remained poor. According to these theories, people spend more during some periods due to a vague notion called rising “animal spirits”. This causes the amount of wealth to grow. Then, after a while, the mysterious “animal spirits” begin to subside, causing people to start spending less. This leads to a reduction in the amount of wealth. Under this perception of the world, one of the central bank’s primary tasks is to combat the unfathomable and destabilising natural force that drives the shifts in spending. This is done by indirectly manipulating prices throughout the economy, including the real price of labour.

The so-called counter-cyclical policies are destined to backfire, but the nature of the eventual backfiring is often difficult to predict. In broad terms, there are two possibilities: There could be a surge in inflation fear followed by a collapse in asset prices, a recession and a moonshot in deflation fear, or the collapse in asset prices and its knock-on effects could happen without a preceding surge in inflation fear. In both cases, the asset-price collapse and recession would likely usher-in a new round of ‘stimulative’ policy, because the devotion to bad theory prevents the right lessons from being learned.

The CEOs of commodity-producing companies are usually knowledgeable about the supply of and the demand for their company’s products, but gold-mining CEOs are exceptions. The vast majority of gold-mining CEOs have almost no understanding of supply and demand in the gold market.

For example, like most gold-market analysts and commentators, most gold-mining CEOs wrongly believe that the change in annual gold production is an important driver of the gold price. In particular, they talk about “Peak Gold” as if a leveling-off or a downward trend in global gold-mine production would be very supportive for the gold price. This means that they don’t understand that the gold-mining industry’s contribution to the total supply of gold currently equates to only 1.5% per year, and, therefore, that changes in industry-wide gold production will always be dwarfed — in terms of effect on the gold price — by changes in investment/speculative demand. (And by the way, changes in investment/speculative demand cannot be quantified by looking at transaction volumes.)

Gold CEOs’ general cluelessness about the gold market is reflected by the performance of the World Gold Council (WGC). Every year, the WGC produces a pile of completely irrelevant information about gold.

Fortunately, understanding the gold market has nothing to do with being a good CEO of a gold-mining company. A good gold-mining CEO is someone who a) implements strategies that keep total costs at relatively low levels, b) prudently manages country, local-community, environmental and other political risks, c) ensures that the balance sheet remains healthy, and d) only makes acquisitions that are accretive.

Last Thursday (4th September) the ECB introduced a cunning new plan to spur growth in the euro-zone, the first part of which involves cutting official interest-rate targets by 0.1%. The benchmark refinancing rate has been reduced to 0.05%, because 0.15% was obviously too high, and the deposit rate has gone further into negative territory, because it obviously wasn’t negative enough. The actions have been taken due to “inflation” and inflation expectations being too low.

Inflation of any kind is the last thing that Europe needs, but from the Keynesian perspective, which is the perspective of all central bankers, it is critical that both inflation and inflation expectations are well above zero. The reason is that in the back-to-front world in which Keynesians are mired, consumption spending comes first and is the driving force of the economy. Furthermore, according to Keynesian logic if people believe that prices are going to be lower in the future they will put off their spending, which will set in motion a vicious deflationary spiral of price declines leading to reduced spending, leading to additional price declines, and so on.

Keynesian logic explains why the computer and smartphone manufacturers never sell anything. Everyone knows that if they wait a year they will be able to buy a better smartphone and a better computer at a lower price, so nobody ever buys these products. As a consequence, the entire computer and smartphone industries have zero sales year after year.

Getting back to the ECB, a goal of reducing the cost of credit to zero is to generate some “price inflation”, which, according to the theories that inform the decisions of central bankers, will boost immediate consumption and cause the economy to grow faster. But if a faster rate of price inflation is what they want, then what they will have to do is increase the rate of monetary inflation. In this regard, taking an overnight interest rate down from 0.15% to 0.05% is probably not going to do much. If the ECB is serious about generating “inflation” then what it really needs to do is implement a Fed-style QE program.

Which brings me to the second part of the ECB’s cunning new plan. The ECB announced that it would begin monetising covered bonds and asset-backed securities (ABS)*, including real-estate-backed securities, next month, with the details to be announced at next month’s ECB meeting. Depending on its size and mechanics, this asset monetisation program could certainly cause prices to rise. To the extent that it does cause prices to rise it will benefit banks and speculators at the expense of savers, productive businesses and wage earners.

Fortunately or unfortunately, depending on your perspective, due to the limited availability of eligible collateral the QE program announced by the ECB last week might be restricted in size to about 200B euros. This means that it might not be large enough to have much effect on the euro-zone money supply.

*Banks create asset-backed securities by pooling mortgages and other loans. Covered bonds are similar, but the underlying assets are ‘ring-fenced’ on the bank’s balance sheet, which means that the assets are still there if the bank goes bust.

The gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms, which are periods when economic confidence rises while mal-investment sets the stage for an economic contraction, and rise during the busts, which are periods when the mistakes of the past come to the fore. This is due to gold’s historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, I’ve indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 16-year period covered by the chart there have been three busts: the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and “great recession” of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012.

The booms tend to fall apart more quickly than they build up, so the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.

Gold/GYX’s current situation looks most similar to Q2-2007. At that time the ratio tested its late-2006 bottom and then reversed upward, marking the end of the boom that began in 2003. However, gold will soon have to start strengthening relative to industrial metals such as copper in order for the 2007 similarity to be maintained. If this doesn’t happen and the gold/GYX ratio breaks decisively below its December-2013 bottom, it will indicate that the boom is going to extend into 2015.

I want to stress that gold’s relationship to the boom/bust cycle is primarily about its performance relative to other commodities, especially the industrial metals. It is not about gold’s performance in US$ terms. For example, from mid-2005 through to mid-2006 gold performed poorly relative to the industrial metals, but this was a good time to be long gold and a very good time to be long gold stocks. It’s just that the industrial metals handily outperformed gold during this period, which makes sense considering the global economic and financial-market backdrop at the time. For another example, from May through November of 2008 gold performed extremely well relative to the industrial metals. This makes sense considering the global economic and financial-market backdrop of the period, but it was a bad time to be long gold and a very bad time to be long gold stocks.

Over the past 15 years there have always been very compelling reasons to short Japanese Government Bonds (JGBs), but almost everyone who has attempted to make money by shorting JGBs has ended up losing money. The consistency with which bearish JGB speculators have lost money over a great many years led to the short-selling of JGBs becoming known as the “widowmaker trade” and spawned the saying: “you can’t claim to be a speculator until you’ve lost money shorting JGBs”.

As evidenced by the steady downward trend on the following Bloomberg.com chart of the 10-year JGB yield, anyone who has attempted to short the JGB since the beginning of this year has lost money. In other words, the “widowmaker trade” is still living up to its name. Moreover, with the exception of a few days during early-April of last year, the 10-year JGB yield has never been lower than it is right now.

Actually, despite the steady upward grind in price and downward grind in yield, I doubt that many speculators have lost money shorting JGBs this year. The reason is that the market for JGBs no longer functions like a real market. It has effectively been squashed by the gigantic boot of the Bank of Japan (BOJ).

Due to the BOJ’s policy of buying-up every piece of government debt it can get its hands on, the JGB is so over-priced that there are no buyers apart from the BOJ. At the same time, nobody in their right mind would bet against a high-priced investment that was being supported by a totally committed buyer with infinitely deep pockets. Consequently, for all intents and purposes the JGB market is dead.

Given the proclivity of the US monetary authorities to copy Japan’s worst policy choices, speculators who believe that they will make a fortune over the years ahead by shorting US government bonds should probably re-think their stance. After all, if a Keynesian remedy fails dismally in Japan, it can only be because the remedy wasn’t implemented aggressively enough.

It is illogical to expect an artificially-low interest rate to help the economy. This is because the best-case scenario resulting from interest-rate suppression is a wealth transfer from savers to speculators. In other words, the best case is a ‘wash’ for the overall economy. The realistic case, however, is very much a negative for the overall economy, because in addition to punishing savers an artificially low interest rate will cause mal-investment and thus make the economy less efficient.

Furthermore, thanks to the Japanese experience of the past two decades there is now a mountain of recent empirical evidence to support the logic outlined above. Japan’s policymakers have tried and tried again to propel their economy to the mythical “escape velocity” by pushing interest rates down to absurdly low levels and keeping them there, but every attempt has failed. Unfortunately, the fact that interest-rate suppression has been a total bust in Japan has not dissuaded other central banks from going down the same path.

The root of the problem is devotion to bad economic theory. If you are convinced that lowering the interest rate, pumping money into the economy and ramping-up government spending is beneficial, then from your perspective a failure of such measures to sustainably boost the rate of economic growth can only mean that the measures weren’t aggressive enough. If the interest rate is reduced to zero and the economy remains sluggish, then a negative interest rate must be needed. If the economy doesn’t become strong in response to 10% annual money-supply growth, then 15% or 20% annual monetary expansion is obviously required. If a hefty boost in government spending fails to kick-start the economy, then it must be the case that government spending wasn’t boosted enough.

The alternative is that the theory underlying the policy is completely wrong, but this possibility must never be acknowledged.

A popular view is that the Bank of Japan (BOJ) is inflating the Yen to oblivion. This view is wrong. The reality is that while there is certainly a risk that the BOJ will eventually inflate Japan’s money supply at a fast pace, it is not currently doing so.

The spectacular QE program introduced by the BOJ in April of last year did have some effect on the money supply, but the effect was nowhere near as great as generally believed. As illustrated by the chart displayed below, the year-over-year (YOY) rate of increase in Japan’s M2 money supply rose from around 3% in early-2013 to just above 4% near year-end, but 4% is a long way from the explosive growth that most analysts thought would result from the BOJ’s new Yen-depreciation policy. Furthermore, the YOY rate of increase in Japan’s M2 has since drifted down to 3% and appears to be on its way back to the long-term average of 2% (I think it will be back at 2% by October). This means that Japan is still maintaining the world’s lowest monetary inflation rate, which prompts me to ask: Why are so many analysts still blindly assuming that the BOJ is rapidly expanding the Yen supply? Why aren’t they spending the 15 minutes that would be needed to validate — or in this case invalidate — their assumptions by checking the money-supply figures available at the BOJ web site?

An implication of the above is that the supply side of the Yen’s supply-demand equation remains bullish for the Yen’s exchange rate. However, for most currency traders this doesn’t matter. The reason is that the supply side dominates very long-term trends in the foreign exchange market, but the demand side often dominates over periods of up to 2 years.

One of the main reasons that T-Bonds continue to rise in price (fall in yield) is that most speculators continue to bet on a price decline (a rise in long-term interest rates). In other words, the sentiment backdrop remains supportive. It’s worth noting, for example, that despite the strong and consistent upward trend of the past 9 months, there is still a substantial speculative net-short position across the 30-year T-Bond and 10-year T-Note futures markets. Therefore, higher T-Bond/T-Note prices and lower long-term interest rates probably lie in store.

That being said, the iShares 20+ Year Treasury ETF (TLT) is now a) very ‘overbought’ by some measures (momentum, not sentiment), b) within 2% of intermediate-term resistance at 120, and c) within 6% of its mid-2012 all-time high. A test of resistance at 120 will almost surely happen and a test of the all-time high will possibly happen prior to the next intermediate-term peak, but a sustained break into all-time-high territory is very unlikely.

TSI was short-term bullish on US Treasury bonds from mid-December of last year through to mid-August of this year, but turned short-term “neutral” in a report published on 17th August. I expect to see additional gains in the T-Bond price and additional declines in the T-Bond yield over the next few months, but the short-term risk/reward is no longer skewed towards reward. It is also not skewed towards risk, meaning that it doesn’t yet make sense to bet against this market.

The extent to which monetary stimulus weakens an economy’s foundations and gets in the way of real progress will be proportional to the aggressiveness of the stimulus. This is because the greater the monetary stimulus, the greater the part within the overall economy that will end up being played by ‘bubble activities’ (businesses, projects, investments and speculations that only seem viable due to artificially low interest rates and a constant, fast-flowing stream of new money). That’s why the unprecedented (at that time) monetary stimulus of 2001-2005 led to the most severe economic fallout in more than 50 years, and why the even more over-the-top monetary stimulus of 2008-2013 has paved the way for an economic downturn of even greater severity than that of 2007-2009.

I’ll be writing more about the coming economic bust (aka severe recession or depression) over the next several months, especially if signs appear that it will soon get underway. For now, here are a few preliminary thoughts:

1) The next economic bust is likely to be worse than, and different from, the one that occurred during 2007-2009. What I mean is that the next bust is unlikely to be an amplified version of what happened previously. The main reason is that almost everyone, including the monetary central planners, will be prepared for a repeat of 2007-2009. Of particular relevance, whereas the Fed didn’t start to pump money into the economy until almost 12 months after the start of the 2007-2009 financial crisis and economic recession (the Fed began to cut its targeted interest rate in September of 2007, but it didn’t begin to monetise assets in a way that boosted the monetary inflation rate until September of 2008), it’s likely that the next time around the Fed will be much quicker to ramp up the money supply.

2) Due to the much quicker application of monetary ‘accommodation’ to counteract future economic weakness, the next bust could be associated with sharply rising commodity prices. This would be due to commodity hoarding in reaction to the belief that money is being trashed.

3) In the lead-up to and during the next economic bust, gold will probably be the best investment because it is the most logical commodity for large investors to hoard. It is the most logical commodity-refuge due to its global liquidity, its globally recognised value, the fact that the amount of gold used in commercial/industrial applications is trivial compared to the amount of gold held for monetary/investment/speculative purposes, and the distinct possibility that a collapse of or an existential threat to the current monetary system would result in gold returning to its traditional role as money.

4) The next economic bust won’t be caused by a geopolitical event, such as the disintegration of Ukraine and/or Iraq, but it will likely be exacerbated by restrictions placed on international trade due to increasing geopolitical tension.

5) The timing of the next bust is currently unknown. Two years ago I thought that it would be well underway by now, but it’s clear that negative real interest rates have a remarkable ability to postpone the day of reckoning. My current guess is that it will begin in 2015.

6) Three things I expect to see shortly before the start of the next economic bust are: a) the S&P500 Index dropping well below its 200-day moving average; b) evidence across the financial markets of a general increase in risk aversion (e.g. widening credit spreads, strength in gold relative to most other commodities); and c) a decline in the US monetary inflation rate to below 7%.