Monday, January 6, 2014

Peter Schiff: Will the Fed Save Us?

Too Big To Pop
By Peter Schiff

Most economic observers are predicting that 2014 will be the year in which the United States finally shrugs off the persistent malaise of the Great Recession. As we embark on this sunny new chapter, we may ask what wisdom the five-year trauma has delivered. Some big thinkers have declared that the episode has forever tarnished freewheeling American capitalism and the myth of Wall Street invincibility. In contrast, I believe that the episode has, for the moment, established supreme confidence in the powers of monetary policy to keep the economy afloat and to keep a floor under asset prices, even in the worst of circumstances. This represents a dramatic change from where we were in the beginning of 2008, and unfortunately gives us the false confidence needed to sail blindly into the next crisis.

Although the media likes to forget, there was indeed a strong minority of bearish investors who did not drink the Goldilocks Kool-Aid of the pre-crisis era. As the Dow moved up in 2006 and 2007 so did gold, even though a rising gold price was supposed to be a sign of economic uncertainty. The counter intuitive gold surge in those years resulted from growing concern among a committed minority that an economic crisis was looming. In the immediate aftermath of the crisis in 2009 and 2010, gold shifted into an even higher gear when those investors became doubly convinced that the extraordinary monetary measures devised by the Fed to combat the recession would fail to stop the economic free fall and would instead kick off a new era of inflation and dollar weakness. This caused many who had been gold naysayers and economic cheerleaders to reluctantly jump on the gold band wagon as well.

But three years later, after a period of monetary activism that went far beyond what most bears had predicted, the economy has apparently turned the corner. The Dow has surged to record levels, inflation (at least the way it is currently being measured) and interest rates have stayed relatively low, and the dollar has largely maintained its value. Ironically, many of those former Nervous Nellies, who correctly identified the problems in advance, have thrown in the towel and concluded that their fears of out of control monetary policy were misplaced. While many of those who had always placed their faith in the Fed (but who had failed - as did Fed leadership - from seeing the crisis in advance) are more confident than ever that the Central Bank can save us from the worst.

A primary element of this new faith is that the Fed can sustain any number of asset bubbles if it simply supplies enough air in the form of freshly minted QE cash and zero percent interest. It's as if the concept of "too big to fail" has evolved into the belief that some bubbles are too big to pop. The warnings delivered by those of us who still understand the negative consequences of such policy have been silenced by the triumphant Dow.

The proof of this shift in sentiment can be seen in the current gold market. If the conditions of 2013 (in which the Federal Government serially failed to control a runaway debt problem, while the Federal Reserve persisted with an $85 billion per month bond buying program and signaled zero interest rates for the foreseeable future)could have been described to a 2007 investor, their conclusions would have most likely been obvious: back up the truck and buy gold. Instead, gold tumbled more than 27% over the course of the year. And despite the fact that 2013 was the first down year for gold in 13 years, one would be hard pressed now to find any mainstream analyst who describes the current three year lows as a buying opportunity. Instead, gold is the redheaded stepchild of the investment world.

This change can only be explained by the growing acceptance of monetary policy as the magic elixir that Keynesians have always claimed it to be. This blind faith has prevented investors from seeing the obvious economic crises that may lay ahead. Over the past five years the economy has become increasingly addicted to low interest rates, which underlies the recent surge in stock prices. Low borrowing costs have inflated corporate profits and have made possible the wave of record stock buybacks. The same is true of the real estate market, which has been buoyed by record low interest rates and a wave of institutional investors using historically easy financing to buy single-family houses in order to rent to average Americans who can no longer afford to buy.

But somehow investors have failed to grasp that the low interest rates are the direct result of the Fed's Quantitative Easing program, which most assume will be wound down in this year. In order to maintain the current optimism, one must assume that the Fed can exit the bond buying business (where it is currently the largest player) without pushing up rates to the point that these markets are severely impacted. This ascribes almost superhuman powers to the Fed. But that type of faith is now the norm.

Market observers have taken the December Fed statement, in which it announced its long-awaited intention to begin tapering (by $10 billion per month), as proof that the dangers are behind us, rather than ahead. They argue that the QE has now gone away without causing turmoil in the markets or a spike in rates. But this ignores the fact that the taper itself has not even begun, and that the Fed has only committed to a $10 billion reduction later this month. In fact, it is arguable that monetary policy is looser now than it was before the announcement.

Based on nothing but pure optimism, the market believes that the Fed can somehow contract its $4 trillion balance sheet without pushing up rates to the point where asset prices are threatened, or where debt service costs become too big a burden for debtors to bear. Such faith would have been impossible to achieve in the time before the crash, when most assumed that the laws of supply and demand functioned in the market for mortgage and government debt. Now we "know" that the demand is endless. This mistakes temporary geo-political paralysis and financial sleepwalking for a fundamental suspension of reality.

The more likely truth is that this widespread mistake will allow us to drift into the next crisis. Now that the European Union has survived its monetary challenge, (the surging euro was one of the surprise stories of 2013), and the developing Asian economies have no immediate plans to stop their currencies from rising against the dollar, there is little reason to expect that the dollar will rally in the coming years. In fact, there has been little notice taken of the 5% decline in the dollar index since a high in July. Similarly, few have sounded alarm bells about the surge in yields of Treasury debt, with 10-year rates flirting with 3% for the first time in two years.

If interest rates rise much further, to perhaps 4% or 5%, the stock and real estate markets will be placed under pressure, and the Fed and the other "Too Big to Fail" banks will see considerablelosses on their portfolios of Treasury and mortgage-backed bonds. Such developments could trigger widespread economic turmoil, forcing the Fed to expand its QE purchases. Such an embarrassing reversal would add to selling pressure on the dollar, and might potentially trigger an exodus of foreign investment and an increase in import prices. I believe that nothing can prevent these trends from continuing to the point where a crisis will be reached. It's extremely difficult to construct a logical argument that avoids this outcome, but that hasn't stopped our best and brightest forecasters from doing just that.

So while the hallelujah chorus is ringing in the New Year with a full-throated crescendo, don't be surprised by sour notes that will bubble to the top with increasing frequency. Ultimately the power of monetary policy to engineer a real economy will be proven to be just as ridiculous as the claims that housing prices must always go up.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.


  1. Higher real interest rates mean lower gold prices. The real interest rate will go up and gold will go down. Look for 800s this time next year.

    1. If it doesn't will you promise to throw your simplistic notions upon the ash heap of history?

    2. Gold and interest rates

      A common misconception in markets about the price of gold is that rising interest rates for a currency will always drive the price of gold down against it. I shall come to market relationships in a moment, but first we must look at the economic relationship between gold and currency.

      The primary driver is changes between the relative quantities of gold and currency, with an overlay of changes in confidence for the currency itself. This quantity relationship is simple to understand and needs little elaboration; but it does not mean that a doubling in the quantity of paper money automatically leads to a doubling of the price of gold. The reason is the purchasing power of a currency can and does vary independently from changes in its quantity. Gold, however, is seen by the majority of the world's population as a better store of value than local currency, so its appeal is global instead of being tied to a single currency's jurisdiction.

      This means that over time the most important relationship between gold and currency cannot be interest rates. However, assuming a period of general stability in a major currency such as the US dollar, interest rates then do come into play. We must take account of traders' opinions, which are normally confined to dealings in the paper markets. There are two different situations to consider: when changes in interest rate policy discount tighter monetary conditions, and when monetary policy reacts to events and therefore do not discount them.

  2. The Price Of Gold: The Fed's 60 Seconds Of Desperation

    Forget the myths that the media's created about the Fed. The truth is, these are not very bright guys and things got out of hand. Follow the money...just follow the money. - My paraphrase of "Deep Throat" from "All The President's Men"
    Mere manipulation by desperate criminals?

    This is the unmistakable sign of desperation. Desperation to keep a lid on the price of gold in an attempt to make the public believe that everything is ok in this country and with the U.S. dollar. But we all know otherwise...

    I have no doubt that the hit was used JP Morgan to get more long Comex gold futures and to induce a flood of GLD share selling. The GLD shares will be turned into the GLD Trust either today or tomorrow and used to remove more gold. I bet within the next couple of days, today inclusive, we'll see a large withdrawal of gold from the GLD Trust. For the record, selling of GLD shares does not trigger the removal of gold Gold can only be removed by the banks who exchange shares for gold.

  3. This comment has been removed by the author.

  4. "most assumed that the laws of supply and demand functioned in the market for mortgage and government debt. Now we "know" that the demand is endless"

    Ahh... it looks like Schiff is finally coming around to the realization that money is special, more special than anything else. Money does not conform to the "law of supply & demand" like any economic good, because it is not just any economic good. The demand for money approaches the infinite, thus it's supply is meaningless, there can never be enough money. Yes it's a "fundamental suspension of reality" for the obligations of an insolvent bank to trade 'money good', but it IS the current reality, a paradox, or better described, a Ponzi scheme.

    Looks like the rest of you Miseans are going to have to reassess your support of the Quantity Theory of Money. One of your own, Phillip Baggus would be a good place to start, then Fekete.

    1. "The demand for money approaches the infinite, thus it's supply is meaningless, there can never be enough money."

      Have you traveled outside of your mom's basement yet? Even a trip down memory lane might help unless you were born just yesterday,