Central Bankers Are the Drug Dealers of an Addicted Market, While You Get to Pay the Bill

December 21 2015

Earlier this year I warned readers that December could prove to be an exciting month. As the dust has settled, we are able to draw some conclusions. The ECB cut its deposit rate (from -0.2% to -0.3%), while the Federal Reserve hiked its policy rate (from 0.25% to 0.5%). Both were within my line of expectation. However, it wasn’t the most important observation to be made this month.

Confirming What We Already Knew

December begun with a characteristic moment: ECB President Mario Draghi, one day after the deposit rate cut, reminded the market that “there cannot be any limit to how far we are willing to deploy our instruments (the printing press).” 

Why? A day earlier he had been shocked by the market’s reaction as the ECB announced its policy decision. The market had reacted with strong disappointment, as the EUR/USD volatility went through the roof, and the euro appreciated by nearly 4% in mere hours. European stock markets plummeted. The decision clearly wasn’t 'good enough' for the markets.

Of course, this is a conventional headline found in every newspaper. But take a moment to think about it. After all, it is rather strange that asset prices are completely dependent on the (potential) monetary stimulus of central banks. Prices on the financial markets should be the result of a discovery process, where prices resemble the preferences of consumers. In other words, stock prices should depend on the performance of the respective business (which depend on factors of consumption), and not on the whims and quirks of a central bank.

The past five years have been characterized by strong reactions on two matters:

  • Every indication that central banks will reduce their monetary stimulus > a strong decline in asset prices
  • Every indication that central bank will expand their monetary stimulus > strong increase of asset prices

Things haven’t been much more complicated than this over the past few years; it seems to be the 'new normal,' and is readily accepted by anyone like it is the most natural thing in the world.  

And it becomes even more absurd: after five years of rising stock prices, that were exclusively the result of zero interest rate policies and monetary stimuli, (almost) all economists and analysts 'simply' expect that stock prices will continue their rise. Even when monetary stimuli will be stopped. A logic that is rather hard to follow.

But that is not how things work! Stock prices, which completely depend on monetary stimulus as Draghi has confirmed once more, will not continue rising when that stimulus is taken away. The high of a drug addict quickly becomes a hangover as the supply of new drugs is stopped. The idea that someone can remain high forever after only having used drugs a couple of times is absurd. And all of this nonsense this can be traced back to the wrong idea of the well-known economist John-Maynard Keynes that the economy is a kind of motor that has to be 'cranked up' when its starts to falter.

In sum, central bankers are the drug dealers of an addicted market. 

The Worst Moment to Introduce a Rate Hike

As expected, the Fed hiked its policy rate. But from the viewpoint of the Fed, Janet Yellen has picked the worst possible moment for a rate hike. The world economy is not doing well, although it appears that many do not (seem to) realize this yet. Let me elaborate on my chain of reasoning.

 

Prices of industrial commodities just keep on declining. For example, prices of oil and natural gas are reaching lows not seen the past decades. These prices depend on supply and demand. Admittedly, supply has increased in the case of oil (as a result of US shale oil).

 

But, we’re missing parts of the story. Commodity prices are also experiencing a significant dip due to lower demand. And that is a sign that the world economy is slowing down.

 

An important indicator for this is the Baltic Dry Index: it provides an indication of the dry bulk carriers. And the dry bulk carriers’ performance is, in turn, a good indicator of the state of the world economy. The more goods are being shipped, the better things are going. 

 

To be more precise: the Baltic Dry Index tells us which rates are paid in shipping. If the world economy strengthens, we should see more demand for bulk shipping by sea.

 

Currently, the exact opposite is true: The Baltic Dry Index is at a historic low. The state of the world economy is weak, very weak. And this is also reflected in: commodity prices, the demand for commodities, pricing in dry bulk shipping, and declining corporate profits (despite lower commodity prices). Do you recall that many economists stated that a lower oil price would be a 'stimulus' for business? Nonsense! Corporate profits are declining, while the oil price has reached the lowest point in decades.

 

Furthermore, the US economy wouldn’t be able to handle higher interest rates. It would lead to a slowdown of the real estate market (mortgages become more expensive) and the automobile sector (which relies on cheap credit). 

You May Have to Pay the Bill

The financial markets are manic-depressive due to the intervention of central banks. This may seem like a far-off problem for you, but it is much closer to home than you think. Central bankers are playing with your financial future. They are orchestrating the biggest monetary experiment in history. And they are not doing so in a laboratory, but with your hard earned money! This makes them reckless gamblers. The medicine supplied by central bankers could be worse than the actual problem they are trying to cure.

So, what exactly am I trying to say?

  • Government indebtedness just keeps on rising. In many countries, pension funds (and therewith the average citizen) own the debt. Without a doubt, part of the debt will have to be written off;
  • You and/or your pension funds invest in very risky corporate bonds to gain a yield. Currently, the amount of bankruptcies is limited due to the expansionary monetary policy, but the amount of bankruptcies will rise in the future;
  • Stock prices are overvalued, and it is very likely that, in a few years, stock prices will be lower than they are today.

In short, a large share of the financial wealth in the Western world will evaporate when the current monetary era (of zero-percent interest rates and monetary stimulus) comes to an end. And it can evaporate due to (a) higher inflation or (b) lower asset prices and write-offs or (c) a combination of both.

The conclusion is simple.

The market is currently held hostage. Central bankers have put the market under the guillotine, but as long as the blade has not fallen yet, the market can still pretend to live happily ever after. But as soon as the central banks lets the rope go, it will be the end of the financial markets. And sooner or later, we’ll have to deal with the consequences. Smart investors can protect themselves by buying gold. While it is possible that the gold price may still decline given the current circumstances, the euro will also lose some of its value. Therefore, it wouldn’t be wise to wait before investing. I believe that, of all commodities, gold will be the first commodity to recover after the longest bear market (multiannual correction) we’ve ever seen. In other words, I believe that the gold/silver and gold/platinum ratios could rise even further.

Only when central bankers will regain some sense of realism, will investing in gold be a bad idea. However, I suspect that this moment will lie far, far, ahead in the future. 

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