2/21/2013 3:15 AM ET|
Gas below $4, or Dow 14,000?
Central banks have fueled the markets with cheap money, but that means inflation -- and rising prices at the pump. The problem? For most of us, the gain isn't worth the pain.
We are in uncharted territory. And no, I'm not talking about a world in which "American Idol" no longer reigns supreme on the airwaves.
I'm talking about the fact that we're in our sixth calendar year of near-0% interest rates, with the Fed engaged in its fifth iteration of direct bond buying with an open-ended commitment to purchase $85 billion a month. I'm talking about the way the Japanese, who tend to lead the way on these things, are now talking about extreme forms of monetary-policy easing, unleashing fears of a global currency war.
I'm talking about easy money reigning supreme everywhere.
What has all this monetary malfeasance bought us? Sure, the Dow Jones Industrial Average ($INDU) 14,000. But we're also looking at shrinking returns from all this economic stimulation as rising prices pinch beleaguered consumers. Policymakers have a choice: They can use cheap money to keep the Dow pushing above 14,000, or they can have gas below $4 a gallon.
You can't have both for long, because cheap money means pricey gasoline, and the economy doesn't run well on premium. Here's why this choice is so critical.
Two roads diverge
The reason the Dow has surged is simple enough. As governments, companies and families try to get out of debt and control spending, policymakers are trying to keep the global economy moving. The effect is a stock market bubble.
It's a bubble not supported by the fundamentals. We've got an unemployment rate tracking back toward 8%, negative growth in the U.S. for the fourth quarter of 2012, new recessions in most of the rich-world economies and soaring government debt levels.
And now, gas prices have surged to new seasonal highs. Gas is pushing over $4 a gallon in much of the country and is already above $5 in California, and seasonality should push prices even higher.
While gas prices are only one of the many economic troubles we face -- add stagnant wages, record food stamp usage, depressed consumer sentiment, higher taxes and more – they're critical. Because, as we saw during similar energy price spikes in 2011 and 2012, the economy suffers when gas costs more than $4 a gallon, and so do stocks.
What central bankers are trying to do
I must admit, the central bankers and the politicians supporting them talk a good game. They say they are concerned about asset bubbles and financial instability. They say that if inflation gets out of control, they'll pull back.
Japan's new prime minister, Shinzo Abe, who set off talk about currency wars by aggressively pushing down the price of the Japanese yen by pressing for a higher inflation target out of the Bank of Japan, said over the weekend that policymakers must be vigilant against asset bubbles.
But he followed by saying the positive effects of monetary policy easing -- cheaper money -- include higher stock prices.
He added that if Japan doesn't get the results it's looking for, other unprecedented options might include the Bank of Japan printing yen and purchasing foreign bonds (such as U.S. Treasury debt) or using the money to directly affect the stock market. Both strategies would be designed to lower the value of the yen.
And if the Bank of Japan, which, like the Federal Reserve, is an institution largely independent of political influence, doesn't play along, Abe suggested it might lose that independence.
This is political meddling in currencies and interest rates on a scale not seen since the U.S. Federal Reserve separated from the Treasury in 1951.
The bad precedents
Historically, when governments have turned to competitive currency devaluation as a last-ditch effort to boost growth and avoid tax hikes and spending cuts, the results haven't been pretty. Weimar Germany's efforts to inflate away war debts and rebuild after World War I come to mind. The abandonment of the gold standard in the 1930s, to cite another example, was followed by currency devaluations, protective tariffs, trade wars and a deepening of the Great Depression.
A few officials at the Fed and European Central Bank pay heed to history's warnings -- or at least say they do. ECB President Mario Draghi said earlier this week that he is aware of the challenges presented by a protracted period of near 0% interest rates, including the negative impact on savers and the risk of bubbles.
And I think a brave speech by Cleveland Fed President Sandra Pianalto last week underlines this point. She highlighted what's become patently obvious for those who are skeptical of optimism surrounding Dow 14,000: Aggressive central bank stimulus, like everything else in the realm of economics, is subject to the law of diminishing returns.
In plain English, the risks of more money printing are beginning to outweigh the benefits.
A look at the risks
Pianalto outlined four distinct risks that are rising:
- Credit risk. The danger here is that with interest rates so low, banks and other institutions could "reach for yield," using cheap money from the Fed to take on more dangerous investments as they try to boost their returns. The Fed's use of low interest rates in 2003 to 2005 resulted in this, magnifying the housing bubble as banks, and then investors, gobbled up higher-risk mortgages offering higher yields. This could fall down around them if the economy weakens and defaults increase.
- Interest-rate risk. This means simply that with rates so low, people aren't prepared for a surprise rise in interest rates -- which would send bond prices down hard.
- Risk of market turmoil. The big fear here is that financial markets could become distorted because of the Fed's large and growing stake in the Treasury and mortgage bond markets as it buys up bonds to push money into the economy. The risk rises as central banks around the world use similar strategies.
- Inflation risk. Finally, all of this cheap money could result in a loss of control of inflation. Gas prices are surging already, as shown in the chart below. Chinese monetary authorities earlier this week restarted a program to drain money from China's financial system for the first time in seven months -- ostensibly to address inflation worries.
No doubt higher gas prices, combined with higher taxes, have weakened consumers to the point that Wal-Mart Stores (WMT) executives called its month-to-date February sales a "disaster" in emails obtained by Bloomberg News last week. Foreign consumers are under pressure, too, with European car sales posting their worst January drop on record, falling nearly 9% from the same period in 2012.
We're already seeing these risks play out. It's starting with inflation, which I believe will damage the economy to the point that defaults rise and market turmoil increases.
The scary thing is what happens if this continues. Pianalto suggests the Fed should slowly reduce its bond purchases to reduce these risks as the economy strengthens. But what if it's too late? Already, 45% of the countries in the Organisation for Economic Co-operation and Development are in a technical recession, defined as two consecutive quarters of negative growth of gross domestic product. What will the Fed do if we follow them into a new downturn?
With monetary policy already at full throttle and potentially contributing to a downturn, where do the Fed, other central bankers and political allies go from here?
Should they pray harder at the altar of cheap money, or try something else? My hope is they will back off and look at our structural problems: inefficient and overpriced health care, substandard education, poor infrastructure and nervous executives withholding needed investments.
Problem: It's not working anymore
The main beneficiaries of all the cheap money sloshing around have been financial markets, banks and politicians. According to Bank of America Merrill Lynch, global financial stress has fallen to a post-recession low over the past few weeks as stocks have posted their best, low-volatility rally in decades. Financial stocks like Goldman Sachs (GS) have been marching higher on a perfect, unblemished 45-degree uptrend.
Yes, average folks have seen some benefit, too. Americans' saw their wealth in 401k and other investments grow as the Standard and Poor's 500 Index ($INX) rose to 3.8% over its September 2012 high. That's good but not great.
And definitely not worth the problems I believe this is causing.
By keeping Treasury bond yields in negative inflation-adjusted territory, the Fed has reduced borrowing costs. That has eased the pressure on Washington to address its unsustainable fiscal path -- just as low rates have allowed Tokyo to gorge on debt, accumulating a government-debt-to-GDP ratio approaching 230%, which is more than twice the rich-world average.
And as the risks are rising, the positive wealth effects are diminishing, according to research by Credit Suisse economists. What they found is that central bankers and their allies are taking more risk, with potentially disastrous consequences for the global financial system, in exchange for less and less wealth benefit.
They also found that since the 2007-2008 financial crisis, the positive economic effects of higher prices for assets like stocks and houses have shrunk. Sensitivity to housing wealth -- or how likely it is that an increase in housing wealth will encourage new consumer spending -- has fallen roughly 35%, while sensitivity to stock market wealth has fallen 27%.
The result helps explain why consumer spending growth has been so modest in this recovery even though the S&P 500 is up 139% from its 2009 low.
The drag is likely being driven by a few things. One is that nearly one-third of mortgages are still "underwater" -- so any price gains now will be viewed only as cutting losses. It's not like back in the 2006 go-go days, when people used the equity in their homes as ATMs.
As for stocks, the S&P 500 has merely returned to its 2007 highs -- levels first reached back in 2000. That doesn't feel like a gain.
Plus, the quirks of human emotion doomed the Fed's efforts from the start. People are much more sensitive to falling home prices and falling stock prices than they are to gains. In other words, declines in wealth have a bigger impact on consumption than increases do. Plus, the wounds from recent losses are still raw.
On the flip side, the work of James Hamilton, an economics professor at the University of California, San Diego, suggests that people are more sensitive to oil prices on the way up than on the way down. And we all know that gas stations raise prices a lot faster than they lower them.
In short, gas going over $4 hurts more than Dow 14,000 feels good.
The path not taken
So after they quelled the panic in 2008 and 2009, central bankers should've stepped back, swallowed their pride, and admitted they had done all they could. We don't have a lack of liquidity. Taking the U.S. monetary base, the most basic measure of the money supply, from $800 billion before the financial crisis to more than $3 trillion now was overkill.
If you take one thing away from this, Federal Reserve historian and Carnegie Mellon economist Allan Meltzer suggests you consider the chart below. It compares consumer sentiment (the blue line) to the massive accumulation of the Fed's cheap money in bank vaults in the form of excess reserves (red line). Before all this started, the banks didn't have a need for extra money sitting idle. Thus, excess reserves were consistently low.
After the past few years, as the Fed and other central banks pump and pump, banks are essentially drowning in the money. They can't find enough high-quality loan opportunities, and loan demand has been tepid, so they are essentially shoving the money under their mattresses, so to speak, by increasing their excess reserves.
And yet, all this enthusiastic money printing and its effect on the stock market have barely budged consumer sentiment. And consumer spending fuels our economy.
Based on those Wal-Mart emails, and considering the other head winds we face in the weeks to come, I expect the blue line to fall away again as consumers retrench and cut spending.
All because Federal Reserve Chairman Ben Bernanke and the handful of souls who control the Fed (and their foreign counterparts) have decided that Dow 14,000 is more important than keeping gas below $4 a gallon.
But we drivers disagree
The research suggests the American people believe otherwise. Just as they did when gas prices spiked in 2011 and 2012, stocks will soon start losing ground as they weigh the risk of a new global recession. A downturn that may well be spiked by this emerging truth: We could be looking at the third cheap-money-fueled bubble in 13 years.
I can't say when this will arrive. Stocks have already kept going for far longer than I believed possible. But what I do know is that, given all the exuberance I'm hearing and seeing, healthy skepticism is warranted. Next time you're filling your tank, ask yourself: Does this mean 2013 gets better, or worse, from here?
If doubts creep in as your fuel bill climbs, consider booking some stock profits and shifting your asset allocation toward safe havens like Treasury bonds, gold, and silver -- all of which are trading at very attractive levels after months in the doldrums.
Because, in the end, if wholesale gasoline at $3.60 in 2008 was enough to pop the housing bubble and send us spiraling into the worst financial crisis in generations, another spike right now, in our weakened state, is sure to cause at least a few backfires if not a blown head gasket.
At the time of publication, Anthony Mirhaydari did not own or control shares of any company mentioned in this column in his personal portfolio.
Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at firstname.lastname@example.org and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.
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All you needed to write was, "We're Screwed."
Supposedly, oil at $90 and above drags on the economy or $118 for Brent. Seemingly, the optimum for W TX is around $80. That being the price at which shale plays are booming and generating cash flow to fund drilling without taking on a lot of debt without dragging down the economy.. Drilling starts to decline at or below $70 in shale plays.
Although the focus is on gas prices because we see it on every corner and buy it frequently, by products, rubber, plastics, synthetics, glass, paint, cosmetics, chemicals drugs etc all experience price increases as petroleum derivatives. Together with gasoline, diesel, kerosene, all these combine to have a significant effect, in a negative way.
It will be interesting to see leading economic indicators if high prices for petroleum products persist for a quarter or longer. I am sure it will be Bushs fault. Interesting the mainstream media is giving Obama a pass on this when they just howled about Bush and Cheney when gas prices went up.
Time has come now and the Fed is in the Red, time to recoup and the market ain't gonna like it.
If you don't believe the seventies are back ,take a look and see what happens when you have cheap money too long, history unfortunately has a tendency to repeat itself. Not enough seem to learn from it.
Better get cash heavy or be a good rider on the way down. The time is nigh.
Instead of gun control laws how about putting some laws on these "players" thats flushing the 3/4 of the populations economy down the crapper while they pad they're retirement. Their philosophy is screw everyone and everything and take as much as you can.
OBAMA AND DEMOCRATS AND THEIR FING GREEN AGENDA HAS CAUSED THE HIGH ENERGY AND FOOD PRICES AND IF YOU
BIG DOPE LIBERAL OBAMANITES KEEP THINKING IT'S BIG OIL YOU ARE FING DOPES! HE PROMISED THIS 'CHANGE' AND HE'S
MAKING SURE ENERGY AND FOOD PRICES SKYROCKET TO PUSH HIS FAILED GREEN AGENDA! THAT'S FACT! OBAMACARE
IS ALREADY BROKE! THEY AREN'T TAKING APPLICATIONS FOR THOSE WITH NO INSURANCE OR PRE EXISTING CONDITIONS
CAUSE THE PROGRAM IS BROKE!!!! AND IT'S NOT EVEN UP AND RUNNING YET! YEAH OBAMACARE WILL BE GREAT! YEAH
OBAMA AND LEFT WING LIBERALS HAVE ALL THE ANSWERS! RAISE TAXES KEEP SPENDNING MONEY YOU DON'T HAVE GIVE
MORE FREEBIES TO LAZY ASSES AND ILLEGALS WHO WANT TO LIVE FREE ON THE HARD WORKING MIDDLE CLASS! YEAH
THAT'S A REAL GREAT PLAN! SOCIALISM HAS FAILED EVERYWHERE AND IT'S NOW TAKING DOWN AMERICA!
Bennie B is Busting his B^lls because yer' Boys in Washington ain't got a clue.
I drive 125 miles a day, roundly trippin' to the shop and back, and I'm paying $4.35 per Gal. as of this A.M. (@ ~35 mpg)
I'm outta equities; got a good part of the run back up, but this is crazy!
My wife and I are running savings for parents in our Roths; they were gettin' squeezed bad. I don't have to tell conservative savers what's up with ZIRP. It hurts!
Bennie's gotta roll out of the throttle here. Hold ZIRP a bit longer, but end the funny money.
Seems USA is going to financial h3ll either way: debt or (non-core; ha ha, my ^$$) inflation...
All the best.
Anyone that believes refiners will push capacity to the max in the name of providing cheap gas to consumers simply doesnt understand their business. I saw a news pundit, Charles gibson, try to get a refinery manager concede that for the good of the country he should push daily production to the point there woudnt be enough profit to do necessary maintainence but Gibson ignored his point because his agenda was to vilify theindustry as evil predators.
I grew up in the oil industy and most of my family was involved as service providers to the industry and worked in it all my adult life. While I dont know everything about it, I know a lot more than most. Media and the gas pump shape public perception which is mostly hype, lies or mis information. To imply as politicians often do and media, that drilling a well in 5000 ft of water is the same as an onshore well is ludicrous or that the required seismic and geology analysis required prior to seecting a drilling location is absurd.
Ignorance is the best friend of those trying to conjure up elaborate conspirarcies. Believe me, if oil companies could collude to gouge and manipulate prices, while not entirely innoncent , nat gas would have NEVER dropped below $7-$8 range.
Currently gasoline prices are about what they were in the 1930s adjusted for inflation-a miracle.
In europe it can be over $9/gal
"So what else is new" screams the crowd. Eventually we will get a period of inflation that will look the last one look like nothing. We will look back on $4 gas with nostalgia, just as I look back at the $0.30 per gallon price of my youth. All of us who scrimped and saved are being taken for fools, while you profligate spenders who are running up big debts will be able to pay them off with inflated bucks. The only consolation I have, is that I know how to get by on very little, and you don't.
In a just universe, Bernanke and his ilk would be tarred and feathered and sent to live under a bridge. In this universe, he will spend his declining years traveling about and giving lectures for big money.
Old Chinese Proverb: He who cannot live on a little, is forever a slave.
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