It's the final call. One last grand rally as central banks try to stimulate a global economy crippled by debt.
This is, essentially, the playbook for investors for the rest of the year. Already, stocks, commodities and precious metals are launching higher as the dollar weakens and the euro strengthens, based on confidence the Federal Reserve will provide more stimulus and Europe's leaders will cobble together another momentary solution to their intractable crisis.
So join in. This is our last dance with the devil of easy money. Ride the wave higher as policymakers pump liquidity into the financial system, just as they did late last year. They have, after all, fueled an impressive rally in the midst of an impotent recovery.
No, I haven't forgotten where this all leads. Inflation has eased, but it will return. America is barreling toward a "fiscal cliff" in 2013, with deep tax hikes and spending cuts ready to kick in. Greece is moving inexorably toward restoring the drachma and exiting the eurozone, though the pace has slowed with the recent election.
So keep an eye on the exits. Be ready to flee when another rush of food- and fuel-led inflation pinches real wages and consumer confidence, as it did earlier this year. You'll want to stand clear as the final tragedy plays out, when central bank supports end and governments impose real austerity.
But those are worries for another day. Right now, the central banks see a need to act, and they're going to give the economy -- and investors -- one last ride.
Anthony Mirhaydari
Here come the waves
On Wednesday, we learned that the Federal Reserve, worried about a slowdown in the economy, will extend its $400 billion "Operation Twist" initiative -- started in September and set to expire this month -- through the end of the year. In dollars, that's worth an additional $267 billion to be used to push down long-term interest rates.
With inflation expected to run at or below its target, the Fed noted that it is "prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions." This is a marked change from its last policy statement, in which the Fed merely said it was "prepared to adjust its (portfolio) holdings as appropriate."
Essentially, this latest statement means that until we get solid 2%-plus GDP growth, or inflation over 3%, the Fed will continue to find new and innovative ways to force cheap cash into the financial system.
Foreign central banks have already acted.
The People's Bank of China surprised on June 7 with a 0.25% interest rate cut, its first since December 2008. It has also cut the reserve requirement ratio, the amount of money banks are required to hold rather than lend out, three times since November. Officials are saying that with inflation risks falling and deflation risks rising, two more rate cuts and three more reserve requirement ratio cuts are likely before the end of the year.
The Bank of England is moving ahead with two new initiatives to support the British economy -- in addition to the $500 billion worth of quantitative easing the bank has already done and its push to hold short-term interest rates at 0.5%, a record low.
The first will be a five-year offering of liquidity to banks in exchange for lending to the "real economy," such as households and non-financial institutions. The second will be an expansion of collateral acceptance terms, giving banks the ability to pledge a wider range of assets to the Bank of England in exchange for cash loans.
Overall, these actions are very similar to what the European Central Bank did late last year with its two separate three-year lending offerings.
You can expect the ECB to act again soon, likely cutting its short-term policy rate to near zero from 1% now.
Why the dramatic, coordinated response from central bankers? Let's set the scene.
Weather report
Worldwide, economic fundamentals have stalled over the past few months on a combination of European weakness and consequences from crude oil's late winter rise to more than $110 a barrel. Not that the economy was going gangbusters before that.
Growth of the gross domestic product here at home has been below 2% in four of the past five quarters. Economists believe we need growth closer to 3% just to keep the unemployment rate steady.
Obviously, we're not getting that. And the only reason the unemployment rate isn't higher than 8.2% is because of a steady drop in the number of people actively looking for work. Essentially, the numbers aren't capturing the army of long-term unemployed who have simply given up.
Much of Europe is already in a new recession. The list includes the Czech Republic, Spain, Italy, Cyprus, Hungary, The Netherlands, Portugal, Romania, Greece and the United Kingdom. All have seen their quarterly economic growth rates sink into negative territory for two or more quarters. Harsh fiscal austerity measures are at work, with tax increases and spending cuts slicing growth right off the top.
According to data from the Organisation for Economic Co-Operation and Development, Greece is on track to cut government spending by 3.5% of GDP by 2013 even as the economy suffers through its fifth year of recession. In Spain, the drop in spending is nearly 4%. This is cutting things like pensions and unemployment benefits in the maw of depression.
Here at home, a surge of inflation earlier this year took the shine off the confidence earned by the multiple injections of cheap cash conducted by the European Central Bank (those two offerings of three-year loans to banks) and the Federal Reserve ($400 billion worth of "Operation Twist" in September and an expansion of dollar swap lines with other central banks to keep currency flowing smoothly) .
With wages flat, consumers started drawing down their savings to keep up with the rising cost of living, especially at the gas pump. This was never going to be sustainable. Sure enough, retail sales have stalled and, in fact, suffered their first back-to-back monthly declines since 2010. As a result, economists at Barclays Capital and Bank of America Merrill Lynch are tracking second-quarter U.S. GDP growth at sub-2% levels. That would make for the fifth subpar economic performance in six quarters.
Funds mentioned on the next page: Direxion Daily Emerging Markets Bull3x (EDC) and Market Vectors Junior Gold Miners (GDXJ).
Surf advisory
So will the cheap money wave cure what ails us? No it won't, unfortunately.
Remember, policymakers haven't addressed the two main structural problems in the economy (see "Washington vs. the midde class") for some time: demographics, with aging boomers unable to retire, and deleveraging, the need to pay down excessive government and household debt. (See "Are baby boomers to blame?" and "The world's $8 trillion debt hole" for more on these topics.)
There are other problems too, including unfunded pubic entitlements (mainly health care spending), a dilapidated infrastructure, an inefficient educational system and the predatory trade policies of countries such as China.
Until these are addressed, subpar growth will continue despite all the stimulus the bankers can pump in -- and stimulus is becoming increasingly dangerous and inflationary with each iteration.
Since the recession started, central bankers have been busy: Federal Reserve assets have jumped from around 6% of GDP to nearly 20% now, the Bank of England has followed a similar path, the European Central Bank has increased its holdings from around 15% of GDP to nearly 30%, and the Bank of Japan has gone from around 20% of GDP to more than 30% now.
These expansions are fueled by new money that authorities create out of the ether and use to buy assets such as Treasury bonds or mortgages, putting more cash into the system.
After a brief reprieve, they're at it again -- big time. What we may be seeing is one last epic, globally coordinated dose of stimulus before inflation kicks in hard and takes that weapon away from policymakers. Drivers of this structural inflation include an inefficient labor market with persistently high unemployment (represented by an upward shift in what economists call the "Beveridge curve"), a peaking of China's workforce, the rising expense of harvesting commodities from the Earth, and tightening food supplies in a world adopting protein-rich Western diets.
The impact
All of this stimulus will fuel speculation in the global markets -- pushing down the dollar, a safe-haven asset, while boosting riskier investments such as stocks, the euro and commodities. But it will do little to help the real economy and address the deeper, structural problems. That's because, in a balance-sheet recession like the one we have now, the problem is too much debt. Making credit cheaper is like offering a strict vegan a big steak.
Nomura economist Richard Koo notes: "Monetary policy is largely ineffective in this type of recession, because those whose balance sheets are under water are not interested in increasing their borrowings at any interest rate." And even if they were interested, tightened credit standards and stricter regulatory oversight of banks mean many can't take advantage of low rates anyway.
Any real solution would need to address the debt overhang and the lack of demand in the overall economy.
In other writings, I've thrown out two ideas: debt restructuring (especially mortgage debt) for households and a call for a national renewal, with increased public investment financed by ultracheap Treasury rates. With inflation-adjusted Treasury yields in negative territory, investors are essentially begging Uncle Sam to borrow from them to rebuild crumbling infrastructure, increase productivity and boost the economy's potential growth. In fact, they're paying him to do that, courtesy of negative inflation-adjusted interest rates.
The government's unwillingness to boost the economy -- amid calls for immediate budget austerity -- is the ultimate expression of the dynamics of Koo's balance-sheet recession. People aren't maximizing profits, they're minimizing debt. Government is doing the same. (Yes, I know we have a large annual deficit, but that's mostly a result of paying for things like Medicare, unemployment benefits and aircraft carriers, not roads and bridges.) And if everyone tightens at the same time -- governments, households and businesses -- you get the mess we're in now.
I don't think my suggested solutions will be implemented. Not only that, but Washington will likely bungle its response to the fiscal cliff problem as Election Day approaches. It's going to be a mess. So, enjoy the reprieve granted by unelected central bankers and try to cash in when we rally. It's not going to last.
Trading update
For now, I continue to recommend that my readers and newsletter subscribers focus on stocks and exchange-traded funds in areas poised to benefit the most from the liquidity waves: precious metals and related mining stocks, emerging market equities and fast-moving "high beta" plays in the pharmaceutical and biotechnology spaces.
Examples in my Edge Letter Sample Portfolio include the Direxion Daily Emerging Markets Bull 3x (EDC), up 15% since I added it on June 6, and Market Vectors Junior Gold Miners (GDXJ), up 12.5% since late May.
For more conservative investors, the best advice in the months to come is to hang on tight and keep an eye on the exit.
At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in his column in his personal portfolio.
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