QUESTION: Hi Martin,
I am a long time reader of your blog and a big fan of the tools that you have developed for investors. Thanks for all that you do and I wanted to reach out and ask about your opinion of the thesis that ——-  outlines for the IMF implementing SDRs as world money during the next downturn? This type of scenario seems to make sense considering the current balance sheets of central banks and the current lack of demand for EU debt.
Nicky

ANSWER: I was in a discussion about that back in the 1980s (see the response from the White House rejecting SDRs). That was a day before the IMF became so corrupt. That was rejected countless times. The entire problem still stems from the cross-currency borrowing by nations. Even if the emerging markets borrowed in SDRs instead of US dollars, it really would not alter the world money system nor prevent a crash at the hand of a Sovereign Debt Crisis. What it would do is simply relieve the dollar marginally. The problem would emerge on how do you manage such a system. As long as governments issue debt, then once they issue that debt in ANY currency other than their own, RISK enters the game.

Even if we switched the reserve currency from the dollar to the SDR, the ONLY way to enforce it would be to restrict currency. For example, I could issue a bond in Japanese yen for years and sell it to you in Canada without it being approved by the Japanese Ministry of Finance. China still has currency controls where its people have to ask permission to send money out of the country. The only way to enforce an EXCLUSIVE SDR reserve currency would be for all debt to be denominated in SDRs. However, then every country would still have the risk of their currency fluctuating against the SDR.

The only way to practically reduce the risk is to prohibit governments from issuing debt in any currency but their own. That introduces yet another problem. Many pensions bought emerging market debt to get the higher yield, but they did so because they issued that debt in dollars to attract foreign buyers. As the dollar rises and rates rise, the value of emerging market debt declines and the risk of default rises as the US dollar rallies.

So you see, if we are really talking about revising the world monetary system, it is going to be far more complicated than simply replacing the dollar with SDR, gold, or clamshells as they issued during currency crisis of 1933.

The interesting fact is that the majority of fund managers today have reduced their equity allocation to their lowest level since November 2016 according to Reuters. The reason for this is their focus of trade and their assumption that the Great Depression was caused by a PROTECTIONISM. According to yet a recent monthly report by Bank of America Merrill Lynch (BAML) where they conducted a survey of fund managers, the majority, some 60%, now fear a trade war. Clearly, the biggest concern out there is a trade war poses the greatest risk to the stock market. Another 19% fear excessively higher interest rates by the Federal Reserve. These two perceptions are the dominant reason we see consolidation.

However, our computer forecasted the consolidation for 2018 at the start of the year. This has sparked a number of emails asking how was it possible for the computer to forecast consolidation before the fundamentals? What I have noticed over the years in working with this model has been that trends will last ONLY for a specific amount of time. Like being cold all winter and suddenly the sun shines with Spring, we call it “Spring Fever” and everyone runs out at starts doing things when the weather changes. We respond similarly to cycles in markets. They will last only for so long and we get tired. It is NOT that specific fundamental that comes into play and causes the consolidation. Instead, the market trend shifts and people begin to look for explanations to explain it.

I have shown charts that demonstrate that rising interest rates are a market myth. The stock market has risen with higher rates and when the market crashes, demand-side economic means they lower rates trying to “stimulate”  demand under Keynesianism which has never worked. The ECB has kept rates so low for nearly 10 years and they have destroyed the European bond market as reduced Europe to an economy that is ranked even below China. And as far a trade is concerned, I have shown that Trade Tariffs were a response to the currency and the collapse in agriculture due to the invention of tractors and electricity during the early 20th century. Like the internet today is displacing jobs, electricity reduced the jobs in the manufacture and the combustion engine expanded to tractors reducing employment in agriculture from 40% of the civil workforce to 3% by 1980.

Consequently, the computer is forecasting the trend. People try to explain the change in trend and fit the fundamentals to try to explain what took place. I have written before that the book I had to read in school on the Great Crash by Gailbraith, never mention the Sovereign debt crisis of 1931 because he was a socialist who wanted to blame corporations EXCLUSIVELY. Others actually claimed that Hoover embraced the rise of Nazis in Germany because he wanted to trade and ignored Russia. Hitler came to power in 1933 and Hoover lost the election in 1932. They will even alter timelines to support a predetermined conclusion.

The trend changes due to cycles for we can only endure a trend for so long before we just want a change as we do in politics. The cycles are not altered by the fundamentals. Commentators fit the fundamentals to explain the cycle. The sharp decline in asset allocation to equities has not been met with a collapse in market prices. This is a very interesting development for the majority NEVER manages to sell the high.

QUESTION: Mr. Armstrong; It appears that Putin also follows your model. He has been selling all debt significantly for it seems he is listening to you forecast that interest rates will rise sharply so get out of government bonds. Do you see his selling because of rate or politics as some are trying to say?

Thank you

KE

ANSWER: Putin is selling off debt very rapidly because of interest rates. The political bashing of Russia has been going on since the 2016 presidential election. It has contributed somewhat to the decision to sell, but honestly, if it were only political, then they would have sold their holdings by the end of 2016. The spin will be political, but the trend toward higher rates is the real driving force. Many countries/corporate/institutions that our clients, we have been advising to shorten maturity.

The crisis is building in debt rapidly. Even the ECB came out and said it would stop its bond-buying program and only a fool would expect rates to stay the same. I seriously doubt, based on my sources, that the ECB can stop buying bonds without a major global crisis. Draghi will keep buying until he is out the door come October 2019. I seriously question if Draghi will be able to hold it together beyond the First Quarter 2019.

Russia sold nearly all of its US Treasury holdings in May. It was an impressive sale reducing their holdings to almost zero in just two months. According to our sources, the Russian government reduced its US bond holdings from $ 96 billion to $ 48.7 billion during April and then down to $14.9 billion by the end of May. At the end of 2017, Russian holding of US debt stood at about $102.2 billion. That was not actually huge. They were in the top 33 countries holding US debt.  They are certainly no longer in that list at all. The Russian sales pushed the yield slightly higher to 3.11%.

QUESTION:  Hi Marty,
I continue to read your blog and if I understand correctly, interest rates are going up.
My question is, can one profit from higher interest rates such as buying CD or bank stocks like Wells Fargo?

ANSWER: The one thing you do not want to do is buy CD with maturity. As rates go higher, you will be locked in and unable to take advantage of the rising rates. Bank stocks will not benefit from higher rates in general. So that is not a valid reason to buy bank stocks. The safest thing would be to buy US TBills or agency paper no more out than 90 days and keep the cash rolling in that area until we reach a point when the rates are peaking. Toward the end, the yield curve will invert so that means the short-term rates will exceed long-term when confidence is shaken.

In an upward cycle for interest rates, never lock & load – always stay nimble.

QUESTION: Mr. Armstrong; Do you have any comment on the latest excuse for the decline in gold is because Trump is forcing it down so he can buy it up and move to gold-backed bonds like Nevada? This is the latest coming from the fringe which just seems so unrealistic any more. I am not sure why these people ignore the past.

Thank you;

PF

ANSWER: The entire issue at its core is this endless desire to eliminate the business cycle. They pitch that ONLY gold is money and if we return to a gold standard that every evil will be cured. They believe that money must be “tangible” and as such, they fail completely to comprehend the true nature of the economy. If ONLY gold was money, then how did Germany, Japan, and China rise to the economic giants without gold and Russia has floundered ever since 1991 when they had the gold, oil, and diamonds?

Kondratieff’s long-wave study observed that the rise and fall of the business cycle existed during the 19th & 20th centuries when the world was on a gold standard. The existence of a gold standard FAILED to eliminate the business cycle and it proved that a “tangible” based monetary system did not make money more valuable than a paper money system. Ironically, ever since 1776, we are still arguing over what is money? Should it be any commodity, paper, some fixed-exchange rate, or is the real wealth of a nation its people and their total capacity to produce? Is this why skilled labor forces and education raise the standard of living of a country than merely farming to grow food to sustain yourself?

Julius Caesar said: Divide and Conquer. If the people come together and form interconnected economic bonds, the economy expands because the synergy of everyone collectively is greater than the individual sum of the parts. Changing the monetary system to one back by gold has NEVER eliminated the business cycle. So this idea that a gold-backed bond will somehow retain its value constantly is like believing in Santa Claus of the promises made by every politician when running for office.

The true Wealth of a Nation was observed and expressed by Adam Smith in 1776 and nobody has been able to demonstrate anything to the contrary. “Money” is by no means some tangible object or a commodity regardless if it has been gold, paper, cattle, slaves, or seashells. The true WEALTH OF A NATION is its people! China, Germany, and Japan lacked the natural resources but their people were its wealth and they produced manufactured goods which they sold to the world and were paid for in return. Russia had the natural resources but it moved from communism to an oligarchy. You cannot open a restaurant in Moscow and compete for you will be dead. A country can have tremendous natural resources like Russia, but unless its people are free to develop the economy in their own self-interest, they will never rise to the top ten list of nations. All the gold, oil, and diamonds of Russia did not propell it to the number one economy. There are plenty of third world nations with natural resources that are being mined yet they remain as third world nations because their people are not educated and their is no domestic economic synergy among the people.

Spain was the classic example. They discovered all this gold and silver in South America. They exploited it, brought it back to Europe, but NEVER developed their own economy. They spend the money lavishly. Unloading the ships was a job for important labor because it was beneath them. The gold joke was that as Spain got rich, everyone else got richer. They used Frenchmen to unload the ships overall.

Spain could not wait to spend its money coming in on the next fleet. When fleets sank in hurricanes, they could not pay their debts. Spain became a serial defaulter moving from the richest nation in Europe to a 3rd world status. They defaulted in 1557, 1570, 1575, 1596, 1607, and 1647.

So this latest excuse is just absurd. They are unwilling to look at their old theories so they spin wild tales to justify being wrong. Trump is by no means forcing metals to decline so the US government can buy it and issue gold-backed bonds like Nevada. Assemblyman Jim Marchant announced the Nevada Gold and Silver Enabling Act on July 2, 2018. He claimed that gold-backed bonds would avert financial armageddon, retire debt, ensure all creditors are paid in full in nominal terms and begin the process of gold circulation. Here is the argument they use:

“The Federal Reserve has a policy of two percent per annum debasement of the US dollar. Other central banks around the world have similar targets, for example, both the Bank of England and the European Central Bank set their targets at two percent. Creditors should prefer gold assets over dollar-, pound, and euro-denominated assets because gold is not subject to this debasement. The 10-year Treasury yields 2.9% as I write this. Assuming that the Fed hits its target without overshooting it, then the central bank is robbing the investor of most of their return.”

The entire argument assumes that somehow a gold-backed bond will eliminate inflation. Even if we assumed that was correct, you can see what this type of policy would create by creating a money supply that was fixed – it is called deflation. This is what has driven unemployment among the youth in Southern Europe to 60%. Germany has been focused on eliminating inflation because of their experience during the 1920s. This policy of austerity cripples economic growth and will only lead to revolution and civil unrest.

Gold-backed debt has existed for hundreds of years. There was still the business cycle, periods of inflation and deflation, as well as revolutions. This theory that someone a gold-backed bond will eliminate the business cycle is actually the same goal of Karl Marx and John Maynard Keynes. Marx proposed Communism and the elimination of all private tangible wealth would produce the perfect world. That failed. Keynes argued that the government could manage the economy by focusing on demand and raise or lower interest rates to also eliminate the business cycle. That failed and even Paul Volcker came out and called it the Rediscovery of the Business Cycle back in 1978.

Even Keynes was honest enough to comment before he died that he had been wrong. Smith’s observation of how the economy works remains the only answer. What all of these theories have in common is the assumption that to create money with a tangible value and eliminate the business cycle, the answer lies in manipulating DEMAND side economics rather than the SUPPLY side. In other words, we eliminate all tangible assets or we manipulate interest rates and the supply of money in hopes of influencing the DEMAND of the people.

Gold-backed bonds will no more eliminate the business cycle than any other attempt to date. Not even Larry Summer’s NEGATIVE INTEREST rate policy has been successful in stimulating the economy by compelling people to spend rather than save. His theory has merely created the next crisis as pension funds, who needed 8% interest to remain solvent, cannot function with historically low rates of interest and will default bringing socialism into crisis.

You must always ask: What is the end goal?  It is always the same – ELIMINATE THE BUSINESS CYCLE.

The the first debt bankruptcy of a major corporation in China has now taken place here on schedule in 2018. This first bankruptcy of a major corporation was due to over-indebtedness which occurred in the current year. The South China Morning Post reported that coal company Wintime Energy has been forced to cease operations after failing to repay a central government bond. The company had recently accumulated a debt of 72.2 billion yuan (about US$10.8 billion). The company’s debt had quadrupled over the past five years.

This failure is attributed to difficulties at Wintime Energy with respect to a change in corporate governance strategy that was announced by the central government in Beijing back in 2016. Since then, the authorities have been trying to prevent excessive borrowing by the corporations fearing a debt crisis was building. As a direct result, the previous excessing lending in the shadow banking market came to a virtual standstill. Previously, the government had actively encouraged companies to raise fresh capital by issuing corporate bonds. The Chinese bond market doubled in size within a few years going into 2016. Today, there is about $12 trillion US dollars outstanding, which makes Chinese corporate debt the third largest bond market in the world. This certainly casts a cloud over all the forecasts that have claimed the death of the dollar and the rise of the yuan.

With the encouragement of the government to sure-up capital, a massive borrowing process became increasingly out of control without the management skills necessary to understand that there is such a thing as a business cycle. Additionally, the buyers of corporate debt lacked information and experience with debt. There was precious little credit analysis experience in China, which is still maturing, and local rating agencies also did not have the competence to understand debt and currency fluctuations particularly when debt is issued in dollars. Consequently, many fear that there was virtually no due diligence until the government allowed bankruptcy for the first time in 2014 and many see this as a parallel for the crisis in bad debts held by Italian banks that also lacked proper analysis of their books.

China’s economic growth has been exploding led by corporate expansion and debt accumulation. This is the concern over the next two years and how the economic engine of China can experience its first real recession moving into the bottom of the Economic Confidence Model in 2020. The Central Bank has been injecting liquidity into the markets on a large scale. The government is thereby injecting cash, but this will still need to be repaid in one year at about 3.3% interest rate. The Central Bank is dealing with the issue directly unlike that central banks in the West who indirectly attempted the stimulus through banks just hoping they would lend out the funds, which they did not. Medium-term notes were first offered directly by the Central Bank to the country’s companies and commercial banks back in 2014. The collateral used is securities pledged by the borrowers. I have pointed out that this is the PROPER way to manage a central bank. The Federal Reserve was originally set up to “stimulate” through buying corporate paper DIRECTLY. That structure was altered by Congress whereby the Fed was directed to buy US government debt exclusively. Therefore, the Fed bought US government bonds hoping the money would find its way into the economy. That effort failed. The Central Bank of China is actually managing the crisis in the proper manner and this will not prevent the downturn, but it will moderate the damage