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Apples and Inflation

Tue, Jun 30 2009, 13:24 GMT
by Michael Pento

Last week on CNBC’s “The Kudlow Report” there was a thrilling debate over inflation between Alan Blinder and Arthur Laffer. Mr. Laffer (former member of Reagan’s Economic Policy Advisory Board) encapsulated his position that we need to fear the return of inflation by simply stating that “…if you have a huge increase the supply of apples, the price of apples falls.” While Mr. Blinder (former Vice Chairman of the Board of Governors of the Federal Reserve System) responded by stating, “If people suddenly want to hoard apples and the apple suppliers provide a lot of apples, you’re not going to have inflation of apple prices.”

The pertinent analogy being; if the monetary base grows, the supply of money increases and its value falls (inflationary). While the other contention being, if banks don’t want to lend money there would merely be a pile up of excess reserves and the increased supply of bank credit would not lead to an increase in money circulating within the economy (non inflationary).

Now I would like to weigh in on this debate. Whenever there is a well promulgated increase in the supply of a commodity (especially currency) it does not have to pervade throughout the economy in order to have its value attenuated. To prove this let’s look at what happened to the level of the Monetary base and its affect on the price of gold and the US dollar.

At the end of August 2008, the monetary base began its record-setting expansion from the $842 billion level to its $1.8 trillion peak in May of 2009. In fact, by January 2009 the base had already made the majority of its move, as it exploded to $1.7 trillion. How did the price of gold react to this monetary expansion?

The dollar price of gold increased from just under $840 an ounce to $980 from the end of August 2008 thru the end of May 2009 time frame. That means gold rose over 16% while the US dollar declined just over 14% against the yellow metal.

Mr. Blinder may claim that it is merely a coincidence that gold moved up sharply when the monetary base expanded, because the money was not loaned into the economy. But I will explain why the moves are directly correlated.

An increase in the monetary base is much the same as a huge discovery in a commodity. Let’s say there was a major oil discovery in the Gulf of Mexico that was very easily accessible and doubled the existing proven reserves. No one would argue that the price of oil would not react negatively. The price would drop instantly upon the announcement as traders and investors began to factor in the imminent increased supply. The majority of the price decline may not occur until all the oil was drilled and available for consumption. But as long as there was a high probability that the discovered oil would soon hit the market, the price should drop.

It’s the same with a buildup in the monetary base. The increased bank reserves account for a latent huge increase in monetary velocity and inflation. Although a huge increase in inflation levels should not occur until the base money was loaned into existence and pervaded through the economy, the value of the dollar would drop in anticipation of that fact. The Fed has now availed banks of a doubling in high powered money and until it is removed the potential for massive inflation exists. In light of that fact, investors have taken down the value of the dollar against gold and most hard assets.

To make matters worse, unlike commodities all fiat currencies have virtually zero intrinsic value, so their worth rests completely on the scarcity of its supply. Therefore a doubling in M2 money supply should lower its purchasing power by 50%, whereas a doubling in apple supplies would not cut their price by half.

Not only was Mr. Blinder wrong about inflation but he was also incorrect when he conveyed complete confidence in Ben Bernanke’s ability to remove the excess liquidity before inflation becomes a problem. Mr. Laffer and I argue that it would be politically and economically devastating for the Fed to dump $800 billion of Treasuries in addition to the $3.25 trillion they must sell in fiscal 2009. And, speaking for myself, I believe the Fed needs to worry less about politics and more about providing long term support for our currency.

Published on Mon, Jun 22 2009, 16:36 GMT

Plastic Green Shoots

Tue, Jun 16 2009, 14:23 GMT
by Michael Pento

Delta Global Advisors, Inc.

Most investors and pundits are celebrating the green shoots of economic stabilization and the belief that there will be a “V” shaped recovery in GDP growth. I believe, however, that what we are experiencing is just an artificially derived respite and that we have only entered the eye of our debt induced hurricane.

There should be no mistaking what was the progenitor for near collapse of the economy late last year. It was clearly the overleveraged consumer and financial sectors, which was the direct result of artificially induced low interest rates and excess money creation. If one can understand and accept that premise, then the idea that a recovery achieved by zero percent interest rates and a doubling of the monetary base becomes an untenable one. Add in a dose of anti-capitalist programs (cap-and-trade), government takeovers (GSEs, Detroit, Banks, Healthcare) and tax increases; what you arrive at is something far from an economic recovery.

Now I’m not saying that things don’t appear better off than they were just six months ago. There are indeed many green shoots. First time jobless claims and Non-Farm Payroll numbers are less bad (our new measure of achievement in this economy), consumer confidence has ticked up and many of the regional manufacturing surveys have shown signs of improvement. But the impetus for these small victories is based on the fact that we have temporarily bailed out the economy by taking down the costs of borrowing across the board.

In the summer of 2006, Helicopter Ben finished his three quarter point rate increases on the Federal Funds target rate and stopped at 5.25%. His belief was that it was enough to vanquish the serious problem of inflation which had risen by 4.3% from a year earlier. However, in July 2007, commodity prices were still surging and year over year inflation had increased by 5.6%. Meanwhile, the debt of our nation had grown to record levels. Household debt as a percentage of GDP reached an all time high of 97% while total debt reached $30 trillion. The trenchant need to deleverage shut down credit markets and by the fall of 2008 had caused economic chaos across the globe.

The Fed chairman then realized debt levels could not sustain higher borrowing costs and quickly turned in his wings for fruit. The new and improved Banana Ben Bernanke subsequently took the overnight bank lending rate to zero percent in short order. In addition to manipulating rates, he has expanded the Fed’s balance sheet to over $2 trillion by purchasing Mortgage Backed Securities and treasuries, all the while instituting a myriad of lending programs designed to keep borrowing costs low.

Can it really be any wonder why the economy has shown signs of stabilization? Significantly bringing down debt service payments has caused a brief period of relief. But while the symptoms of distress have been removed, the real issue remains unresolved. The facts are that we have not deleveraged as a country at all. In fact, as a direct result of government’s actions we have exacerbated the problem.

The resulting interruption of free market impulses to pare down debt has caused household, corporate and public debt to reach $33.9 trillion as of April 2009—an all time record high. I do not know how long this ersatz recovery in the economy will last. What I do know is that even though there is diminished demand for money on the part of the private sector, the necessity of the government to issue 3.6 times the amount of debt this year as compared to fiscal 2008 will cause the Fed to monetize a good portion of that debt. And with the Fed Funds target rate remaining at 0-25bps since December 2008, the chances of producing a rate of inflation that meets or exceeds that which we experienced in 2007 are highly probable.

My belief is that the green shoots will be killed off by inflation and/or higher interest rates. The fact is that interest rates must increase dramatically, which will either put us in the same situation as the summer of 2007 thru the spring of 2009, or the inflation tactic will be sought to lower the value of debt.

The former scenario will lead to a deflationary recession/depression which will be favorable to cash and the dollar. The latter scenario—which the Fed and Administration have shown conclusively to favor--will send gold above $1,500 an ounce and oil to $200 per barrel just for starters. It will also mean the end of the US dollar as the world’s reserve currency. In either case, the resulting economic shock will be severe and the difference it will make to your investment strategy is impossible to overstate.

Published on Tue, Jun 16 2009, 14:23 GMT

The Consequences Have Started to Arrive

Tue, Jun 9 2009, 13:43 GMT
by Michael Pento

Delta Global Advisors, Inc.

The consequences of adopting a weak dollar and inflationary monetary policy to bail out the economy have begun to manifest themselves, although the real effects of the government’s $12.8 trillion dollar recovery plan have only just started to show up. Investors should not be surprised to learn that the commitments, guarantees, and prodigal spending of the past two Administrations have come with harrowing consequences. Surprising or not, these painful consequences are just beginning to appear and are rather insidious in nature.

But the regular readers of my commentaries had been warned that massive money printing and government incursions into the free market would spark higher inflation and a falling dollar. To illustrate the point, the price of oil has increased 53% this year while gasoline has increased 26% in price since May 1st. That move alone should start to ring the alarm bells for everyone. But commodity prices have risen across the board sending the CRB Index up 14% in May alone. In addition, copper is up over 60% this year while cotton is up 18% in 2009 and the US dollar has also lost about 10% of its value since early March. So much for the deflation argument!

The cause of steep rises in basic materials and energy is not so much a U.S. demand story. Asia seems to be faring better; (their economy expanded at a 6.1% annual rate in Q1, the slowest rate in 10 years) while our economy has shed over 6 million jobs since the recession began and GDP contracted at a 5.7% annual rate in the first quarter. But the real cause in the rise of commodities can be found in the weakness of the US dollar.

Even with all of this in mind, the biggest negative effect thus far from the Administration’s profligacy has shown up in surging bond yields. After hitting a secular low of 2.5% on the 10 year note, yields jumped to 3.9%! Meanwhile, mortgage rates leapt from a low of 4.85% to 5.45% last week, following the move in Treasuries.

Therein lays the problem. The progenitor of this crisis was a collapse in real estate prices and it has shown only a few signs of stabilization in sales, but is still far from a marked recovery in prices. In fact, last month’s report on existing home sales showed a drop of 15.4% Y.O.Y. Both mortgage delinquencies and foreclosures reached record levels in Q1 2009 while the months’ supply of existing homes actually climbed to 10.2 from 9.6. So while mortgage rates are on the rise, housing fundamentals continue to exhibit weakness.

Those soaring bond yields and mortgage rates will wreak havoc on our debt-imbued economy. Already we saw a report by the Mortgage Bankers Association showing a drop of 16% in the Refinance and Purchase Index for the week ending May 29th. For an economy that has a total debt to GDP ratio of 370%, we can also expect dire repercussions in everything from credit card loans to municipal bonds.

This is why Mr. Bernanke’s next move on quantitative easing is so critical. Wednesday’s auction of $19 billion in 10 year notes and Thursday’s auction of $11 billion in 30 year bonds will be viewed with great anticipation. If Banana Ben steps up his manipulation of bond prices, the current fall in the dollar along with the rise in commodity prices and interest rates will seem inconsequential by comparison in the not too distant future.

Our government risks morphing what would have been a severe deflationary recession into an inflationary recession/depression in the longer term. Their decision to choose the inflationary route is based on the fact that inflation bails out those in debt. Make no mistake, for a country with $11.4 trillion in debt and a 2009 deficit equal to 13% of GDP, inflation is perceived as the only way out. However, inflation can never bail out anything or anyone, it only helps the very rich maintain their purchasing power while robbing it from the rest of the country. It will also be at the great expense of those who have made the mistake of holding their savings in dollar denominated fixed income instruments and who have not protected themselves by owning hard assets.

Published on Tue, Jun 9 2009, 13:43 GMT

The Plummeting Dollar Prosperity Plan

Fri, Jun 5 2009, 08:54 GMT
by Michael Pento

Delta Global Advisors, Inc.

It is becoming painfully obvious that the Fed, Treasury, and Administration's disastrous recovery plan hinges on the devaluation of the U.S. dollar. Their specious strategy stems from the belief that a falling currency can re-ignite exports and spark a recovery in manufacturing while putting a floor in U.S. asset prices. But just as the President's initials indicate, the plan stinks of B.O.

Firstly, a falling currency does nothing to expand a country's exports or domestic production. Let's say for example, country "A" has a dollar that is trading in parity with that of country "B". Let us then assume that country A departs on a currency printing policy that mimics that of the United States. Let's also say that because of the increased supply of newly minted dollars, the value of country A's currency is eventually cut in half. Then, just one unit of country B's currency can be exchanged for two of A's dollars. The mistaken belief held by those who espouse a weak currency is that now country B can buy two dollars worth of goods with just one unit of their currency--thus expanding the foreign demand for A's goods and ushering in a manufacturing boom.

However, what they neglect to understand is that the inflationary policy of A has not left the dollar price of the country's goods static. In fact, the value of goods and services provided by A should have doubled as the purchasing power of the currency was halved. The result being that country B is immune from A's inflation and can purchase the same amount of goods with just the same amount of money.

The resulting problem is that not only has A done nothing to stimulate domestic production, it has discouraged foreign investment while destroying the purchasing power of the dollar, sending prices for both domestic and foreign purchases out of reach for the average consumer. The resulting inflation eventually discourages domestic manufacturing because the purchasing power of the country's middle class and poor is wiped out. The result of skyrocketing prices is that discretionary purchases are eliminated, causing massive job loss and plummeting GDP output.

History clearly shows any such currency devaluation strategy to be a complete failure. In 2005 China announced it would increase the value of its currency and abandon its decade-old fixed exchange rate to the U.S. dollar in favor of a link to a basket of world currencies. Since then the Yuan has rallied from .1208 USD to .1467 USD. But the falling dollar has had a negligible effect on U.S. exports. For all of 2005 the U.S. deficit with China was $201.5 billion. In 2008, three years into the dollar devaluation, it soared to $266.3 billion. And despite the worst economy since the great depression--which caused U.S. imports to decline sharply--the annualized rate for 2009 is still $201.2 billion.

If all a country needed to do to achieve manufacturing supremacy and economic dominance was devalue their currency then Georgia and Bosnia would be considered paragons of economic prosperity. That's because a country's economic health, productive output and balance of payments has less to do with the value of the currency and more to do with tax rates, union influence and environmental legislation.

As long as we continue to substitute spurious growth models for genuine growth policies we will continue to lose global power and influence. The only part of the current plan that is sure to work is the cessation of falling asset prices. Unfortunately for us, that will come at the risk of creating intractable inflation and putting our foreign creditors on notice that we will destroy not only the value of their U.S. dollar holdings but the very value of the currency in which they are denominated. Who does Mr. Geithner think he’s kidding? The Chinese have already moved to purchase short dated Treasuries so as to allow them an easy escape. They may also dramatically curtail their purchases. For a country that needs to issue nearly $3.25 trillion dollars of debt this year alone and trillions of dollars for many years to come, that is disastrous for this debt-laden economy.

Published on Fri, Jun 5 2009, 08:54 GMT

It's Decision Time in the USA

Mon, May 25 2009, 10:15 GMT
by Michael Pento

Delta Global Advisors, Inc.

Last week Standard and Poor’s announced that the AAA credit outlook of the United Kingdom was lowered to “negative” from “stable.” The action caused many in the US, including Bill Gross, to impugn the United States’ AAA credit rating and wonder if the same devaluation should be applicable here.

If the reasoning behind S&P’s decision to call into question Britain’s ability to repay debt is due to their budget deficit this year being 175 billion pounds ($273 billion), or 12.4% of gross domestic product for this year alone, then America’s budget deficit ($1.84 trillion and approaching 13% of GDP) should yield the same result. Investors agreed with that reasoning and sent the yield on the 10 year note soaring to 3.43% during Friday’s trading session, up over 90 bps from the Fed’s March 18th announcement to purchase $300 billion in treasuries.

Those rising yields, a dollar which has dropped 10% from the March highs and rising commodity prices are forcing the Fed and Administration to take a stand. Do they wish to continue their efforts of artificially engineering a recovery by deficit spending and monetary stimulus or will they chose to return to a real economy—one which pursues policies that allows rates to rise and increases the purchasing power of our currency?

The government is now hopefully learning a valuable lesson. A country can’t manipulate interest rates lower and stimulate the economy by piling on an insurmountable level of debt without consequences. The problem they face is clear. The incipient healing of the economy hinges on the continuation of very low borrowing costs for the consumer and government, as well as an economy that enjoys price stability. Record levels of debt require interest costs to remain low otherwise debt service becomes intractable. On the other hand, the massive build up in the monetary base and levels of debt demand for commodity prices to rise, the dollar to fall and bond yields to soar.

The point is they just can’t have it both ways. The government will have to decide to either step up their purchases of coupons in a direct assault on the bond vigilantes or acquiesce and allow rates to rise above inflation. The more long term debt they purchase by expanding money supply, the more inflation they will create. Therefore, the higher those yields must eventually rise. If they were to have a change of heart and allow the free market to work, rates would rise initially because they have been suppressed for so long. But although that would cause an extreme amount of economic pain in the short term, it is the only path that leads toward the long term health and viability of the country.

This is a critical time in our nation’s history. The bond, foreign exchange and commodity markets are forcing government’s hand. Comments made by Timothy Geithner and Alan Blinder last week give us a clue as to what road they will take. The Treasury Secretary and former Vice Chair of the Federal Reserve clearly indicated that it would be a serious problem if government exited its prodigal spending too soon. If that wrong decision is made and the government doubles down on its losing bet to artificially control interest rates, we face an economic environment that will be stigmatized by stagflation as far as the eye can see.

If higher inflation, more taxes, and debt lead to economic prosperity the economy is right on course. If however, you believe that a sound currency, low inflation, les debt and lower taxes lead to productivity gains—the only real way to grow an economy—you may have to wait until the next life.

Published on Mon, May 25 2009, 10:15 GMT

Who Will TARP America?

Wed, May 20 2009, 09:10 GMT
by Michael Pento

Delta Global Advisors, Inc.

Last week the nation’s number one trucking company, YRC Worldwide Inc., announced that it will seek $1 billion in TARP assistance to bailout the company’s pension plan. Never mind the fact that the request is light years away from the original intention and approval given by congress to purchase toxic assets from banks’ balance sheets. The point is that the troubled company’s request of the government to cover its pension obligations should remind us of the bigger issue; who will bailout our country’s pension plan and can the USA TARP itself?

The question has particular saliency given the recent release of the Medicare and Social Security Trustees report. The report provided more sobering news about the long and short term insolvency of our nation’s retirement plans and revealed the problem of funding our nation’s entitlement programs is becoming much worse.

The Social Security trust fund will run out of assets four years earlier than previously forecast. It should be noted at this time that the continued belief in the existence of any government trust fund (including FDIC insurance) is tantamount to a belief in the tooth fairy, because the special-issue bonds will need to be redeemed just as would any ordinary Treasury obligation. Therefore the only date of importance is the date at which expenditures exceed revenues, which in the case of Social Security, has been moved up one year to 2016. The report also bumped up the amount needed over the next 75 years to fulfill its benefit obligations by $5.3 trillion.

Medicare, which is by far the bigger issue, is already in a cash flow negative situation. Medicare Part A turned cash-flow negative in 2008, as payments exceeded revenue by $21 billion. The trust fund is projected to run out in 2017, two years sooner than predicted just last year.

How big is the entire problem you ask? According to the Trustee’s report, if you add together the unfunded liabilities from Medicare and Social Security, it comes to more than $100 trillion over the infinite horizon—talk about the mother of all bailouts. There is no doubt in my mind that if the government conducted a stress test on its own ability to remain solvent given the amount of entitlement program spending we face; they would receive a failing grade.

A study done by the Center on Budget and Policy Priorities shows that for 2/3 of Americans over age 65, Social Security provided half or more of retirement income. As for the remaining third, it provided 90% or more! That is why any proposed reductions in benefits will face an impenetrable line of defense from AARP and other lobbying groups which represent retirees—a voting bloc with increasing numbers and influence. When you factor in the wealth decline from the Dow Jones Industrial Average that has declined 42% from its October 2007 high, home prices that are off 31% from their high water mark set in 2006, and the decline in influence of most private pension plans, you understand that the reliance on entitlement programs is increasing substantially.

So back to the original question: Who will bail out the USA? Up until now it has been foreign Central Banks. For instance, the Chinese now have $1.9 trillion in currency reserves of which $740 billion are in US Treasuries. The notion that they will continue to provide the United States with an unlimited supply of Treasury demand is specious in nature. Premier Wen Jiabao has already expressed his concern over his country’s concentrated dollar position. Additionally, the Chinese have a waning trade surplus and their own stimulus program to fund. This means that they may not have the desire or the means to fund our ballooning debt.

Increasing taxes have been proposed by some to close the gap. In reality imposing new taxes or increasing existing tax rates does not necessarily equate to increased revenue. In fact, an increased tax burden imposed on this already fragile economy may prove to have the opposite effect on government income.

A partial solution is to grow the economy as much as possible. But the truth is that the antithesis of growth is what is being deployed. Higher taxes, inflation and debt are the antidotes to growth and will only exacerbate our funding issues.

That leaves the Federal Reserve in charge of bailing out the entire country. TARPer in Chief Banana Ben Bernanke--who has unlimited counterfeit funds to deploy--will be looked to once again to provide relief by leaving interest well below inflation and keeping the monetary base incredibly high. The worst fear of all is that he will be the buyer of last resort and purchase an ever increasing quantity of US Treasury debt. Any relief experienced by his prodigal efforts will be fleeting. Unfortunately, we will have to learn the hard way that inflation solves nothing and seeking a panacea through the printing press leads to perdition.

Published on Wed, May 20 2009, 09:10 GMT

The Bad Old days are Here Again

Thu, May 14 2009, 08:35 GMT
by Michael Pento

Delta Global Advisors, Inc.

Commodities are rising, the dollar is falling and the trade deficit is growing. Everything bad is good again, thanks to the Feds.

All of the pernicious factors that brought us to the brink of financial Armageddon are now once again returning and are still—amazingly enough--being embraced as both normal and healthy for the long term viability of the U.S. economy. Factors such as a strengthening U.S. dollar, shrinking trade deficit, a surging savings rate and falling commodity prices were all being viewed as the bane of the U.S. economy. And now, unfortunately, what had been the budding re-emergence of economic sanity is being obliterated by a killing frost thanks to the Fed and the Administration.

Despite whatever comes from their mouths, the most important goal of this government is to stop the slide in the stock and real estate markets. The major averages have rallied since their March lows because of the massive deficit spending and liquidity provided by our government. But the costs of providing market increases that are based solely on inflation are pyrrhic in nature.

The US dollar index hit a cyclical high of just over 89 in early March while the S&P 500 reached its cyclical bottom of 676.53 on March 9th. Today we find the S&P trading above 900 while the dollar has fallen below 83. This is a direct result of our government’s incorrect viewpoint that a strengthening US dollar is bad for trade and the economy. But the truth is that a strong currency is the backbone of a healthy economy and is essential for providing price stability and low interest rates.

As a direct result of this recession and the insipient desire on the part of the US consumer to save, we have seen the trade deficit cut in half over the past year. But right on cue, the trade gap in March rose for the first time in eight months to $27.6 billion from the February low print of $ 26.1 billion. Again, this is all part of the government’s plan to eschew savings and encourage consumption; its borrow-and-spend mantra of the past is being viewed as the panacea for the economy. In reality, savings provides the capital for investment and which leads to innovation and productivity increases—the only true method of growth.

And continuing with this theme of reflation, the Reuters Jefferies CRB Index made a triple bottom on March 3rd at 200. Today, the nineteen commodities in the index are trading at 242—a 21% increase. How can the money printing policies of the Fed, which have caused the increase in energy and materials, be viewed as helpful for the consumer? Can oil priced at $58 a barrel be considered cheap and a sign of deflation? Does $920 for an ounce of gold presage the strengthening purchasing power of our currency?

The preceding data is not at all coincidental. There can be no mistake, the Administration and Fed are succeeding in their desire to re-inflate the bubble and have dragged us further away from what was the beginning of true and lasting healing in the U.S. economy.

It is true a rising dollar, increased savings and deflating asset prices are all painful in the short term for the economy and the consumer. But they are essential for the healing process of deleveraging to occur. By not allowing the process to consummate, the government is ensuring that when—not if—inflation returns, it will be impossible to vanquish without severely harming our already vulnerable economy.

Published on Thu, May 14 2009, 08:35 GMT

Sorry Ben, You Don't Control Long Term Rates

Tue, May 5 2009, 10:46 GMT
by Michael Pento

Delta Global Advisors, Inc.

It is disappointing to discover that the Harvard- and M.I.T.-educated Ben Bernanke did not learn while attending school that long-term interest rates must be set by the free market. Belatedly, the Chairman of the Federal Reserve is about to learn this valuable and costly lesson because these rates cannot be manipulated lower by any central bank for a great length of time.

On March 18th, the Federal Reserve committed to buying up to $300 billion in long-term Treasuries over the ensuing six months. After that announcement, the market initially celebrated and interest rates immediately fell on the 10-year note from 3.02% to 2.51%. But less than two months later, rates have spiked up to 3.17%, 66 bps higher than the reaction low on the day of the announcement.

That jump in rates places into jeopardy the nascent recovery in the market and economy because so much of Washington’s planned “healing” is predicated on halting the fall in real estate prices, which have implications for consumers’ and banks’ balance sheets. Thirty-year fixed mortgages, which had fallen to a recent low of 4.625%, now face the pressure of a rising 10 year note, which has a direct impact on newly-minted mortgages (as opposed to LIBOR rates which affect ARMs).

The recent rise in Treasuries has created an incredibly important standoff between Mr. Bernanke and the bond vigilantes whose clients demand a real return on their investments.

You see, rates on the long end of the curve are primarily concerned with inflation; if inflation is expected to increase, rates must eventually reflect this by moving higher. I realize that today many are mistaking the deleveraging processes seen in stocks and real estate prices as deflation but as long as the Fed continues to monetize Treasury debt, the money supply will continue to increase dramatically and deflation in the long run will be off the table.

So just how realistic is the current level of Treasuries? As noted in my commentary written in October 2008 entitled “The Debt vs. Interest Rate Conundrum”, the 46 year average constant yield for the 10 year note was 7.04%. The yield rose above 3% in June of 1958 and did not drop below that rate until November of 2008! Back in 1958 the monetary base was just $38 billion and the gross Federal debt was only $279 billion (60% of GDP). Today, base money has grown to $1.7 trillion—with more than half of that amount having been added just since last Autumn— and the National debt has skyrocketed to $11.2 trillion (80% of GDP). Therefore, from both an economic and historic perspective the yield on the Ten year note is unnaturally and unsustainably low.

Some may also say that today’s low rates are justified given the fact that Consumer Price Index increased just .1% for all of 2008. But when you look at the first three months of 2009, the CPI is already rising at a 2.2% annual rate; clearly, traders in the bond market are beginning to realize that deflation will not be our next major concern.

This, when you think about it, is completely justified given the tremendous increase in debt and money supply, which are the progenitors to rising inflation.

So how high will the Fed allow long-term rates to rise and how much money will they print in an attempt to stem that increase? Ben Bernanke may be surprised to learn that the more Treasuries he buys, the lower their prices will go. After all, printing money is the definition of inflation and investors simply cannot tolerate a negative return on their money for very long.

Will the Federal Reserve abandon its dangerous current course and let our economy experience a painful, but much needed recession or will it persist in its belief that long-term rates are under its dominion? Unfortunately, it seems clear that instead of capitulating to the bond market’s clear signals and reversing course, Bernanke will continue down this path. Indeed, if long-term rates go much higher from here—and it is pathetic to think our economy can’t stand a 10-year Treasury rate of much over 3%-- don’t be surprised if the Fed soon announces additional commitments to purchase even more government debt in a futile attempt to keep Treasury yields artificially low and to sustain the “recovery” now supposedly in progress. And that, unfortunately, spells disaster for both an inflationary outcome and the viability of our debt-laden and credit-dependent economy in the not-too-distant future.

The market will not be fooled by this game indefinitely, as the 10-year yield is already hinting.

Published on Tue, May 5 2009, 10:46 GMT

It's Stag, not Hyperinflation—For Now

Tue, Apr 28 2009, 14:14 GMT
by Michael Pento

Delta Global Advisors, Inc.

In the longer term, the risk of the U.S. suffering through a bout with hyperinflation is very real. However, in the short term what we most likely face is a protracted period of stagflation first because of our record debt and the Fed’s decision to pay interest on excess bank reserves.

What is clear is that despite government’s best efforts, the rate of increase in bank lending is falling off a cliff. According to the St. Louis Federal Reserve, Total Commercial and Industrial Loans are up 3% from the year ago period and Total Loans and leases are up just 2% Y.O.Y. While that’s still an increase in lending those rates are down from 22% and 13% respectively from their 2007 level.

So why are banks not pushing more money out the door even at record low interest rates? It’s a fairly well known fact that Household debt (97% of GDP) and total debt (360% of GDP) are dampening the general desire to borrow. But what is less talked about is the decision by the Federal Reserve to pay the same interest rate on both commercial banks’ excess and required reserves held at the Fed.

In October of 2008, the Fed decided to pay interest on the money it holds for commercial banks because it wanted to place a floor under the Funds Rate, which is the rate banks charge each other for overnight loans. At that time, the spread between the interest paid on required reserves and the interest paid on excess reserves was .75%. Banks still had plenty of incentive to lend their money held at the Fed as they received a much higher rate on required reserves (money-backing loans) than excess reserves. But on December 24th, 2008, the Fed lowered the interest paid on all reserves to .25%. Although that may seem like a paltry rate, it is still averaging about .10% above the Effective Federal Funds Rate and .16% above the 3 month Treasury bill. Banks now have little reason to lend to each other and can earn more loaning risk free to the Fed for 3 months than by lending money to the Treasury.

The Monetary Base now stands at $1.78 trillion, but the amount of excess reserves has also grown to $862 billion—both all-time record highs. So, while many (including myself) fret over the tremendous build up in the Base, much of that increase is currently laying dormant at the Fed. The question is: why does the Fed continue to pay banks not to make loans?

Its rational for performing a levitation act on the Funds rate seems a bit futile as it now stands at just .15%. One can only hope that the Fed is actually fearful of its own monetary creation and does not want banks to deploy the full force of the Base as that would lead to hyperinflation in short order.

Until banks begin to increase lending and the money multiplier kicks into full gear we will not experience surging inflation. However, because of our record deficit spending, the Fed will be huge factor in funding Treasury’s ballooning debt. Thus, Mr. Bernanke is now forced to be a major participant in Treasury auctions because of his desire to keep rates artificially low. The most likely outcome is for economic growth to remain well below trend because of the massive deleveraging that the economy still must endure while inflation simultaneously becomes more salient as the Fed monetizes the national debt.

The Fed’s challenge in the long term will be to remove that liquidity without destroying the economy in the meantime, a nearly impossible task as I outlined in a previous commentary "The Fed Has Surrendered to Inflation". If Bernanke and company cannot shrink the balance sheet once banks begin to lend with abandon once again, the likelihood of hyperinflation skyrockets. Or if the government continues to print trillion-dollar deficits as far as the eye can see, the Fed will eventually create intractable inflation in order to diminish the value of that debt. But for investors the current challenge will be to hedge their portfolio against insidious inflation that should not be of the” hyper” variety—at least for now.

Download The Fed Has Surrendered to Inflation report

Published on Tue, Apr 28 2009, 14:14 GMT

Obama: the Grand Illusionist

Tue, Apr 21 2009, 13:26 GMT
by Michael Pento

Delta Global Advisors, Inc.

President Obama is smooth. He has an incomparable ability to say the correct thing and then doing the exact opposite. For instance, he says the United States cannot continue the boom bust cycle of economic activity and must repent from its proclivity to engender GDP growth off the back of building asset bubbles. He also contends that George W. Bush was disingenuously hiding the size of the true deficit by keeping certain items off budget. In those two statements he is completely correct.

However, he uses the magician’s tactic of deflection to sell his economic gimmickry. First Obama directs your attention towards his promise of removing Bush’s budget tricks and repudiating his fiscal irresponsibility, but then whips out his smoke and mirrors of trillion dollar deficits and accounting games.

Taking a closer look at how the President arrives at his rosy projection of cutting the deficit to “just” $530 billion by the end of 2013 you find he accomplishes it not by keeping expenditures off budget, like his processor, but by utilizing grossly unrealistic economic growth assumptions.

Mr. Obama assumes the contraction in GDP for 2009 will be only 1.2%. That’s a big improvement from the -6.34% annual rate drop of last quarter and far better than the non-partisan Congressional Budget Office’s (CBO) prediction of -2.2% growth for 2009. Then from there things get truly surreal. The Obama administration predicts GDP growth for 2010 will rebound to 3.2% and then increase by more than 4% for each of the next three years!

How realistic you ask is a 4% growth rate in GDP for the years 2011-2013? Well, let’s look at the past 11 years for some guidance. Starting from the beginning of 1998 thru Q4 of 2008, the average quarterly GDP growth rate was 2.17%. And the average yearly growth rate was just 2.7%. What’s truly amazing about the growth rate over the last 11 years (which was well below trend growth of 3%) is that it encompassed two of the biggest manias in the history of the United States—the equity bubble of the late 90’s and real estate bubble in the middle of this decade. You see, once you know the trick it’s easy. If you want to make deficits appear smaller, just pretend growth will be higher than what should be responsibly expected. Then simply bury your growth expectations in the fine print.

Perhaps part of Obama’s magical act of producing well above trend GDP growth will be to conjure up another asset bubble that equals or rivals that of the previous two. But the sad truth is that whether you use Obama’s overly optimistic projections or that of the CBO’s, deficits as a percentage of GDP will eclipse 100% of total output by 2019 (a record outside the years just after the end of WWll). But during the post war era we controlled the entire world’s manufacturing base and were not facing that wave of entitlement spending which looms straight ahead. Which means the consequences of such an onerous debt will be far dire than what was experienced 65 years ago.

When the veil of illusion is dropped the truth behind what this administration will produce is revealed. Record debt, lack luster growth and robust inflation will be the products of runaway spending and increased government intrusion into the free market. Barack Obama wants you to believe he is a fiscal conservative and that he is providing honesty and transparency in the government. The Administration’s trick is to make opacity appear as transparency and mendacity to appear as truth. But their performance is best viewed through gold (not rose) colored glasses.

Published on Tue, Apr 21 2009, 13:26 GMT

Ben's Un−shrinkable Balance Sheet

Wed, Apr 15 2009, 08:15 GMT
by Michael Pento

Delta Global Advisors, Inc.

As he stated again clearly today, the Chairman of the Federal Reserve has deluded himself into thinking that when the time comes, he will be able to shrink the size of the Fed’s balance sheet and reduce the monetary base with both ease and impunity. He also has deluded himself into thinking inflation will be easily contained.

It is very important that he does not fool you, as well.

The Fed believes low interest rates should not be the result of a high savings rate, but instead can exist by decree, a conviction which has directly led consumers to believe their spending can outstrip disposable income.

The result of such thinking has been a rise in household debt from 47% of GDP in 1980 to 97% of total output in Q4 2008. As a result of this ever increasing burden, the Fed has been forced into a series of lower lows and lower highs on its benchmark lending rate. Keeping rates low is an attempt to make debt service levels manageable and the consumer afloat. Problem is, this endless pursuit of unnaturally low rates has so altered the Fed’s balance sheet that Mr. Bernanke will be hard-pressed to substantially raise rates to combat inflation once consumer and wholesale prices begin to significantly increase.

Banana Ben Bernanke has grown the monetary base from just $842 billion in August 2008 to a record high of $1,723 billion as of April 2009.

But it’s not only the size of the balance sheet that is so daunting; it’s the makeup that’s becoming truly scary.

Historically speaking, the composition of the Fed’s balance sheet has been mostly Treasuries. And the Federal Open Market Committee would typically raise rates by selling Treasuries from its balance sheet into the market to soak up excess liquidity. However, because of the Fed’s decision to purchase up to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings), it will not be selling highly-liquid US debt to drain reserves from banks. Rather, it will be unwinding highly distressed MBS and packaged loans to AIG. Not to mention the fact the Fed would have to break its promise of being a “hold-to-maturity investor” of such assets.

Moreover, not only are the new assets on the Fed’s balance sheet less liquid but the durations of the loans are being extended. According to Bloomberg, the Fed is contemplating extending TALF loans to buy mortgaged backed securities to five years from three after pressure it received from lobbyists and a failed second monthly round of auctions. That means when it finally decides it’s time to fight inflation, the Fed will find it much more difficult to reverse course.

But because of the extraordinary and unprecedented (some would say illegal) measures Mr. Bernanke has implemented, only $505 billion of the $2 trillion balance sheet is composed of U.S. Treasury debt. Today, most Fed assets are derived from the alphabet soup of lending programs including $250 billion in commercial paper, $312 billion of Central Bank liquidity swaps and $236 billion in mortgage-backed securities.

Thus, our economy has become more addicted than ever to low interest rates. But because bank assets will now be collecting income at record low rates, when and if the Fed tries to raise rates it will only be able to do so on the margin. If Bernanke raises rates substantially to fight inflation, banks will be paying out more on deposits than they collect on their income streams. Couple that with their already distressed balances sheets and look out!

Additionally, not only do the consumers need low rates to keep their Financial Obligation Ratio low, but the Federal government also needs low rates to ensure interest rates on the skyrocketing national debt can be serviced. Our projected $1.8 trillion annual deficit stems from the belief that the government must expand its balance sheet as the consumer begins to deleverage. In fact, both the consumer and government need to deleverage for total debt relief to occur, else we’re just shuffling debts around and avoiding a healthy deleveraging entirely.

In order to have viable and sustainable growth total debt levels must decrease, savings must increase and interest rates must rise. But that would require an extended period of negative GDP growth—a completely untenable position for politicians of all stripes. Ben Bernanke would like you to believe inflation will be quiescent and he can vanquish it if it ever becomes a problem. Just make sure you don’t invest as though you believe him.

Published on Wed, Apr 15 2009, 08:15 GMT

Actually, we're not saving yet

Wed, Apr 1 2009, 12:59 GMT
by Michael Pento

Delta Global Advisors, Inc.

There seems to be much confusion lately about the consumer’s increased savings rate and if this is a good or bad condition for the health of the U.S. economy. While many Austrian economists are lauding our new found predilection to save, the Administration is obsessing over forcing banks to increase lending and compelling consumers to step up their borrowing.

It is factually correct to believe the U.S. consumer must embark on a protracted period of savings and reduced consumption in order to reconcile the decades of imbalances encouraged by the Fed and banking system. Unfortunately, the very idea of a newly-frugal consumer is a complete farce.

According to the Bureau of Economic Research, Americans saved 1.8% of their disposable income in 2008. That equates to a total savings of $191.4 billion. And in another seemingly encouraging sign, consumers saved at an annual rate of 4.4% in January and at a 4.2% annual rate in February 2009. At the current pace, consumers would save $464.4 billion in this year. This has caused some economists to take heart that the excess consumption patterns of the past few decades have begun to reverse.

However, the problem is that at the same time our government is busy ensuring that any private sector saving is more than offset by increased public debt. In 2008, the budget deficit was a then-record $438 billion. This year the budget deficit is projected by the Congressional Budget Office to be $1.8 trillion—a four-fold increase!

Thus, as a nation we have not saved a nickel. What most economists overlook is that all public debt is a direct obligation upon the consumer, meaning taxpayers—a much smaller universe than consumers, mind you—saw their debt burden increase by $246.6 billion last year and will watch it skyrocket by a projected $1,335.6 billion this year alone!

What makes today’s policy course such a travesty is that our government is creating this record-shattering debt in order to increase bank lending and to specifically reverse the positive recent trend in consumer savings. Thus, the Obama Administration is seamlessly taking the baton from the Bushies and is even more aggressively seeking to borrow our way out of debt and print our way back to prosperity.

As long as savings is viewed as the problem and consumption is viewed as the solution, there we will be no escaping our economic malaise. Consumers may have finally begun to repent for their profligate ways, but as long as government annuls that effort we will still face all the ravaging effects from onerous debt.

Our nation’s debt now stands at over $11 trillion, with CBOE estimates suggesting it will grow by another $9.3 trillion over the next ten years. That is the perfect condition to engender yet higher rates of unemployment, along with increasing tax and interest rates.

After the short-term euphoria wears off from the Obama stimulus packages, we’ll be left to discover that we’ve not only squandered even more current and future savings, but that we have cooked up the perfect recipe for stagflation.

Published on Wed, Apr 1 2009, 12:59 GMT

Banana Ben Bernanke

Tue, Mar 24 2009, 17:40 GMT
by Michael Pento

Delta Global Advisors, Inc.

Helicopter Ben Bernanke has earned the new moniker of Banana Ben. He has earned the new name because of his desire to make the United States resemble a banana republic instead of embracing the policies that made the U.S. the greatest nation on earth. It is now abundantly clear to all that not only the Fed Chairman but also this administration will do everything in their power to create inflation. Their efforts are derived from the mistaken belief that inflation can solve everything.

Listen to two quotes from the administration about their desire to re-inflate the credit bubble that wreaked havoc on our economy earlier this decade. Barack Obama said on March 17th that his $15 billion move to bolster the securitization market will be “a jolt in the arm for community banks.” With his own exhortation, Treasury Secretary Tim Geithner urged banks “to go the extra mile” regarding increasing lending and that they have a “special responsibility” to assist in the recovery. And the administration is actually going to force the 21 largest banks getting bailout money to provide a monthly report on how much they are lending to small businesses.

But the mother of all efforts to return to inflation nation came from the Federal Reserve. Following the FOMC meeting on Wednesday March 18th, Mr. Bernanke gave all investors a final warning to get out of cash with his plan to expand the Fed’s balance sheet to nearly $4 trillion. It did not phase the Fed head that earlier that morning the Consumer Price Index was released and showed inflation growing at a 1.8% annual rate. He remained undaunted by the fact that MZM (money of zero maturity) is up over 12% from last year. He does not care that Total Loans and Leases at Commercial banks are up 2.5% YOY. In fact, he is not worried about inflation at all. He is concerned about deflation even though he does not understand the definition of it. Deflation is a fall in the money supply not collapsing prices in assets that were previously in a bubble.

Despite those facts, the Fed decided to increase its already skyrocketing balance sheet by $1.2 trillion. The most egregious part of the Fed’s announcement that it will purchase up to $300 billion of long term Treasuries. In yet another miscalculation by the Fed, it mistakenly believes that China will be comforted that the price of Treasuries will be supported by the Fed but will be paid off in worth less dollars.

But by far the biggest misstep by the Fed and Administration is the belief that this liquidity can be removed once the economy recovers. Ten year bond yields collapsed the most since 1962 (50bps), to yield just 2.5%. Loan rates are expected to drop to 4.25% for a thirty year fixed mortgage. Millions of loans will be made at this new, artificially-engendered rate. Since bank assets will be collecting income at a much lower rate, the Fed will be hard pressed to move rates higher in the future. Even a relatively small increase in the Fed Funds rate down the road could eliminate bank profits and put extraordinary pressure on their balance sheets.

As of today, total debt is over 360% of GDP. If banks increase lending that number is sure to grow. We also know that the National Debt, which is now over $11 trillion, is increasing at about a $2 trillion annual rate. If raising rates to 5.25% in 2007 sent the economy into a deep recession, how much room does the Fed have to raise rates in the future when the nominal level of debt and the percentage of debt to GDP will be much greater?

The truth is that this stimulus will be impossible to remove without bringing about another collapse in the economy; hence, inflation will be with us for a very long time. However, an inflationary path is seen as the Holy Grail by the Fed. Ben Bernanke, a “student” of the Great Depression, was apparently absent from class when the part of history that dealt with the hyperinflationary economies of South America and Africa was taught. Banana Ben believes inflation could have saved us from the Depression of the 1930’s. He couldn’t be more wrong. Depressions are caused by debt, not by a decrease in the money supply.

The truth is inflation completely destroys an economy by wiping out savers, crushing those who exist on a fixed income and crippling those at the lowest end of the income scale by raising prices of the most basic goods.

Further, what might surprise the new President—allegedly a champion of the poor—is that an increased supply of money is never evenly distributed throughout the economy; it always finds a home with the nation’s most wealthy citizens who have access to credit first. Skyrocketing prices relegate the middle and lower classes to use all their available funds for the basic necessities of life. Since the demand for discretionary purchases collapses, unemployment rates explode and the economy is left in shambles.

Investors would be wise to continue trading in measurable portions of their cash holdings for gold. It may also be prudent to for some to speculate in the beaten-down bank and home building sectors for a brief period of time, as I believe the entire market will benefit from the initial stages of inflation—the Fed and Administration may be able to provide a truncated period of ersatz prosperity before the terror begins. But because of their decision to monetize away what would have been a deep—and necessary—recession, the economy and country will be far worse off in the long run.

Published on Tue, Mar 24 2009, 17:40 GMT

The FDIC: as Rock Solid as Social Security

Tue, Mar 17 2009, 10:02 GMT
by Michael Pento

Delta Global Advisors, Inc.

We all should be painfully aware by now that there is nothing held inside the Social Security and Medicare trust funds but a bunch of IOUs. Monies collected from payroll taxes are treated as general revenues and used in the “unified budget.” But how many of us are aware that the FDIC’s Deposit Insurance Fund works in a similar fashion?

On March 2nd, FDIC Chairman Sheila Bair made some remarkable statements in defense of the Insurance Corporation’s decision to raise fees and increase revenues. She said in a letter sent to the over 8,300 insured banks that, “Without substantial amounts of additional assessment revenue in the near future, current projections indicate that the fund balance will approach zero or even become negative.”

After talking with an Information Specialist at the FDIC, I learned some important facts about the agency that all taxpayers should find interesting. Exactly how quickly is the insurance fund being depleted you ask? At the start of 2008 the fund held $52.4 billion, which fell to just $34.6 billion by the end of the third quarter. And at the end of Q4 there was a mere $18.9 billion left in the coffers, so there seems to be good reason for Ms. Bair to worry. Even more troublesome is the projections for further drain on fund reserves. The FDIC itself predicts there will be an additional $65 billion in losses through the year 2013.

The most interesting part of my conversation with the FDIC came when I heard confirmation of my worst fear about where the assets held in the insurance fund are kept: the vast majority of the Deposit Fund’s assets are held in U.S. Treasuries. This is extra puzzling when you see the next quote from the Chairman, “Some have suggested that we should turn to the taxpayers for funding. But banks not taxpayers are expected to fund the system…” Now I’m really confused. She doesn’t want the taxpayer stuck with funding the FDIC, yet nearly all of the reserves are held in Treasuries?

Since the insurance which backstops all eligible bank deposits are primarily invested in Treasuries, is there much difference between the FDIC insurance fund and the Social Security and Medicare funds? No. In fact, they are essentially the same. It would be far less egregious if the fund bought Treasuries in the secondary or even primary market. But, according to a Senior Consumer Affairs specialist at the FDIC, U.S. debt purchases are transacted solely and directly with the Treasury Department and not done at auction—directly funding the expenditures of the government so Ms. Bair should understand that taxpayers are already on the hook for bailing out the insurance fund. Any drain on FDIC reserves starting from dollar number one is met by sales of Treasuries, which are a direct obligation upon the U.S. taxpayer.

That impugns the very existence of the FDIC Deposit Insurance “trust fund.” The Bair truth is: there is no fund, only the system of IOUs which backs the entitlement programs. It turns out Congress, via the Treasury, has found yet another “unused” pool of money to pour into the budget each year. Collecting more fees to feed another wealth redistribution arm of government bureaucracy won’t solve anything.

Published on Tue, Mar 17 2009, 10:02 GMT

What the Citi Conversion Might Really Mean

Tue, Mar 10 2009, 11:28 GMT
by Michael Pento

Delta Global Advisors, Inc.

We learned on February 27th of the Treasury’s plan to convert up to $25 billion of their $45 billion preferred Citigroup shares to common equity. According to the company, the existing shareholders would be diluted by 74%. Thus, the taxpayers will cease collecting dividends on their holdings and they’ll slide down the capital structure in Citigroup to the lowest rung on the ladder. Ostensibly, it looks like a good deal for the bank and not such a great deal for the government/taxpayer.

So why would the government allow such a deal to occur? The answer is to gain more control over Citigroup (with other major banks next in line) in order to garner complete control over the money supply. The Treasury’s preferred holdings in Citigroup carry no voting rights, whereas the common shares will. After conversion, the government would own 36% of the common stock. The government does not need to be the largest shareholder in the company to dictate policy, but it does greatly facilitate the process. The power grab will increase the Administration’s and Fed’s ability to direct bank lending, which can lead to an abrogation of the system of checks and balances that control our money supply.

Under “normal” conditions in a fiat currency system, a Central Bank influences the cost of money through the manipulation of the overnight interbank lending rate. In the U.S., the Federal Reserve influences the Fed Funds rate and Discount rate through the everyday operations (buying and selling of Treasuries) of the Federal Open Market Committee (F.O.M.C.). Those rates in turn influence interest rates across the yield curve and therefore, indirectly controlling the cost of money. Additionally, the Federal Reserve directly controls the amount of money in the Monetary Base (high powered money) through the expansion and contraction of its balance sheet. Base money is then used by banks through the Fractional Reserve System to multiply “high powered” money tenfold or greater.

Therefore we know that the amount and cost of money is highly influenced by the government. But the system has built in one key element which allows for a condition of checks and balances to exist. The consumer must still want to borrow and banks must still desire to lend. Unless that situation exists, the larger monetary aggregates will be very slow to increase. And if base money is not loaned into existence, it remains limited in its ability to drive up prices. In today’s economy, banks’ balance sheets are in disrepair and the consumer has taken on a record amount of debt. Thus, despite the best efforts of the Fed and Administration to force-feed more borrowing, market forces have determined not to increase the amount of debt regardless of its availability or rate.

However, none other than Ben Bernanke himself said at his February 25th House Financial Services Committee hearing that the Treasury may own a “substantial minority” of banks’ common shares. Their goal is not to nationalize banks but to garner significant control. If they can control the lending practices of financial institutions, they dominate all three factors in the process that determine the supply of money—the quantity of base money, the level of interest rates and the amount of lending provided by banks.

The U.S. government would then be able to expand the money supply buy purchasing Treasury’s burgeoning debt relatively unfettered. The American consumer, businesses and banks may be cut out of the equation. All that will matter is government’s desire to spend our way out of a depression and their ability to finance it with alacrity. As of today there are $673 billion in excess reserves sitting on the Fed’s balance sheet, which government can then use to purchase Treasuries and keep yields low by forcing banks to finance their spending plans.

One of the most important freedoms which made America great was the protection of the purchasing power of our money. The wisdom of our founding fathers was such that they understood the cornerstone for a successful economy was to ensure the stability of our nation’s currency. While that protection began to be eroded with the signing of the Federal Reserve Act of 1913, we may now be abdicating complete control of our money supply to the government. If so, we’ll be able to thank our government for not only creating a depression, but making sure it is accompanied by intractable inflation.

Published on Tue, Mar 10 2009, 11:28 GMT

There's only one Cure for a Depression

Mon, Feb 23 2009, 15:32 GMT
by Michael Pento

Delta Global Advisors, Inc.

In contrast with a depression, a recession is relatively easy to bring to an end. The genesis of a recession is caused by excessive credit creation on the part of banks and the Fed. The superfluous money drives prices higher and the rate of inflation begins to increase at a pace that makes the Fed uncomfortable. The Central bank then begins to raise rates in order to soak up that liquidity and put an end to its easy monetary policy. The higher interest rates serve to choke off consumer borrowing and the amount of money in the system compared to the total availability of goods and services becomes reduced. Any inflation that was in the economy gets squeezed out. Once prices return to a favorable level, the Fed begins to reduce rates again and the boom bust cycle repeats. That’s the playbook response to a minor reduction in GDP.

However, the only cure for a depression is time. Not the abrogation of the free market. The seeds of a depression are sown when an extreme over supply of money and credit is allowed to continue for a protracted period of time. When this phenomenon occurs, it produces a pernicious level of debt to pervade throughout the economy. All sectors of the economy become overleveraged and the need to reduce debt becomes paramount. The economy then experiences a severe contraction in GDP. In a depression, the pull back in borrowing is not caused by interest rate increases from the Fed but an inability of the economy to take on further debt. A depression can last for many years as consumers, banks and the government goes through the painfully long and arduous process of deleveraging.

Unfortunately, the kneejerk response on the part of the government and central bank is to stimulate the economy by spending money and reducing interest rates. That is the very same strategy used to combat a recession. However, their response fails to produce the desired result because it ignores the root cause of the problem—debt levels that have become unsustainable. It is not lower interest rates on borrowed money that the consumer seeks, it is less debt. If fact, all attempts by the government to mollify the depression tend to exacerbate the situation by force feeding more debt when it is least capable of being serviced.

What does history say about the effectiveness of government intervention? In Japan, the Nikkei Dow hit a high of 39,957.44 on December 29th 1989. Then it’s epic real estate and equity bubble burst. The composite average is trading below 7,600 today. Even after two decades of trying to turn their market around, their government’s barrage of stimulus plans and a near zero percent interest rate policy has done little to ameliorate the malaise. In fact, it has only prolonged the healing process. Average annual growth remained an anemic 1.5% throughout the 1990’s. And in the last quarter of 2008, Japanese GDP contracted at an annual rate of 12.7%!

A similar result was experienced by both Herbert Hoover and Franklin Delano Roosevelt after they deployed a plethora of government interventions to combat the Great Depression. After four years of Hoover’s wealth distribution and trade wars, and five years into the New Deal, they both failed to bring the economy out of the depression. Unemployment reached 20% in the years 1937-1938 and the percent change in GDP dropped 18.2%. It wasn’t until we fought and won WWll that the economy began to enjoy a sustainable recover.

Unfortunately, we see the same playbook being deployed today as was used under the Hoover/Roosevelt regime. President Obama is following George W. Bush with the signing last week of his own stimulus plan that totals $787 billion. And of course, this is probably the first in a series of spending plans that are intended to help bring the economy back on track.

The reason all the government’s efforts fail to solve the problem is clear. Time is needed to allow asset values to retreat back to historically normal levels that can be supported by the free market. And time is necessary for debt levels to be attenuated to a level where the can be serviced without having the Fed artificially forcing interest rates down. Any and all attempts to prevent deleveraging and to prop up asset prices will cause years to be added to the healing process. Additionally, all government efforts to “help” end up becoming a huge misallocation of resources as they take capital from the private sector and redistribute it in the most inefficient manner. What’s worse is that the increased government spending adds yet more public sector debt to an economy already reeling from a mountain of liabilities.

This buildup in debt levels was unprecedented in history, thanks to a Real Estate bubble that was used to bail out an equity bubble. It would stand to reason that if the government continues to try to manufacture a recovery, it could take more than a decade to return to prosperity. The question is, do we have the patience to let the free market function and endure several years of hardship, but then emerge as a much stronger country. Or will the compulsion to intervene just propel us yet deeper into the abyss.

Published on Mon, Feb 23 2009, 15:32 GMT

The Reality Behind Real Estate

Wed, Feb 11 2009, 10:37 GMT
by Michael Pento

Delta Global Advisors, Inc.

Much has been written lately about the beginnings of a recovery in the real estate market. Just last week housing bugs (investment “bugs” are not exclusive to those who only love gold) were cheering the latest data point which they claimed as evidence the market is making a comeback.

The Pending home sales index rose 6.3%, to 87.7 from 82.5 in November. That figure was also 2.1% higher than that of December 2007 when it registered 85.9. Helping to drive the increase in pending home sales are three major factors: lower home prices, lower new home construction rates and lower mortgage rates.

However, although those three factors have improved greatly since the bubble burst in 2006, they still do not signal an end to falling prices.

At the height of the bubble, the median home price-to-income ratio reached about 5:1. It has since retreated to 3.6:1, which is still above the historic level of 3.2:1 but promising nonetheless.

According to the distinguished Vince Farrell of Soleil Securities, the spread between thirty-year fixed rate mortgages and the 10-year Treasury note is about 235 basis points. The historic spread is about 170 bps and the high water mark spread was well above 500 bps. Although rates are falling, (much like home prices) they are still above historic norms. But, nevertheless, they’re still headed in the right direction… another point for housing bulls.

New home construction rates are now running at 550,000 units annually, down 15.5% in January from its November reading and down 45% from its year-ago period. The peak of new home construction rates reached over 2mm units annually in August of 2005, a number I repeatedly said had to come down. While we’d reach a housing bottom if homebuilders weren’t building any new homes at all, this decreased rate represents another real estate positive.

So with all this good news out there, why am I still projecting a continuation of falling home prices? Inventories, especially the key reading of vacant homes for sale. The reason the number of vacant homes for sale is more salient than those that are occupied is that a home sitting vacant is much more likely to stay on the market until it is sold, regardless of price (as opposed to occupied homes, with owners who might simply pull the listing if they don’t like the price). Because the owners of so many unoccupied homes are banks, they are especially motivated to hit the bid on a property.

Data released this month show there are currently a record 19 million U.S. homes that are sitting vacant. Of those empty homes, 2.23 million units are on the market—another record. The share of empty homes for sale rose to 2.9% in the fourth quarter of 2008, the most since data recording began in 1956. And according to FDIC data, U.S. banks owned $11.5 billion worth of homes—a figure which stood at just $5.4 billion a year ago!

Additionally, at the end of 2008 the supply of new homes hit an all time high of 12.9 months. Thus, despite all the “good news” on the home front, the supply of both new and vacant homes for sale remain at all-time highs.

Now, some good news was registered in existing homes, as the supply dropped to 9.3 months, down from 11.2 in November of 2008. Still, even this number represents about twice the amount needed to bring about price stability.

The reason there is an intractable level of homes for sale clearly stems from the faltering economy, which is causing massive layoffs and skyrocketing unemployment. The rate is currently 7.6%, a 17-year high. This compels homeowners (many of whom owe more on their home than it is worth) to walk away from their properties. After all, how much motivation do home owners need to abort if they are already upside down on the home and now find themselves without a job?

Home prices and mortgages rates may have to fall well below historical levels in order to clear away the massive buildup in inventories, and it’s a condition which may need to exist for a protracted period of time before home price stability can occur.

Until home prices stabilize there can be no stemming the decline of bank assets. Until bank assets stop falling, there can be no real healing in the stock market or the economy.

Today we got the latest round of bailout babble from the Treasury Department. In this newest bank bailout plan, there is supposed to be yet another attempt at stemming the rise in foreclosures with a $50 billion forbearance package. In their continued effort to abrogate the market, however, government stubbornly chooses to ignore the obvious: what took years to build into a bubble will take years to reconcile.

Healing takes time, but that is not part of our new administration’s plan to fix the real estate market. Instead, like his predecessor George W. Bush, the Obama team feels it is better to artificially prop up home prices at an unsustainable level rather than have them retreat to a price that can be supported by the free market. But then again, isn’t this just more evidence that the idea of free market capitalism is being trampled—by both parties.

Published on Wed, Feb 11 2009, 10:37 GMT

Any Hope for Job Growth?

Thu, Feb 5 2009, 09:22 GMT
by Michael Pento

Delta Global Advisors, Inc.

This Friday’s release on nonfarm payrolls will shine a burning light on our nation’s need to promote growth and create new jobs. After losing 2.7 million jobs in 2008, projections are to start off 2009 with a 500 million reduction in payrolls. The unemployment rate which closed the year at 7.2% is expected to climb to 7.4% in this latest report.

The reason for the continued pessimism in employment trends can be derived in the recent job cut announcements from U.S. major employers. For example, in January alone these companies announced work force reductions in the following percentages; Eastman Kodak 18%, Caterpillar 18%, WellPoint 36%, Rohm & Haas 59% and Circuit City 100%. According to the Wall St. Journal, a small sampling of just 52 listed firms announced a total of 241,300 job cuts thus far in 2009.

The Obama administration’s response to creating jobs is a massive government debt and spending regimen that will, in his aspirations, create 4.1 million jobs—a number which has itself grown from just 2.5 million this past fall. His plan ignores both economics and history.

What helped turn the great recession into the Great Depression was the Revenue act of 1932. The act raised rates on income, estate and corporate taxes. The result was a maximum unemployment rate of 20% and a net change of GDP of -18.2% between May of 1937 through June 1938—nine years after the crash of 1929. There were other exacerbating forces such as a move toward protectionism, but clearly all of Roosevelt’s efforts to end the Depression did not bring about an end to unemployment or a return to trend G.D.P. growth even towards the beginning of WWll.

That’s because growth does not come from money printing or government deficit spending. It comes from encouraging the private sector to create new technologies and innovations that expand the amount of goods and services available for consumption. That can only be achieved by incentivizing the private sector to take risks (tax cuts). It also requires low interest rates that themselves can only truly be provided through sound monetary and fiscal policies.

Investors understand the true derivation of growth and they understand that some things take time and cannot be forced or manipulated to occur by a central planning authority. They understand that the private sector is best at creating jobs that are viable and accretive to economic growth. Perhaps that is the reason why investors greeted the New Year with the worst January performance on the S&P 500 and Dow Jones Industrial average ever.

Consumers can always hope for a favorable report this Friday, but the evidence in so far does not offer much hope and the administration’s reaction to the economic malaise promises more pain ahead in the future.

Published on Thu, Feb 5 2009, 09:22 GMT

Today's Interest Rates are Unreal!

Thu, Jan 29 2009, 09:13 GMT
by Michael Pento

Delta Global Advisors, Inc.

I’m often asked the question if rising interest rates will cause downward pressure on gold prices. The answer is yes, but only if those rates are rising in real terms and not in nominal terms only. But an even more important question that needs to be asked is whether or not the Fed will be able to allow rates to rise to a level that provides the market with a positive real return. The answer, unfortunately, is no.

The average gold price increased from $41.09 an ounce in 1971 to $612.29 per ounce in 1980. During that same time frame, the constant rate on the 10-year note increased from 6.16% to 11.46%. But it was not until 1981 that the average yearly price of gold began to retreat. Its average price for that year fell to $458.48, as the interest rate on the 10-year note continued rising to a record high of 13.91%!

It took ten years of steady increases in interest rates before the price of gold started to decline because it was not until then that investors in the Treasury market began to receive something close to a real return on their invested dollars. According to official Consumer Price Inflation data, the rate of inflation which began in the early part of that decade at 3%, then rose all the way to the low double digits in the middle of the ‘70’s, ultimately peaking at 15% in 1980.

Clearly, then, interest rates on government debt securities can appreciate without causing the price of gold to fall because one of the most important factors driving the price of gold is the real rate of return available on Treasuries.

Today there is only a nascent rise in 10 year yields from their low of 2.08% reached on December 18th 2008, to today’s yield of 2.70%. The trenchant difference from 29 years ago is not only the relatively small increase in yield, but that the rise in yield is not the result of a rising Fed Funds rate.

The price of gold began its descent in 1980 from its then record high of $875 per ounce. However, it was during that same time period that the Fed Funds rate went from 4.5% in early 1971 to its all time high of its target between 19-20% reached in early 1981. But today we see this small rise in yield comes without even the slightest hint of an inflation-fighting rate increase from the Fed.

A flat or inverted yield curve exists only when the Fed is aggressively selling Treasuries in order to absorb excess liquidity. This causes rates on the short end of the curve to rise to levels that are at or above those on the long end of the yield curve. In contrast, today Ben Bernanke is buying massive amounts of bank debt in order to keep interest rates low. However, this inflationary practice is causing the long end of the curve to rise as the free market is trying to provide investors with a positive yield.

Regardless of what the Fed does, however, the point is made clear from the current bull market in gold; the yield provided from government fixed income instruments is still below what investors expect the rate of inflation to be.

But here is the unique problem facing the Fed this time. Unlike the Volker Fed—who crushed inflation with unprecedented hikes in the Fed Funds rate—Mr. Bernanke may find it nearly impossible to raise rates without causing massive economic carnage. The reason is clear: the level of debt outstanding in both a public and private sectors has increased to the point where servicing it becomes impossible without artificially-induced low interest rates.

In the first quarter of 1980, the household financial obligation ratio—a measure of household debt service as a percentage of disposable income--was 15.9%. It is now over 19%. As bad as today’s number is, it pales in comparison to the level of consumer debt as a percentage of GDP, which is now nearly 100% of total output. Back in the early ‘80’s, by contrast, it was just over 50%. On the public sector level the numbers are just as grim. National debt as a percentage of GDP has now reached 85% of output, while in 1980 it was a mere 40%.

Just imagine the stress on the consumer and the government that would be experienced if the Fed were to raise rates aggressively, as Volcker did. How could the consumer continue to service his or her mortgage and how could the U.S. Treasury finance the titanic national debt if rates were to increase much above today’s levels?

The problem with inflation is real. The Fed Funds rate is currently at an historic low of 0-.25%. Meanwhile, the increase in the monetary base (high powered money) is unprecedented in history and now stands at nearly $2 trillion dollars, up from just $850 billion in September of 2008. The rate of increase is now over 300% annually. The monetary aggregates (M1, M2, M3 and MZM) have increased by double digit rates on a year-over- year basis and the fiscal 2009 deficit should eclipse $2 trillion for the first time in U.S. history.

This level of debt should lead to an even further expansion of the money supply and cause the rate of inflation to increase significantly. Yet, as the free market demands rates to rise, they must be kept under wrap by an intervening Central Bank that is forced into printing money to keep them low.

But creating inflation in order to keep interest rates low is a diametrically opposing force that cannot coexist for any extended period of time. On the losing side will be government, as free market forces will ultimately prevail in the long run.

So not only can gold appreciate in a rising rate environment, it now seems clear that any increase in rates is a long way off (if the Fed has its way). Thus, the only two bull markets that exist at this juncture are gold and U.S. debt, a condition that cannot last for long either. Investors who believe in the free market have to believe that one of those assets is in a bubble and that one is undervalued, perhaps dramatically so.

Figuring out which one is which seems simple enough to this observer.

Published on Thu, Jan 29 2009, 09:13 GMT

Banks of America

Wed, Jan 21 2009, 09:36 GMT
by Michael Pento

Delta Global Advisors, Inc.

Investors who have been pining for a chance to buy into the beleaguered banking sector may have a bit longer to wait. Just this past Friday holders of Bank of America's (NYSE: BAC) stock were greeted with the reporting of the company's first quarterly loss ($1.79 billion) since 1991. To make matters worse, the company cut its quarterly dividend from $.32 to $.01. The loss prompted a new rescue package totaling $138 billion, which comes on the heels of the recent round of government injected capital of $25 billion last year.

That level of distress has forced the shares of the largest U.S. bank by assets down 74% in the last 6 months. But it's not just BofA that has been suffering lately; the Financial Select Sector SPDR (NYSE: XLF) has nearly 2/3 of its value in that same time period.

So why have financials suffered so much in the past year and is now a good time to jump in? After all, with losses like those it's hard to imagine how the sector wouldn't offer a good opportunity, even if just from a contrarian's perspective. But there are three factors that belie the inclination to pony up new cash at this time.

First, investors must understand that Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), et al could all be named "Bank of America," as they have become de facto wards of the state. Government investment in the financial sector goes hand in hand with government control. That means lending practices, dividend payouts and compensation packages will now be highly influenced by the government. Unless you view the post office or DMV as models of efficiency, this wouldn't seem the best path back to corporate health.

Second, since there appears to be no imminent end to their write downs, many of these banks will likely need to raise yet more capital from the government in the future. More capital injections mean more dilution to the existing shareholders.

And finally, investors must realize that before these financial companies can begin to return profits to their investors, the government must get paid back first.

It is not until the housing market bottoms and the unemployment rate plateaus that the economy can begin to stabilize. That would help place a floor under banks' assets and put an end to their seemingly endless parade of write downs. Only then can investors accurately access the value of banking shares. Until then it is advisable to avoid trying to catch the proverbial falling dagger.

Published on Wed, Jan 21 2009, 09:36 GMT

The Anti−Reagan/Volcker Revolution

Thu, Jan 15 2009, 09:22 GMT
by Michael Pento

Delta Global Advisors, Inc.

With over 2.5 million jobs lost in 2008 and G.D.P. estimates for Q4 projected to fall at a minus 6% annual rate, all hopes are now pinned on an Obama stimulus program that could exceed $1 trillion. Are investors hopes well-grounded in believing a government going further into debt can bring about a sustained economic recovery? I think not, and here’s why:

When a government’s revenue falls short of expenditures it issues debt to pay for the difference. That debt can be sold to the private sector, foreign investors or monetized by the Fed.

If the debt is sold to the private sector, money is merely transferred from domestic investors to the government. Moving money from the private to the public sector usually results in a misallocation of capital. Essentially, this is a voluntary tax increase, but one that requires a true tax increase in the future to pay off the debt. All that is accomplished is to decrease the money available for private investment and to increase the money available for government redistribution. The result is not improved growth but an increase in government control over the economy. Since the U.S. consumer does not have adequate savings at this time, most of the new debt will not be financed from domestic purchases.

If the debt is purchased by foreign entities, you generate an obligation to pay principal and interest in U.S. dollars which must be eventually sold and converted into foreign currencies. This puts downward pressure on the dollar and, hence, upward pressure on inflation. China holds $1.9 trillion in currency reserves of which about 70% are in U.S. dollars. But China has ginned up its own $600 billion stimulus package (a much larger percentage of their G.D.P.) and thus will not likely have the money available to finance our debt to the same degree as it has in the past. A reduced trade surplus along with pressing domestic needs to stimulate their own economy leads to the conclusion that most of our new debt will also not be gobbled up by China.

That leaves the last payment option for Mr. Obama’s deficit spending plan—inflation, since the Fed will be the primary purchaser of the new debt. However, an increase in the money supply from today’s already robust growth levels will not bolster productivity or G.D.P. growth. Any new money introduced into the economy at this juncture should only encourage producers to raise prices rather than boost output. What our government has still yet to learn is that throwing more money at a problem is not the solution and substituting inflation for deflation solves nothing. Economic growth comes from permanently low taxes, low inflation, savings and naturally-low interest rates. Those conditions tend to exist only in an economy where government intervention is waning, not waxing. I remember when government was considered a cancer, not the cure. RIP, Ronald Reagan.

Amazingly, it seems the man credited along with Reagan for laying the foundation for our long era of prosperity, Paul Volcker, is effectively no longer with us, either.

Published on Thu, Jan 15 2009, 09:22 GMT

Is the U.S. a Banana Republic?

Mon, Jan 5 2009, 10:17 GMT
by Michael Pento

Delta Global Advisors, Inc.

Well, agriculturally speaking the answer is no: the United States has minimal banana production and the four leading exporters of the fruit are all located south of the Tropic of Cancer. Sadly, however, once you “peel” away the façade, the U.S. has recently embraced economic policies that could soon lead us to carrying the moniker of “banana republic.” Hanlon, being the optimist that he is, gets a little queasy when I use such phrases, but since respectable figures such as Steve Forbes and Larry Kudlow have even raised the question lately, he’ll hold his nose and indulge me here!

If the current path remains unaltered, our trillion dollar annual deficits and artificially-derived zero percent interest rates could become habitual, leading eventually to the once endemic economies of Honduras, Columbia and others to be our own.

The two hallmarks of a banana republic are very high rates of inflation coupled with substantial government controls over the economy. Those two factors inevitably lead to high rates of unemployment and poverty. The once-mighty U.S. manufacturing base, over 28% of G.D.P. in 1953, is now just barely above 11% of total output. What was once the world’s reserve currency now sadly offers little in the way of interest to our foreign purchasers. And now, since the Federal Reserve has decided it can repeal the business cycle and prevent recessions, the Central Bank has doubled the monetary base in just six months!

Like Hoover before FDR, George Bush’s push towards statist economic policies promises to continue unabated under Barack Obama. Mr. Bush gave us Medicare Part D and a nearly 6-year war against Iraq, which helped increase the national debt by over 85%! Not to be outdone, Mr. Obama plans to hit the ground running with a massive stimulus package that, according to many estimates, could exceed $1 trillion dollars! As the unemployment rate climes to a 26-year high, our government is seeking to replace the private sector’s role in providing market based employment with mandates from Washington.

But the most egregious aspect of our current economic condition is the buildup of potential inflation. Non-borrowed reserves sitting on the Federal Reserve’s balance sheet has jumped from under $2 billion in August of 2008 to over $774 billion as of December 27, 2008. Read that again.

All this high-powered money that’s piling up has the potential to be loaned out over 10 times its nominal amount, and presumably it will--eventually. To put that into perspective, the M2 money stock is now only $8 trillion. Gold prices are trading at nearly $900 per ounce. And even with oil trading down over $100 a barrel since this summer’s high, Consumer Price Inflation was still up 1.1% Y.O.Y. in November. Since another 72% drop in oil is unlikely, imagine how high C.P.I. inflation will go once banks start lending out their excess reserves.

All of the above sets the stage for a protracted period of inflation and economic turmoil unless the U.S. abandons its pursuit of a centralized command and control economy, and decides that savings and production will stem this tide, not more spending and debt.

Against this backdrop, it is hard to conclude that the fundamentals for gold are anything but wildly bullish (gold stocks are worth a look, too, as Scott Wright just wrote).

The only thing we should envy about any banana republic is its climate, not its economy. Until our politicians show signs of understanding this, keep your focus on hard assets.

Happy new year.

Published on Mon, Jan 5 2009, 10:17 GMT

Bond Bubble Hits Manic Stage

Fri, Dec 12 2008, 09:07 GMT
by Michael Pento

Delta Global Advisors, Inc.

This week marked the beginning of what I believe is the manic bubble stage in the nearly three decade long Treasury bull market. On Monday, the U.S. Department of Treasury sold $27 billion of three month bills at a discount rate of .005%. That rate is the lowest since the auction began in 1929. On Tuesday, $30 billion of four-week Treasury bills were sold at 0%! Again, the lowest yield ever recorded for that security.

According to data compiled by Bloomberg, 41 U.S. money market funds have daily annualized yields at or less than .05% including four funds with a yield of zero. If one needed more evidence of this epic bubble, you could find it in the fact that a 2-year Treasury note yields just .8% and a 1 year bill offers a paltry .45% as of today’s trading.

Now there are those who are claiming these yields are justified because we are entering a Japanese-style lost decade of deflation—Merrily Lynch’s chief North American economist David Rosenberg was espousing that belief just this morning on CNBC’s Squawk Box. What Mr. Rosenberg chooses to ignore is that Japan has a tradition of one of the highest rates of savings on the planet. And while their virtual zero interest rate policy may not have caused runaway inflation domestically, it has served to inflate asset prices across the world due to the Yen carry trade.

Many who claim that there is justification for today’s bond yields are the same folks who claimed back in 2006 that home prices had never before in history declined on a national level and any talk of a bubble in real estate was therefore nonsense. Many of them are also the same people who assured you in the year 2000 that prices of internet stocks were fairly priced because they should be valued by the number of eyeballs that view a webpage.

To receive zero percent interest after loaning your money to the government for one month is ridiculous. Even more absurd is to hand over your money for 10 years and receive just 2.64% per annum. In order to believe you will receive a real rate of return on that trade, you have to assume the rate of inflation will average far below the after tax return on that bond--well below 2%!

The fact is, Treasury issuance is set to increase dramatically as our annual budget deficits are projected to be well north of $1 trillion dollars for at least the next few years. Along with the increasing debt supply, there is a huge increase in potential inflation from the expansion of the Fed’s balance sheet and a Fed Funds rate that is quickly approaching zero. Those two factors alone paint a very ugly picture for the direction of bond prices. Manias can last a very long time and become more extended than reason should allow. But wise investors should eschew owning Treasuries and continue to accumulate inflation-sensitive assets, despite their recent corrections; fundamentals are clearly on their side.

Published on Fri, Dec 12 2008, 09:07 GMT

Inflation is No Cure for a Recession

Wed, Nov 26 2008, 09:44 GMT
by Michael Pento

Delta Global Advisors, Inc.

There are some in our government who claim that we face a possible depression if we do not engage in a massive amount of deficit spending and money printing to resurrect the economy. The prescription is intended to cure the credit crisis by forcing banks to step up their lending practices. In their inability to accept or understand the cause of our current crisis in the first place, however, we face increasing odds of a depression as our fearless leaders fight this recession with yet more of the disease itself: inflation.

The recession I have been predicting since January 2006 has arrived, but a depression can still be avoided if we cease these silly government interventions immediately and stop trying to inflate the credit crisis away. Although it sounds heartless—especially to those who just can’t fight their supposedly good intentions to just “do something”—allowing the economic downturn to run its course is not only the prudent tact our government should take, it is the best option for America. If we continue in this effort to artificially prop up the economy, it will virtually ensure our recession turns into a depression—perhaps one more severe than any other in our history.

The catalyst for our current recession was the collapse of an asset bubble that had formerly pervaded throughout the economy. In the wake of the credit bubble, the demand for money waned as a result from strained corporate and consumer balance sheets. The rate of monetary growth shrank not because of a government-directed policy, but because of the private sector’s new desire to pay off debt. If left to market forces, a severe recession would ensue—but a relatively short-lived, healthy reconciliation of market imbalances that would allow for a quicker return to renewed growth.

However, back in the spring of this year when the Fed facilitated the sale of Bear Stearns to JP Morgan, it began a parade of now seemingly endless bailouts, stimulus packages and money printing. What is designed to save us from suffering a depression may be the process which ensures that very condition. It could be the beginning of a devastating inflationary cycle caused by a massive increase in the Federal Reserve’s balance sheet coupled with the explosion of debt issued by the Treasury.

A phenomenon that is facilitating the expansion of debt is the historically low Treasury yields currently enjoyed by the government. The credit crisis along with ephemeral fears of deflation is causing those yields to plummet. That has misled the government to believe it can issue tremendous amounts of debt without consequence.

The insidious thing about inflation is it can allow a government to temporarily prop up the economy by tricking producers to increase output even though the currency is rapidly depreciating in value. In the short term, this inflation could mollify our current economic malaise as the consumer experiences relief from falling asset prices and the economy enjoys an ersatz recovery. However, what starts out as relief will soon turn to panic when consumer prices begin to spiral out of control.

This is because replacing the consumer’s balance sheet with that of the government’s will cause our already mounting debt to soar at an even faster pace than is occurring today. The crisis will become acute when the ability of the government to raise money from foreign sources to fund its prodigious spending ends. Without China’s money to purchase our scores of trillions in debt, the government’s ability to finance its obligations will become compromised. That will further place pressure on the Fed to step up its monetization of the debt. The Fed will also intervene in the Treasury market in an effort to keep interest rates from spiraling out of control. Investment grinds to a halt, the dollar plummets (especially against hard assets) and a depression coupled with inflation--the worst of all possible scenarios--ensues.

This morning, President-elect Obama spoke quite plainly about the need to curtail wasteful government spending. As encouraging as that sentiment is, I wonder if he truly appreciates the size of the axe that needs to be wielded, particularly since he is simultaneously contemplating the next “stimulus package,” the largest one yet and merely one more example of aggressive government borrowing.

History is clear that a country cannot print, borrow and spend its way back into prosperity. The sooner we recognize that fact the less severe our economic pain will be.

Published on Wed, Nov 26 2008, 09:44 GMT

Four Words Obama Will Never Say

Fri, Nov 14 2008, 08:46 GMT
by Michael Pento

Delta Global Advisors, Inc.

Will the new Obama administration offer a solution to our country's short and long term fiscal imbalances? I'm willing to bet four words you will never hear him say during his tenure are "The budget is balanced!" First, take a look at a couple of estimates regarding how great our long term debt will accrue due to the demographic challenges we face. According to estimates from a 2007 study done by USA Today, the projected debt for our country could reach $59 trillion dollars because of the unfunded mandates from entitlement programs. And if you think that's scary, Richard Fisher, President and CEO of none other than the Federal Reserve Bank of Dallas, puts the figure in a speech given May 28th 2008 at $99.2 trillion! Medicare parts A & B account for 69% of the debt, Part D for prescription drugs (thanks George W. Bush) accounts for 17%, while Social Security accounts for just 14%. As foreboding as those estimates are for our future, it appears that recent events will preclude any substantive efforts at tackling this looming catastrophe.

The election of Barack Obama coupled with the current economic crisis virtually guarantees that our collision course with the entitlement iceberg will remain unaltered. After all, Democrats have historically railed against privatizing any aspect of our entitlement programs. Not that privatization would provide a panacea for all our long term fiscal imbalances, but clearly something must be done during his new administration. But lest you think Republicans have the high road, I hasten to add the Bush administration was nothing short of a fiscal disaster. Given the recent performance (or lack thereof) from stocks and real estate, it would seem highly unlikely that an Obama administration would propose investing funds into the market. What needs to be done is a massive reduction in entitlement benefits; a phased-in reduction of expenditures until outlays equal receipts is the only viable long term solution to the problem. The problem with such harsh medicine is that it would take trillions of dollars in promises to retirees out of the economy. That would inevitably bring about a severe recession, one that would dramatically lower the standard of living for all Americans and impact quality of life for millions of our elderly population.

The bottom line is that we've made promises to future generations that we can never keep unless we print the money to redeem our obligations. But that would only be accomplished by depreciating the currency until it has lost much of its purchasing power. It isn't any benefit for retirees to send them money that has lost most its value. That "solution" becomes even less viable when you take into account that entitlement benefits are pegged to inflation.

The problems associated with our long term imbalances have been exacerbated by the reduced wealth experienced as a result of the credit crisis. The S&P 500 has lost about 35% of its value in 2008 and home prices have dropped 16% year over year. Making matters worse is the fact that bank lending has fallen sharply, and home equity extractions have plummeted as American's percent of equity in the home as fallen to just 46%--the lowest level since the end of WW ll. That situation will force the consumer to rely on those entitlement programs as a means of survival more than ever before.

According to a report from the Center on Budget and Policy Priorities, Social Security benefits account for 90% of income for 34% of our elderly, and for half of all retirees it accounts for 66% of their income. There can be no doubt how essential our nation's entitlement programs have become for the health of the country. Do you see the rub? We either have to print, tax or cut our way out of the problem but all those solutions carry an undeniable amount of dire consequences to our economy and standard of living. However, some combination of all three will most likely occur and the longer we wait, the worse the situation grows. Quoting from Mr. Fisher, "No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion or receive $99.2 trillion less than they have been promised...the decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight."

If there is one thing investors should have learned from this credit crisis is that the United States will do whatever it can to avoid a recession. Whether it is printing money or socializing a significant portion of the economy, our government will go to extreme limits to avoid dealing with its sins, be they in the past or in the future. The unfortunate consequence of that stance is that it's unlikely the new democratic administration will do anything in a proactive measure to solve the problem. In fact,, the President-elect's proposals will make our problems much worse.

George W. Bush was about as fiscally conservative as Lyndon Banes Johnson but Barack Obama shows no signs of being any more conservative than his predecessor. His promises of "free" education and healthcare, for starters, should only guarantee that the U.S. Treasury Department's announcement that it will borrow $550 billion in the fourth quarter is just the prelude to future deficits to come. As long as foreign central banks continue to purchase our debt and keep interest rates low the problem doesn't seem acute. But net foreign purchase of U.S. debt was about $550 billion in each of the last two years. According to estimates from Goldman Sachs and Moneymorning.com, the Treasury must raise $1.4 trillion in new money in fiscal 2009, which would leave about $850 billion to be financed domestically.

Because we don't have the adequate savings, our annual deficits should lead to much higher interest rates and inflation. We Americans must hope that the Obama administration is honest with the people and makes some difficult choices early in his tenure to deal with our growing annual deficits and long term debt. But as history reveals, we have a habit of only dealing with a problem when we have no other choice.

Published on Fri, Nov 14 2008, 08:46 GMT

The Debt vs. Interest Rate Conundrum

Fri, Oct 17 2008, 07:57 GMT
by Michael Pento

Delta Global Advisors, Inc.

I’ve written before about the dramatic rise in fixed income rates that face investors in the very near future due to the funding issues associated with our entitlement programs coupled with the incalculable measures taken by the government in the past few weeks to stem the credit crisis. Those efforts ensure the amount of Treasury issuance will explode.

One of the major ramifications of having our national debt move above the $10 trillion mark is that the sustainability of the government, consumer spending and the economy rests on the continuation of artificially low interest rates. In fact, low rates that are the result of money printing have become our addiction.

In last week’s commentary I pointed out that it now takes about 10 cents on every tax dollar collected just to pay the interest on the debt. As bad as that is, it is only because interest rates are at record lows that the debt service is still manageable.

The yield on the 10 year note as of this writing is 4.01 %. To illustrate how low that yield is in historical terms, the average constant yield on the ten year treasury going back 46 years is 7.04%. Keep in mind that this historically low yield exists at the same time consumer price inflation has increased by 5.4% over the last 12 months. Why are real yields negative while debt levels are soaring and the monetary base is growing at a 114% annual rate (you read that correctly—114% annualized in recent weeks)? Part of the answer has to do with investors’ mistrust of holding debt that is not backed by the government. But to get to the main reason why rates are so low you have to understand how the Fed Funds rate is set. When the Fed wants interest rates to fall, it prints money and purchases Treasuries as well as other bank assets. Printing money, however, increases its supply and is the definition of inflation.

Can you see the conundrum? The Fed needs to constantly print money and expand the money supply in order to keep their target rate from rising. However, printing money is inflationary and demands that yields rise in order to provide a positive return for fixed income investors. The more they print the less the Federal Funds Rate will rise. And rates, especially on the short end of the yield curve, will most likely stay low—the Fed can only control the target rate for intra-bank lending, but free market short- and long-term rates also tend to be influenced by the central bank’s target rate. Yet the further out on the yield curve you move, the more highly influenced rates are by inflation. It is important to stress that short-term rates have become much more important in recent years as banks and the government have increased the use of short term financing to fund their operations.

The bottom line is this: debts at the public and private levels have risen to the point that in order to insure against default, interest rates must remain at an unnaturally low and negative real level. In order to achieve that artificial level, the Federal Reserve must continually inflate the money supply. How high would the overnight rate be if not for government operations? Well, one of the consequences of the credit crisis is that banks mistrust each other’s assets and are reluctant to lend to one another. If market forces were allowed to operate, intra-bank lending rates would soar just as they did several weeks ago when the Effective Federal Funds rate hit 6%! Clearly the free market rate bears little resemblance to today’s Fed Funds target rate of 1.5%.

However, inflation and low interest rates cannot coexist indefinitely. One will have to give way to the other. It is my view that government efforts to keep yields low across the curve will fail. At some point, the yield curve will start to move sharply higher as short term rates remain relatively low and long term rates soar in response to inflation. It is at that juncture that market forces will prevail and send the economy into the greatly needed recession (or worse) that until this point was held in abeyance by our government. We can only hope this process happens sooner rather than later, as the longer it takes to occur the more severe the economic suffering will be.

Published on Fri, Oct 17 2008, 07:57 GMT

Porky the Bailout Bill

Thu, Oct 9 2008, 09:42 GMT
by Chip Hanlon

Delta Global Advisors, Inc.

Buried in the bailout bill signed into law on Friday was a plethora of tax incentives and increases in government intrusion into our privacy. Following in the spirit of the Patriot Act, this new law now allows the IRS to run undercover operations where they can pose as accountants and offer illicit advice to entrap clients. Additionally, it provides in total over $100 billion in tax exemptions for makers of wooden arrowheads, owners of stock car racetracks, Virgin Island rum runners and others.

Of course, lost in all this nonsense is one forgotten word: DEBT. This administration’s unprecedented, eight-year spending spree has culminated with passage of this $810 billion bailout package. George W. Bush’s tenure—which featured massive increases in government spending--has led to the national debt ceiling being raised seven (7) times! In fact, the limit on the nation’s debt has now been authorized to reach $11.315 trillion.

Under Mr. Bush, the debt has increased by $5.7 trillion or 75%, to reach a record of over $10 trillion. Currently, about ten cents on every tax dollar goes to paying just the interest on the debt, and that number is projected to skyrocket. According to the Congressional Budget Office (CBO), interest on the debt alone will grow to 12.4% of our entire GDP by 2050. With annual deficits ballooning to nearly $½ trillion, that estimate might actually be much too optimistic! Even more frightening is the estimate that by the same year, the nation’s total debt will reach 246% of GDP. Putting things into perspective: that number is now only about 40%.

One can only wonder why the government would pass a bill that would dramatically increase the annual deficits against our nation’s backdrop of ever-increasing obligations. Whom do they think will pay for it all? The U.S. consumer doesn’t have the savings. Surely the Japanese and Chinese who currently own about 42% of foreign Treasury holdings will probably not; we simply cannot count on the continuation of foreigners to fund our spending.

As I have been warning investors for years, the increasing need for the Department of Treasury to greatly expand its debt issuance will bring about two pernicious consequences. The first one is a falling price accompanied by sharply rising yields. The second is a falling US dollar—which may not be empirically observed today on the foreign exchange market but will become blatantly obvious when compared to hard assets. This process feeds on itself as foreign selling begets falling prices which begets further selling. Treasury yields will ultimately soar in the above scenario, even if the Fed is the primary purchaser of the debt.

Of course, politicians and market pundits will claim that deficits don’t matter and there is nothing to worry about. Remember, these are the same people who claimed that the current crisis was only a subprime problem and was well contained. Astute investors should prepare now for the coming economic cycle which will be characterized by much higher Treasury yields, runaway inflation, higher taxes and a significant increase in unemployment.

As can be plainly seen already, the “bailout” bill was nothing of the sort.

Published on Thu, Oct 9 2008, 09:42 GMT

From Russia, With Lumps

Thu, Oct 9 2008, 09:32 GMT
by Chip Hanlon

Delta Global Advisors, Inc.

After taking yet another beating on Monday, Russia found its stock market down 60% on the year-- sixty percent!

Citigroup recently suggested that investors put 55% of their portfolios in foreign markets. And there are those who have long recommend even heavier foreign exposure, saying that the rest of the world would hardly notice-- or somehow be better off--if the U.S. experienced a sharp recession on the back of a housing burst. Decoupling was always a fanciful idea, but one that looks particularly silly in retrospect.

What's the additional risk factor investors forget when looking overseas? Currency risk. Keep in mind: if you hold an overseas stock that's flat while its currency declines 25%, you're down 25%, as well. Look at the New Zealand dollar's action this year, for example:

The Kiwi's fall has been nearly 25% this year.

For example's sake, let's roughly call the Kiwi's fall as having been from $.80 to $.60 this year. Using such numbers, then if you held a N.Z. stock worth $10 when the currency was at $.80, then in U.S. dollar terms it was worth $8/share. Even if that stock held flat at $10 NZD, it would only be worth $6/share U.S. due to the Kiwi's fall alone--you're down 25% just like the New Zealand dollar.

Now, let's make it more real-world: what if the stock declines 20% at the same time the currency is falling? Now you're down 40% in total. How? You started with a stock that had a U.S. dollar value of $8 ($10/share NZD X a currency rate of $.80). You ended up with a stock at $4.80/share ($8 NZD share price X a currency of $.60).

Bang.

Just as with the dot-com mania and the housing bubble, I think a lot of investors forgot this reality the last couple of years because foreign stocks and currencies had been on the rise together, leading to outsized returns.

What those investors lost sight of was that even a seemingly benign, Western market like Australia, which after Monday's close was down "only" 30% in local terms, has delievered a black eye to unwitting American investors, because it's down nearly 45% in U.S. dollar terms. It'll take a heck of a lot more rallies like Tuesday's, where a surprise 1-point rate cut lifted Aussie stocks, to make up for such whoopin'.

Hey, our firm focuses on international markets, but putting 55% or more of an American investor's portolio overseas is aggressive, to say the least.

Emerging markets offer the most exciting economic growth potential in years to come. At the same time, they still offer the most risk... something to keep in mind when wading back in.

Download full New Commentary with charts

Published on Thu, Oct 9 2008, 09:32 GMT

Bill Gross Should be Ashamed of Himself

Thu, Sep 25 2008, 09:16 GMT
by Chip Hanlon

Delta Global Advisors, Inc.

I just got the chance to read the op-ed penned by Pimco's Bill Gross in this morning's Washington Post. Wow, have you read this mess?

He did get one thing right, and he backed up his math well enough: the government could potentially make some money on this plan by buying up securitized debt instruments at deeper discounts than they should otherwise be trading. But that actually points to a key, lynchpin part of the problem: mark-to-market accounting is undoubtedly preventing many free-market speculators from purchasing such securities today due to what it would immediately do to their balance sheets. Thus, government may get to scoop up this paper at a deeper discount than is warranted due to its own accounting rules! Ay, yi yi.

Other than that, some lowlights from the truly Gross editorial:

"Finance has run amok because of oversecuritization, poor regulation and the excessively exuberant spirits of investors..."

Actually, it ran amok because political leaders pushed Fannie and Freddie into the subprime arena, followed by Greenspan's ultra-low interest rate policy. When he had the Fed Funds rate at 1% and the market put the 10-year Treasury near 4.5%, it was modern American history's steepest yield curve in percentage terms. Thus private industry, which exists for one reason--to maximize profits-- had a D.C.-created incentive to lend to anyone with a pulse. And it did.

This doesn't excuse the shoddy lending practices some in the industry engaged in-- nor the home buyers who willingly participated, yet somehow remain unindicted co-conspirators-- but Gross seems to blame the market, with government's fault being merely one of a lack of oversight. Going on, he writes:

"Democratic party earmarks mandating forbearance on home mortgage foreclosures will be critical as well."

How, exactly, will the Depression-era solution of a foreclosure moratorium aid credit markets? Tell a lender he has no recourse should a borrower stiff him and let's just see how much he'll lend.

"If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed."

Again blaming free markets, not government.

Going back to his math on how the government might actually make money on the deal: if he's so confident in his thesis, why not lobby Washington to fix its accounting rules so Pimco and its more than $800 billion in assets can back up the truck and buy the paper itself?

Published on Thu, Sep 25 2008, 09:16 GMT

The Picture Must Get Uglier Still

Mon, Sep 22 2008, 10:50 GMT
by Michael Pento

Delta Global Advisors, Inc.

Despite the incessant, nauseating calls for a bottom in real estate and banks, financial firms now find themselves in their most vulnerable conditions since the credit crisis began last summer. Just this week alone we were given three data points that help underscore just how precarious a situation these companies are in.

Wachovia Bank corp. reported that its non-performing assets soared to $11.9 billion in Q2 2008 from just $1.9 billion a year earlier. Obviously, Wachovia is not alone in experiencing the deterioration in this key metric. As more loans become insolvent, more homes will become part of the existing home inventory. This will place further pressure on the mortgage backed securities market as well as real estate prices, and so on.

To add to the pressure banks are experiencing from their real estate assets, credit card payments that are 30 days or more overdue soared to a 4 ½ year high. Why? After banks tightened lending standards on home equity loans and equity lines of credit, consumers began to lean on their credit cards to bridge the gap between income and debt service. Not only do these loans carry a much greater rate of interest, they are also unsecured lines of credit to the banks. Now that the bill has come due, consumers find themselves increasingly without the means to remain solvent by relying on this type of loan.

Meanwhile, commercial bank borrowing at the discount window reached a record high in six of the last eight weeks. The Fed also injected $70 billion in one day (the most since the September 11th terrorist attacks) and the effective Fed Funds rate hit a record high of 4 percentage points above its target rate of 2%. These are all indications that banks are hoarding cash at record levels. When banks undergo this level of duress, they do not create loans for consumers to buy more houses and cars. They instead must hold on to cash as they seek to repair their balance sheets. This puts further pressure on asset prices and hence further pressure on bank assets.

I could go on and discuss the blowing out of credit spreads e.g. TED and LIBOR OIS spread, but it should be clear that both the financial sector and housing market are still very far from making a bottom. The real estate market--much like water seeks its own level--will eventually reach a point that reconciles the imbalance between household income and price. Once that level has been achieved, the financial industry can stabilize and the economy should regain its footing. In the meantime, we can only hope that those in the administration and at the Federal Reserve realize that in the end there is no such thing as a bailout. Merely placing distressed assets on the taxpayer's balance sheet is no panacea. In the long term markets will always prevail and the sooner we let them work the quicker we will find a resolution to this crisis.

Published on Mon, Sep 22 2008, 10:50 GMT

Another Late−Summer Natural Gas Low?

Mon, Sep 22 2008, 08:31 GMT
by Chip Hanlon

Delta Global Advisors, Inc.

In mid-July, I warned that natural gas prices were likely to head lower under typical seasonal pressure, but how's it acting now?

At first glance it looks like gas may be making yet another late summer low, just as it has done in every normal year this decade. I say "normal" year because natural gas didn't make a late-summer low in '05, but that was due to Hurrican Katrina. Take a look:

Looks like we've set up for another autumn bump in natural gas prices right? Maybe. Here's a closer look at recent price action via a 1-year chart, though:

The deeply oversold conditions of the last few weeks have been worked off slighty while nat gas has headed... lower. That's not good technical action.

Fundamentally, inventory data like today's supply build is really tough to rely on for more than a very short-term impact on price. It's more important to look at big picture issues like the fact that global gas consumption has continued to grow despite elevated prices (positive), the return of the North American winter (typically a positive) and the attractiveness of nat gas as substitute for oil (an increasing negative given crude's recent decline), then just understand that bigger price whipsaws will occur due to weather, a reality unique to natural gas.

So, it is reasonable to think we're putting in another late-summer low and that natural gas is a buy right now? I'd say that's a trade for more aggressive types only, and they could look to scale in via the gas ETF (NYSE: UNG) or gas-focused energy trusts like Advantage (NYSE: AAV) or Toronto-listed trusts like Progress Energy (TSX:PGX-UN) or Paramount Energy (TSX:PMT-UN).

Given the lack of traction in commodities prices (except precious metals), however, more risk-averse investors might be wise to sit tight and wait for better price action in natural gas to believe it's living up to its seasonal pattern.

Published on Mon, Sep 22 2008, 08:31 GMT

A Legacy of Inflation

Mon, Aug 11 2008, 10:10 GMT
by Michael Pento

Delta Global Advisors, Inc.

It amazes me how many investors are now concerned about a deflationary spiral occurring in commodity prices. They site oil prices that are slightly off all time highs or a falling CRB index as their examples. While it is true many commodities are off historic highs, it is hardly reasonable to project a continuation of falling asset prices given the state of the banking sector and the consumer.

I know that sounds counterintuitive given the current state of the credit crisis, but it is exactly that crisis and the Fed’s response to it, which will soon forge the path to inflation rates the likes of which have never before been experienced in this country’s history. The most important question investors must ask themselves is how inflationary is the current 2% Fed Funds rate?

In a real economy, low interest rates are the product of a high savings rates. When consumers defer consumption, banks find themselves flush with cash, they then lower rates to attract consumers to take on new debt. Likewise, when banks are short on funds they raise rates in order to preserve capital. This is the natural flow of interest rate cycles. But under a fiat currency system, as we made the mistake of embracing in 1971, all logic leaves the system. To give you a historical perspective, look at the chart below of the Fed Funds rate since 1958.

We see from the above chart that the key overnight lending rate is at its lowest point since the years immediately after 9/11. And before that emergency rate was achieved, you have to go back to 1962 to find a commensurate level. It is important to remember that 46 years ago we did not have a 100% fiat currency system, so the 2% rate was a much more realistic and natural level of interest to charge. Notice most importantly, the long term trend of falling interest rates after Paul Volker took rates above 18% in the early 80’s. His mission was clear, to absorb the excess liquidity in the banking system and economy.

The next chart below shows our love affair with consumption and debt rather than savings. Keep in mind the government seems to want to promote more of this behavior at any cost. For example, this summer’s stimulus checks were unpaid for and temporary in nature. Since producers don’t change long term production plans, these temporary gimmicks only promote inflation and increase deficits. In fact, recent official projections are that the deficit will reach $490 billion in 2009.

The key metric here is that total debt as a percentage of disposable income was a mere 60% back in 1962. Today, we have debt levels at an all time high of 135% of disposable income and growing at unprecedented rates. The Fed must be very careful not to have rates rise too high and choke off the ability of consumers to service their debt.

The last two charts below show the decline in the personal savings rate. The first shows the decline from 1950-2005 and the second is a close up view of the last 8 years. This illustrates just how artificial and inflationary a 2% Fed Funds rate is.

According to the National Income Product Accounts (NIPA), we find that back in the early 1960’s consumers saved about 8% of their disposable income. During the early 1970’s it averaged about 9.5% and in the early 1980s it averaged close to 10.5%. Today we save about zero % of our after tax income. The savings trend of the American consumer is in a free fall yet we find that interest rates have followed that downtrend lower!

These statistics hammer home the point of how unrealistically low a 2% funds rate is today. It can only be achieved by massive injections of fiat money printing from the Federal Reserve. Since consumers are mired in record debt and are not adding to their savings, the Fed has been the sole provider of banking liquidity.

We have seen this play before. After the bursting of the equity bubble in 2000, the economy entered a slowdown that was combated by the Fed with a 1% Funds rate. A short and shallow recession ensued but was followed by the biggest bubble in our history—the real estate frenzy. While it is possible commodities may experience a continued pullback after their record advance, I believe it should be welcomed as an opportunity to purchase them at bargain prices. These ersatz interest rates have always led to inflation and will continue to do so to an even greater degree in the future.

Those that are in charge of our economy have come to the conclusion that the only way out of the collapse of this latest asset bubble is to create another one. This time however, the consumer is completely without any added savings. Therefore, the ridiculously low rate of 2% is more inflationary than at any time in our history. The Fed has come to believe that the economy cannot tolerate a real interest rate because debt on the private and public level has become intractable. Knowing this, can you really start believing in a 1930’s style deflation? Protect yourself by owning something the government can’t devalue by decree. Unless the government perfects alchemy, buy gold.

Published on Mon, Aug 11 2008, 10:10 GMT

The Mysterious Ways of Bond Investors

Wed, Jul 2 2008, 15:53 GMT
by Michael Pento

Delta Global Advisors, Inc.

It has become apparent to me that investors who continue to place money in the U.S. Treasury market don’t have any idea how to protect themselves from inflation or how to achieve a real return on their investments. Even though inflation is running at a multi-decade high (according to official government numbers), we find that these fixed income investors were willing to send the yield on the 10 year note to an historical low of 3.38% on March 19th of this year. As amazing as that sounds in a world of 4+% “official” inflation rates, it was nothing compared to what happened just last month.

To illustrate how off base and directionless these investors can be, let me point to Ben Bernanke’s rhetoric about the dollar and inflation in a speech on June 3rd and the bond market’s reaction to it. On that day, the yield on the 10 year Treasury was 3.92%. Then, during a speech to an international banker’s forum he made the following statements, “In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in the foreign exchange markets.”

He continued, in reference to the long term picture for the dollar, “…the Federal Reserve’s commitment to both price stability and maximum sustainable employment and the underlying strength of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.”

Never mind the plethora of economic fallacies that exist in those two statements—like the U.S. has actually had a strong and stable currency or how the Fed can even know, let alone provide for, maximum sustainable employment—but the point here is what was the bond market’s reaction to his comments: in just 10 days, the yield on the 10 year note shot up to 4.27%.

The reported reason? Finally, the Fed was being viewed as hawkish on inflation and would send the Fed Funds rate up in the near future in order to stop the dollar’s decline.

So let me get this straight: the Fed was going to start fighting inflation and that is what sent rates higher? In reality, lower inflation rates should send bond yields lower! The only conclusion to reach is bond investors needed Ben Bernanke to remind them that a lower dollar is inflationary and that they should now start worrying about accepting such a low yield from their investments.

Later in June, of course, the Fed took a pass on backing its words with actions and left interest rates unchanged. The counter-intuitive reaction of the bond market in this instance? The yield on the 10 year dropped from 4.12% down to 3.91% as of July 1, 2008.

Unbelievably, the Fed’s tacit statement that it is now powerless to fight inflation or protect the U.S. dollar was greeted by a flood of buying in the Treasury market! I understand that much of this move in Treasury yields is a flight to safety, but there have been much safer and more profitable places to hide. Yet one must think in terms of real returns to understand this, a notion apparently foreign to the bond market.It is impossible to predict when fixed income investors will finally demand a positive return on their investments, but if we continue down this inflationary path the erosion of investors’ buying power will force them to flee those paltry yields

For now, the fact remains that inflation is increasing while the yield on Treasuries is falling. It is a situation which mystifies me, yet I remain convinced it is an unsustainable condition; thus, it is of the utmost importance that investors position their portfolios to avoid the carnage that will likely ensue when the bond bubble finally bursts.

If fixed income investors desire to protect themselves from the ravages of inflation, they need to look no further than gold, which has increased 44% in the last 12 months alone. In light of the low nominal yield--and the negative real yield of 10-year Treasuries—there is no comparison.

Published on Wed, Jul 2 2008, 15:53 GMT

The McDonalds Falling Dollar Menu

Tue, Jun 3 2008, 12:57 GMT
by Michael Pento

Delta Global Advisors, Inc.

McDonalds Corp (MCD) held its annual meeting last Thursday, May 22nd, and stated it has no plans to tamper with its highly successful dollar menu, which accounts for 14% of the company’s sales. However, The Golden Arches must wish that its dollar menu was on the McGold standard instead of being based on a currency that has fallen 40% in the last 6 years. That dollar decline is putting the squeeze on the Oak Brook, Illinois-based firm, as agricultural input prices are surging while consumer food prices are only up about 4% since last year.

Indeed, the price of food ingredients has risen sharply in recent years. Since the start of 2006, rice is up more than 200%, wheat more than 130% and corn has increased 125%. Meanwhile, the World Bank has stated that average food prices are up 250% since 2002.

Unfortunately, the future also looks bleak. According to projections from McDonald’s itself, the price of cheese should increase another 13-14% in 2008 alone. While it is true the higher input cost of agricultural commodities is partly due to wealthier consumer’s diets in developing economies as well as the ethanol phenomenon, the falling dollar is responsible for much of the elevated prices in many commodities. For example, if the US dollar kept parity with the Euro the price of oil would be just over $80 a barrel instead of $133 where it is today.

One must wonder how much longer the dollar menu can be priced in dollars. Perhaps a suggestion would be to price the menu in Euros. However, what is more likely to occur is that they will keep the menu at par and use something akin to reverse hedonics.

Hedonics, of course, is a method used in the calculation of the Consumer Price Index which reduces prices for improvements made in the quality or features of a good or service. In the case of McDonald’s it may be necessary to reduce the quantity or quality of items on the dollar menu in order to maintain the price. If neither of those methods is employed, it is reasonable to deduce that a serious compression of the company’s margins would occur and impact their earnings going forward. The bottom line is that the consumer will most likely be hurt by reduced quality, higher prices or a combination of both.

The company’s CEO Jim Skinner said last week that they would try to allay higher food costs by speculating in the futures market. While I’m not at all confident investors can count on the trading skills of Ronald McDonald to defray higher input costs, Skinner himself admits that not all costs can be offset. Under this environment of pricing pressure, it is astonishing that the company’s stock is up 15% year over year and has a trailing P/E multiple of nearly 20. Aside from its international growth prospects, the most plausible explanation is that the highly stressed consumer is downsizing his cuisine standards and switching from more upscale dining.

Still, the company faces very difficult choices as it struggles to maintain cost and quality. Will McDonalds’ costumers soon borrow a slogan from Wendy’s and ask, “Where’s the beef”? To maintain its dollar menu, diners at McDonalds may have to look forward to eating hamburgers containing a series of ever-smaller concentric circles as their patties suffers from the dreaded “shrinkage.” Unfortunately, to maintain its dollar menu, the company may have to become a microcosm of America’s shrinking standard of living.

We all have a lot to worry about indeed when the US dollar loses value against the Happy Meal.

Published on Tue, Jun 3 2008, 12:57 GMT

Getting Real with GDP

Mon, May 19 2008, 15:04 GMT
by Michael Pento

Delta Global Advisors, Inc.

With the release of last week’s Consumer Price inflation numbers, the debate over the accuracy of the government’s reported Consumer Price Index data was once again front and center. The official numbers showed that the overall rate of consumer inflation rose .2% while the over-hyped core rate rose just a paltry .1%.

However, these incredible April numbers were the result of a seasonal adjustment that removed much of the increase in gasoline prices. Unbelievably, the report claimed that consumer’s energy costs were unchanged while the actual price of crude oil rose about 12.5% and gas prices rose 11% during the same period in question—that’s some adjustment!

One of the reasons it is imperative to accurately calculate inflation is that you need a true reading on price increases in order to get a true reading on economic growth. If we used an accurate inflation rate to deflate nominal G.D.P. it would have certainly settled the argument as to whether we or not the economy is in recession. Since most investors are bound by official government data, I thought it would be worthwhile to use the Consumer Price Index to derive real G.D.P. rather than the chain type price index—which is an even more tortured inflation measurement than the C.P.I. The reason why the C.P.I. is a better estimate of inflation than the chain type price index is the chain type index allows substitution between categories, while the C.P.I. is limited to substitution within a specific category.

The following graphs show G.D.P. growth rates using the chain type price index, annualized quarterly growth rate in C.P.I. and the year over year growth rate in C.P.I.

Download full New Commentary with charts

Published on Mon, May 19 2008, 15:04 GMT

Will the Fed's Rollercoaster Ride Save the Dollar?

Thu, May 1 2008, 08:50 GMT
by Michael Pento

Delta Global Advisors, Inc.

Why we Americans ever abdicated our financial freedom to a group of 12 unelected individuals who sit on the Federal Open Market Committee, is beyond me. That being said, we are stuck with a system that allows an unaccountable and unconstitutional institution dictate the appropriate level of interest rates instead of the free market. Our founding fathers made it clear that they wanted money to consist of only gold and silver. They did this so as to guarantee that the money supply had intrinsic value and would be limited in nature. This would also allow bank interest rates to be a function of savings vs. demand, not a matter of decree. Because of the above situation, we have been forced to endure a dizzying ride of interest rate gyrations that have created severe imbalances in our economy.

The market has now priced in the end of the Fed’s interest rate slashing campaign that began in the summer of 2007. The prices of most commodities have contracted and the US dollar has staged a minor rebound, anticipating the conclusion of this cycle. The question is, will the downward pressure in commodities continue and should investors expect the end of this interest rate toboggan ride?

To help The following charts show the performance of gold, the CRB index and the Dollar index (DXY) during the period of June 29th 2004 thru September 17th 2007. This is the period of time when the Federal Funds rate began rising from 1-5.25%, and the date when the Fed started this current easing cycle.

Gold:

CRB Index:

US Dollar Index:

We can see from the charts above that despite the Fed’s actions, gold and commodities appreciated in price while the US. Dollar continued in its secular bear market. The reason for these counterintuitive movements is that even at 5.25%, the Fed was still very accommodative in its monetary stance.

Assuming the Fed cuts again today, this recent round of rate cuts will have taken us all the way back to 2%, which is a historically low and highly inflationary level. Fed officials would have us believe that they can take rates higher soon to combat the inflation already present in the economy, but how can anyone take them seriously when the consumer and the economy have become even more leveraged since the Fed caved into saving the housing and stock markets just last summer? Can we really have any confidence in an institution that took rates from 1% to 5.25%, then back to 2% and now wants to move back up again, all in the space of a few years? This is the type of roller coaster action you get when you let a small group of individuals decide the cost of money instead of the market.

Surely, the fate of commodities can be expected to be heavily influenced by the direction of the U.S. dollar. Despite any counter-rally, however, the secular bear market in the dollar should continue because all the factors that lead to a falling currency remain in place—trenchant interest rate differentials, a $700 billion a year trade deficit, a record $9.44 trillion dollar fiscal deficit and a comparatively weak GDP growth rate. Given our recent history and the current state of the economy, gold and commodities should have little to fear.

Published on Thu, May 1 2008, 08:50 GMT

"Hallelujah" for the Falling Dollar?!

Fri, Apr 25 2008, 08:08 GMT
by Michael Pento

Delta Global Advisors, Inc.

Hallelujah, of course, is a word of praise. To use that word to describe the fact that the USD has lost 40% of its value in the last 5 years, however, is economic blasphemy. Yet last week on television I had the pleasure of debating a well known strategist on the fallout of our crumbling currency and his angelic chorus was heard praising the falling dollar because of his belief that it would boost exports, rescue the economy from recession and encourage future GDP growth. Truly, “Hallelujah for the falling dollar!” is exactly what he exclaimed.

How this type of popcorn economics is allowed to permeate the airwaves is beyond me, but we have all endured this kind of rhetoric long enough that it is time to draw a line in the sand to protect our currency. His contention, along with many others, further underscores my belief that if continue on our current monetary course, we will be doomed to further a further, banana republic-style loss of purchasing power. With this sort of thinking today, It should come as no surprise to the U.S. consumer that the price of oil is now approaching $120/barrel and that most commodities are at or near record highs. There can be no mystery as to why inflation is at a multi-decade high.

Let’s be clear: a falling dollar makes all Americans poorer. It not only forces our import dependent economy to experience higher prices, it causes domestic prices to rise as well. But the most pernicious part of our chronically weak currency will come in the near future because it will discourage foreign investment into our economy just when we need it the most. In prior commentaries I have stressed how our future debt obligations will cause tremendous strain on our economic growth, and it is becoming more widely known that our projected entitlement deficits are expected to reach $59 trillion. With no domestic savings, our hopes of prosperity lie in the lap of continued foreign largess.

The trouble with that plan is that foreign central banks already own 53% of our publicly-traded debt. Compounding the problem is that 64% of their currency reserves are already held in U.S. dollars. Having a non-diversified and concentrated currency reserve is an untenable position—how are these foreign creditors supposed to increase their U.S. dollar weightings from here?

By the way, if you think that foreign central banks have no choice but to support our treasury market, listen to a quote made on March 27th 2008 from Kwang Dae-hwan, head of South Korea’s Pension fund (the fifth largest pension fund in the world). “It is difficult to buy more US Treasuries because the portion of our Treasury Investment is already too big and Treasury yields have fallen a lot.”

I would hasten to add to Mr. Dae-hwan’s comments that the value of his Treasuries has crumbled in currency-adjusted terms. The above quote received little attention, especially from those who believe that un-ending deficits are our birthright but just how long can these foreign creditors be expected to support our Treasury market, struggling currency and reckless spending habits regardless of how it affects their economy?

It would seem prudent to me that the U.S. should do everything in its power now to strengthen the currency and boost domestic savings, especially in light of the amount of Treasury issuance which will be needed in the near future as Medicare and Social Security really come home to roost.

Hallelujahs aside, it is without question a horrible tradeoff to suffer runaway inflation and a stagnant economy in the simplistic name of boosting exports—especially in view of the fact that manufacturing today represents little over 10% of U.S. Gross Domestic Product.

Unfortunately, it appears the chorus in praise of currency debasement is growing louder even as the dollar continues to sink. If Wall St. and Washington, D.C. continue to worship at the feet of crumbling currency, it won’t be long until their Hallelujahs fall silent against the crashing wave of hyperinflation.

Published on Fri, Apr 25 2008, 08:08 GMT

Encouraging Action for Gold Bulls

Wed, Apr 23 2008, 09:06 GMT
by Chip Hanlon

Delta Global Advisors, Inc.

When discussing gold and commodities on CNBC last month, I said I expected gold to underperform commodities such as energy, base metals and agriculture for a period of time. While that scenario has played out and will likely continue to for a little while longer, gold bugs should be encouraged by how the precious metal has performed in recent weeks; while gold was quite overbought on a short-term basis a month ago, it has very quickly moved to a less overbought state while giving back only about 10% of its price as we speak. That’s bull market action.

Now, this correction could go on awhile longer and I don’t consider a downside target between $800-$850 to be out of the question, but we may only end up seeing a time (sideways) correction in gold much without much more downside in terms of price. 3-year chart of gold:

As you can see, a case could be made that gold recently looked as overbought as it did at its last important intermediate peak in 2006—although for a number of reasons I don’t consider its recent peak to have been as extreme as that last one—but even if so, it is reasonable to think that most of the price damage that’s going to be done to gold in this correction has already occurred.

At the same time, look at the U.S dollar:

While gold was starting its correction a month ago, the U.S. dollar was very well set up for an oversold rally. What has happened, though? The Greenback has become much less oversold without going anywhere—this should strike any dollar bull as worrisome, weak action. Maybe it will start to get going to the upside from here, but it better do so in a hurry else a break to new lows is likely to result soon.

Should someone without precious metals exposure go piling headlong into a holding like GLD today based on this snapshot? I wouldn’t think so, but those looking to average in over time can start doing so much more comfortably than they could have just a month ago.

Published on Wed, Apr 23 2008, 09:06 GMT

No Bubbles in Riotville

Fri, Apr 18 2008, 07:30 GMT
by Michael Pento

Delta Global Advisors, Inc.

All investors have become contrarians and are now experts in being able to spot bubbles. Hence, they all are fully aware that a bubble exists in agricultural commodities at this juncture. Really, you can listen to just about any financial source and hear someone warning about the epic bubble that is evident in agricultural commodity prices. However, some of these same folks were completely blindsided by the collapse of the tech bubble in 2000. And they also were shocked that real estate prices could ever decline in value. Of course, this new class of maverick investor is also currently incapable of viewing the real bubble occurring in the Treasury market (it doesn’t bother them that real yields on government debt are negative). The only thing they are sure of is that agricultural prices are poised to plummet.

This sophomoric conclusion focuses on just the increase in commodity prices, yet ignores some key factors that must be present for a bubble to exist. For an investment to reach bubble territory there must first be a dramatic increase in the quantity of the investment in question. Once demand contracts, an environment ensues where a massive oversupply imbalance in the investment out strips intrinsic demand by a great degree.

The two most recent actual bubbles offer great examples to this phenomenon. The tech bubble produced massive increases in stock issuance that exceeded the real demand for such equities, and the creation of new shares had a virtually unlimited supply constraint. Likewise, new home construction companies increased production rates to over 2mm units per annum, which grossly oversupplied the intrinsic demand of just 1.15mm units needed to house the growth in population. Once demand returned to historic levels, the excess inventories become a massive overhang on the market pushing prices down precipitously—an environment which persists today.

The question investors must ask themselves is whether a condition of oversupply now exists in agricultural commodities. In fact, the evidence shows just the opposite situation exists. If there was a bubble, the amount of land available for crop production would be expanding rapidly. In actuality, China has lost 6.6% of arable land in the past 10 years. Globally, we have less than half the amount of arable land per capita available for production since 1950. If crop prices were poised to fall, then inventories would be surging, yet we find that inventories for most crops are at or multi-decade lows while stock to-use ratios are also extremely thin. That hardly represents an environment where investors should fear pricing pressures.

The fact is that the food supply cannot be readily increased in short order, and the World Bank would is estimating that 33 countries face civil unrest and riots due to food emergencies. If the price and quantity of agricultural commodities could be easily manipulated, then we would not be seeing shortages breaking out on a global level. The truth is that the demand for these commodities is far more genuine then it was for house and stock flippers.

Although the world’s productive agricultural capacity will one day catch up, land and infrastructure challenges around the globe will make it much more difficult for growers to increase the crop supply as easily as Wall Street was able to flood the market with new homes and equities.

On the demand side, we see that the Global need for food is projected to increase by 50% in the next 20 years. Outside of cutting subsidies for ethanol production, which seems highly unlikely, this projected future demand for food cannot be decreased substantially. Plus, there is no evidence at all that today’s demand for food is artificial or temporal in nature, nor is there evidence that a major supply of crops is about to hit the market.

Ask the citizens of Egypt, Cameroon, Ivory Coast, Senegal and Ethiopia if their demand for food is real or speculative. Bottom line is people don’t riot when all they want to do is speculate, they riot when they are hungry and cannot find or afford food to eat.

No, the increased demand for agricultural goods is real, as is the supply constraint facing the market. Investors may choose to ignore the massive growth in earnings that are being reported by Monsanto (MON), Potash (POT), Mosaic (MOS) and others that service the agricultural industry.

But sorry, no bubbles will be found there.

Published on Fri, Apr 18 2008, 07:30 GMT

Where's the "Protection" in TIPS?

Fri, Apr 4 2008, 08:19 GMT
by Michael Pento

Delta Global Advisors, Inc.

Every investment product on planet earth is designed to at least offer a chance at a positive, real after-tax return. Put another way, all investments are designed to bring you a return that is greater than the rate of inflation. Some offer a higher stated yield because of their inherent risk, while others display smaller yields due to their perceived relative safety. But all true investments are designed to outpace inflation.

It is ironic, then, that the only true investment to ever bake in a negative return after inflation is Treasury Inflation Protected Securities—ironic because the very purpose of TIPS existence, of course, is to provide for a guaranteed real return. In fact, TIPS recently yielded a negative return for the first time since their inception in 1997. The 5-year TIPS note ended February 29th at a -.043% and remained negative through most of the month of March.

Comparing TIPS to a genuine inflation hedge like gold reveals their ineptness as an inflation-protected product. Since President Nixon broke the gold window in 1971, gold has soared from roughly 35$ an ounce to $950 per ounce as of this writing. That equates to an annual return of 9.33%, while TIPS have returned an average annual rate of just 5.4% since 1997.

The standard five-year Treasury Note now yields 2.45%. Meanwhile, today’s 5-year TIPS yield is only a slightly positive .07%, implying that investors’ anticipated rate of inflation over the next five years is just 2.38%. That means investors expect a dramatic decline in inflation rates from the current “official” rate 4.1%-- which itself is likely understated. Such expectations are untenable given the actions taken by the government and Fed over the past 7 months.

In fact, today’s inflation rates should escalate due to the current excessive rate of monetary creation. Money of Zero Maturity (MZM) is currently rising at an annualized rate of 36.8%, while the Fed Funds rate is at a historically low, inflationary level.

As most know, the Fed Funds target is currently 2.25% while the effective Federal Funds rate is now trading at 2.09%. Putting this rate in historic terms, the rate on the effective Federal Funds rate traded above 2.15% in January of 1962 and remained above that rate until November of 2001 when it declined to 2.09% for the first time in nearly 40 years.

Already, this key interest rate is back to the post-9/11, post dot-com “emergency level, a rate which of course engendered the now-defunct housing bubble and today’s secular bull market in most commodities.

All the while, commentators from far and wide have been quick to call the recent commodities correction the actual bubble which has burst. Quite the contrary; given this inflationary monetary backdrop, it is time to take advantage of the recent pullback in precious metals. Investors need to place their money in a real inflation hedge, and that is gold.

Published on Fri, Apr 4 2008, 08:19 GMT

No Tears for Gold

Thu, Mar 27 2008, 10:56 GMT
by Michael Pento

Delta Global Advisors, Inc.

So, the word on the street—both Wall Street and Main Street—is that the rally is over for gold and other hard assets. It’s time to look elsewhere for increasing value, right? Actually, we believe the recent sell off is a blip rather than a reversal of a trend, one which will provide an entry point for those who are paying attention.

Wall Street pundits are cheering last week’s $100 sell off in the price of gold, and investors have turned their back on the gold miners, betting on their downfall. Short interest is up 16% for ABX, 22.2% for AEM and 22.4% for GG between the end of February and mid-March.

But here’s the problem with this premature requiem for gold: it presumes that the cause of falling gold prices is a change in monetary policy and the start of a bull market in the US dollar. That’s a wonderful scenario but not one supported by other events creating pressure on the economy.

First, there’s the Fed’s 75-basis point cut in a single meeting last week. That’s hardly a hawkish move for the dollar. In fact, the Federal Reserve is quickly closing in on the fed funds rate that originally precipitated the commodities rally in the early part of the decade.

Then there is the lending expansion by Government Sponsored Enterprises FHA, FNM, FRE and FHL. Easing of capital requirements and bond purchasing rules for these entities will add around $350 billion to lending capacity.

Let’s face reality: moves by the Fed and GSEs to take bad debt off banks’ balance sheets don’t improve the quality of the underlying assets. Losses will eventually become the responsibility of taxpayers—yet another burden for all of us to carry.

Are we hearing the sounds of more money creation? The eventual sound of the dollar slipping yet further vs. gold and commodities? That’s what I hear, despite the earplugs the Fed and the stock market seem to be wearing.

The recent sell-off in metal was due in part to hedge fund/fast money selling, yet keep in mind that gold is still up approximately 10% for 2008 and up more than 35% over the past 12 months.

I just can’t see what has changed about the fundamental backdrop for gold. A great investment in recent years, we think gold will continue to trend upward once this short-term selling abates. I discuss this rate cutting nonsense, the pullback in gold and more in my new podcast, the Mid-Week Reality Check. Five minutes of sanity in an insane financial world!

Download full New Commentary with charts

Published on Thu, Mar 27 2008, 10:56 GMT

The Patchy Nature of this Credit Crisis

Fri, Mar 14 2008, 08:33 GMT
by Michael Pento

Delta Global Advisors, Inc.

The strange thing about myths is that while some have their basis in truth, for the most part they suffer from a dearth of reality. The same is true about today's well promulgated credit crisis.

First let me admit, there clearly is a crisis in certain areas of the credit markets. For instance, there is definitive evidence of duress for hedge funds that hold Credit Default Obligations, especially in leveraged portfolios. A crunch also exists for mortgage lending companies that must issue asset-backed commercial paper. There also is a crisis evident for consumers with bad credit and few assets. However, at this moment in time, the crisis is mostly limited to the above examples and to the investment banks on Wall Street. The overall commercial banking & lending environment remains quite healthy.

According to Federal Reserve economic data, we see robust activity occurring in most areas of commercial bank lending. The following graphs depict lending activity in four key areas of the economy.

The facts are that for commercial and industrial loans, the year-over-year growth rate in lending is 19%; for real estate loans it is 5%; for Consumer loans it is 8%; and for total loans and leases it is 10%. This healthy lending environment exists even after the banking sector has endured over two years of contracting real estate prices and eight months following the so called bursting of the credit bubble.

I know this runs counter to everything you hear, see and read today but the truth is that while the banks are still lending at historically robust levels, we see the Fed pumping in yet more liquidity through rate cuts and other "tools" like the Treasury Securities Lending Facility. Thus, the Fed's pumping and printing activity today is merely an attempt to compel banks to increase lending even further. If money supply growth is so strong (M3 y-o-y growth is 18%), why try to force banks to lend more? The answer is that the Fed plans on increasing the money supply and real estate loan volume until home prices cease contracting. This is all there is to its ultimate plan for rescuing the economy and balance sheets of investment banks.

Put another way, the Fed is trying to bail out certain investment banks on the back of the currency and at the expense of savers-- simple cronyism in its most base form.

What the Fed and Wall Street do not understand is that printing money never has and never will be able to create true economic growth. Printing money beyond the productive capacity of an economy always leads to higher prices, hence today's inflationary pressures which can no longer be ignored. As more investors come to understand these facts, it is clear why precious metals, energy, the CRB index and the dollar all point to higher inflation. The real crisis exists on Wall Street, and for investors who are unable or unwilling to protect themselves from surging inflation.

Download the full report

Published on Fri, Mar 14 2008, 08:33 GMT

Treasuries vs. the CRB

Thu, Mar 6 2008, 09:40 GMT
by Michael Pento

Delta Global Advisors, Inc.

From 1980 until the spring of 2002, 10-year Treasury note yields held a positive correlation with the CRB index. Since 2002, however, there has been a dramatic divergence between Treasury yields and commodity prices. This trend is unsustainable in the long term because bond yields must eventually reflect rising inflationary pressures and at some point offer a positive real after-tax return.

There can be only two possible conclusions reached when viewing this disparity, shown in the chart below. One is that commodity prices are no longer an indication of inflationary pressures, a ridiculous contention that cannot be taken seriously. After all, the CRB Index contains 19 commodities that include precious metals, base metals, agriculture and energy, broad measures of the pricing pressures that exist in today's economy.

The other conclusion-the right one, in my estimation-is that Treasury securities are grossly overvalued.

Source: Bloomberg

[The 15-year chart above shows the close relationship that existed between 10-year yields (shown above in white) and the CRB index (green) from November 1993 into 2002. The decoupling since that time can clearly be seen here.]

Today's disparity between rising bond prices and inflation are likely the result of bondholders' fears of holding any debt not backed by the full faith and credit of the U.S. Government, but this is a not a disparity that should be able to continue indefinitely. After all, even according to the "official" inflation measure-the Consumer Price Index, which likely understates inflation-buyers of 10-year treasuries are currently getting a negative real return to the tune of nearly a full 1%!

History is clear that we should look for a reversion to the mean, either via a dramatic downward break in commodity prices, a sharp increase in Treasury bond yields or some combination of the two. It is my belief that the continued actions undertaken by the Fed to re-liquefy the banking sector will engender a further increase in inflation pressures and send commodity prices higher still.

As a result, the most likely outcome in this scenario is for a collapse in bond prices as opposed to a dramatic retrenchment in commodities.

In the current economic environment, rising interest rates would exacerbate the decline in home prices and restrict credit availability even further, thus the Fed will be unable to hike rates until any economic recovery is well underway. So, despite the incessant claims over the last few days that commodities are "in a bubble," the risk of falling bond prices far outweighs the risk of falling commodity prices.

While it may be true that commodities are a little overbought on a short-term basis, today's real bubble exists in the bond market.

Published on Thu, Mar 6 2008, 09:40 GMT

Food Inflation Set to Rise Further

Thu, Feb 28 2008, 08:25 GMT
by Michael Pento

Delta Global Advisors, Inc.

There was a clear consensus emanating from the annual U.S.D.A. Agricultural Outlook Forum, which I attended in Arlington, Virginia last week: most in attendance believed that food prices will continue their assent of last year (4%) and perhaps rise by another 3.8%-4% in 2008. U.S. food price inflation will be the result of increasing cost pressures from higher agricultural input prices. These prices, in turn, are the result of strong global demand, continued weakness in the U.S. dollar, the push for renewable energy, low stock-to-use-ratios and global weather that has not been conducive to crop growth in certain regions.

Global Plusses and Minuses

Despite the general concern about rising agricultural commodity prices, there was some good news from the conference, particularly from Paul Schickler, a general manager with DuPont who spoke of technology advances that have been made in plant genetics. He stated, for example, that advances in seed production have led to an increase of 30% in corn harvest yield since the start of the decade. However, the demand side has increased commensurate with supply. Population has increased 13%, income has increased 35% and meat consumption has risen 25% over those same 8 years.

Globally, the two main drivers for the agricultural commodity boom are the appetites from emerging markets and the push for increased use of bio-fuels. That’s not news, but what is new this year is that China, Russia and India have made policy moves that should bolster U.S. prices in 2008. These countries have raised export duties while simultaneously lowering import duties on many agricultural commodities in an attempt to satisfy the demand inside their own booming economies. For example, starting January 1, 2008 China raised export duties 25% on wheat flour and starch and added a 10% charge to outgoing rice, soybean and corn flour shipments. India, meanwhile, removed a 36% import duty on wheat flour until April 2009 and Russia raised export duties on wheat from 10% to 40%!

Ag as an Energy Resource

Meanwhile, despite the fact that rising corn prices are making ethanol increasingly un-economic, the U.S. is upping the ante on bio-fuels. The mantra from the USDA, which dreams of creating an energy-independent America, was that we must break the economy’s addiction to oil. This explains the 60 ethanol plants currently under construction to go along with the 140 already in existence here. Indeed, last year’s 6.5 billion gallons of ethanol produced in the U.S. is projected to reach 8 billion in 2008. And the goal of this government agency is to take 1.2 million traditional gas vehicles off the road next year while helping to increase the production of ethanol from cellulose, as well.

Worthy goals, perhaps, but of paramount importance at this conference were Robert Dinneen, President and C.E.O. of the Renewable Fuels Association and Dr. Roger Conway of the Office of the Chief Economist from the U.S.D.A. Their contention was that it takes only .7 gallons of fossil fuel to produce a gallon of ethanol.

Here there exists much debate. According to the International Monetary fund, for example, it takes .82 gallons of fossil fuels to create a gallon of ethanol—some yield!

Yet the story might be even worse. According to David Pimentel of Cornell, it takes 29%, more fossil fuel to create a gallon of ethanol than energy yielded from the resulting fuel, a net energy loss! Cellulose and wood biomass seem even less efficient, requiring 45% and 57% more fossil fuel energy than they yield, respectively!

Included in Dr. Pimentel’s analysis are the costs associated with producing the crops including fertilization, irrigation, transportation and processing. Not included in his assessment are the costs for Federal and State subsidies or the costs associated with any resulting environmental pollution.

This professor and ecologist was quoted as saying, “The government spends more than $3 billion a year to subsidize ethanol production when it does not provide a net energy gain, is not a renewable energy source or an economical fuel.” He has also stated that ethanol production leads to natural gas and oil imports and U.S. deficits. And these doubts don’t come from someone who’s biased against alternative fuels; Dr. Pimentel endorses the use of wind power and photovoltaic cells in lieu of ethanol fuel.

How Best to Invest in Agriculture

Economics be damned, we’re apparently going to keep flushing money down the ethanol toilet, which will continue to put upward price pressure on grain prices at precisely the wrong moment in history, but so be it—we must simply focus on how best to invest in this trend, then.

Along these lines, I wanted to highlight one other interesting set of comments, these from C. Larry Pope, President and C.E.O. of Smithfield Food, whose honesty and candor was quite refreshing to hear. In reference to the current market situation he stated it was “…an unsustainable condition for livestock producers,” pointing out, “input prices have never been higher.” He continued, saying, “There will be a dramatic reduction in meat production and food inflation is set to rapidly increase much higher…it has to happen.”

While I have written in the past about how to invest in this agriculture theme—by owning growers, seed and ag chemical companies—what he said further underscored my contention that investing in livestock companies is a very ineffective way to participate in rising agricultural commodity prices.

This also explains why we avoid including companies such as Tyson (TSN), for example, in the Delta Global Agriculture Portfolio on which we advise (CDGACX); such producers are hurt by rising grain prices.

Attending this year’s conference, then, only strengthened my beliefs in both the bull market in agriculture and in the right way to invest in it. Regardless of whether you agree that the use of food for fuel makes sense, it is imperative not to underestimate the devotion from our government to pursue that endeavor. Investors should continue looking to invest in agricultural commodity producing companies and those that help increase crop yields, as the most likely ways to profit from ongoing food price inflation.

Published on Thu, Feb 28 2008, 08:25 GMT

Don't Bet the Farm on Rate Cuts

Thu, Feb 21 2008, 08:26 GMT
by Michael Pento

Delta Global Advisors, Inc.

The black hole consisting of record consumer debt ($2.52 trillion), falling asset prices, elevated inflation and weakening job and income growth is pulling us inexorably towards recession. As a result, the cacophony for yet more rate cuts has now become deafening. These rate cuts are anticipated to cure all of our ills, from the credit crisis to the Ebola virus. But will the lower interest rates really solve the banking crisis and turn the equity markets around in short order? I thought it would be informative to look at the last two interest rate cycles and compare them to the performance of the equity market.

The monthly average of the Effective Federal Funds rate hit 6.54% at the high point of the interest rate cycle in July of 2000. At that point the S&P500 was trading at 1,509.98. The bottom of that interest rate cycle was in May of 2004 when the funds rate traded at 1%. On May the 14th of ‘04, the S&P traded at 1,095.70--a decline of 414.28 points or 27.43%.

The interest rate cycle began to turn upwards in June of 2004 when the rate went from 1.03% and peaked at 5.26% in July of 2007. In the beginning of that tightening cycle on 6/15/2004, the S&P traded at 1,132.01 and ended at 1,549.52 on 7/16/2007--an increase of 417.51 points or 36.88%.

In this current cycle, interest rates based on the Effective Fed funds rate began their decline in July 2007 and went from 5.26% to the current level of 2.97% as of 2/15/2008. On July 16th 2007 the S&P was trading at 1,549.52 and as of 2/15/2008 was trading at 1,364.72--a decline of 184.8 points or 11.92%.

During the early stages of interest rate cycles, there exists a negative correlation between the Fed funds rate and equity market returns. History is clear that rate cuts from the Fed work with a lag and their cycles may last for several years. Given that this current cycle is only 7 months long, it may be a couple of years before the stock market can make a cyclical bull move higher. If history is our guide, those calling for a market bottom may be a bit premature. I believe in the long run rate cuts will bring about both nominally higher stock prices and much higher inflation, but patience on behalf of bullish investors may be a prudent course of action at this time.

Published on Thu, Feb 21 2008, 08:26 GMT

Recession Debate Turns Toward Inflation

Mon, Feb 18 2008, 09:15 GMT
by Michael Pento

Delta Global Advisors, Inc.

The debate over the "R" word has been the focus on Wall St. for months on end. This obsession over whether the degree of the economic slowdown will in fact reach the technical definition of recession (2 consecutive quarters of negative GDP) is unproductive for the average investor. What investors need to know is that while economic growth is clearly weak, inflation is rising and that the current value of the stock market has not priced this in. Meanwhile, the Fed's response to this crisis is causing great harm to investors and could lead to hyperinflation in the long term.

The current P&E ratio on the S&P 500 is 18.3 times trailing 12-month earnings. The average is just over 15 for the history of the index--meaning it's not dramatically expensive compared to historical norms, but the market is certainly not cheap. What is not debatable is that the U.S. economy is flirting with a recession, if not officially in one and that inflation is at a multi-decade high. This recessionary environment is the result of a slowdown in consumer spending due to a lack of job and earnings growth, falling real estate values and negative equity market returns, while the inflation is the result of unprecedented levels of money supply growth.

Some will say that the government's stimulus package will shorten the duration of the economic contraction and that the economy will rebound in the second half of 2008. Sound familiar? We heard the same prediction in 2007. The truth is that the Fed can only control one rate and that is the rate banks charge each other for overnight loans. The Fed can't force banks to lend and cannot force overleveraged consumers to take on more debt. The point is that any interest rate reductions need time to work themselves thru the economy; giving consumers a one-time check does not force producers to increase the availability of goods and services.

Government Chooses the Inflationary Approach

As to why our government continues to place its primary focus on monetary stimulus is beyond me. It seems apparent that we have tried this experiment before with disastrous results. The loose monetary policy of the 1970's and late 1990's resulted in massive inflationary imbalances in the economy. A much better approach would be the use of fiscal stimulus along with spending cuts that would reduce the size of government, lower inflation and interest rates, empower the individual and free market, and boost output and growth. But when was the last time you observed congress cutting spending while permanently lowering taxes?

Unfortunately, our economy has become addicted to fiat money, leverage and debt. As a result, GDP growth now depends on ever-increasing asset price inflation. In order to keep the economy from sinking, the Fed must continuously increase the rate of money supply growth.

When the Fed attempted to reign in asset prices in the year 2000, they ended up quickly reversing course upon the collapse of the equity bubble. Today, we find after raising rates to just 5.25%--a historically low Fed Funds rate--the Fed was forced to turn on a dime as the collapse of the real estate bubble sent banks and the market into turmoil.

This course of action has us quickly approaching the point of no return. The Fed may soon have to decide between following the path towards hyper-inflation or allowing the economy to sink into a severe recession, one bordering on depression. I know that sounds like hyperbole, but you have to ask yourself what are the consequences of a Central Bank that is unable to raise rates without causing tremendous market dislocations.

With each passing interest rate cycle, the rate required to stimulate growth becomes lower and its duration must be protracted. The result is intractable inflation and that should lead investors to increase their purchases of precious metals and non-U.S. dollar denominated assets.

Published on Mon, Feb 18 2008, 09:15 GMT

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