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    The Unkindest Cut of All

    by Chris Martenson

    Friday, October 19, 2007, 4:00 AM

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Friday, October 19, 2007

Executive Summary

  • It’s not over; the trouble has only just begun
  • Look out – inflation is coming!
  • The Fed cuts rates, bails out big banks
  • Inflation set to rip
  • Oil
  • Oh, the dollar!
  • August TIC data and the dollar
  • Bank runs in the US and England, and a failure in Germany
  • Uh oh – derivatives

Last time I wrote that the game is afoot. Boy, is it ever. This past month, while the stock market bizarrely hovered near all-time highs (more on that later), the credit markets slipped into even deeper disarray (an understatement) and commodities became pricier (a severe understatement). As always, my primary goal here is to help you understand what’s going on, and that it’s all a matter of policy, not accident. Bad policy, perhaps, but policy nonetheless. My secondary goal is to connect the dots and provide you with a source of news aggregation you can trust.

To begin, let’s review my most recent recommendations from my August 30th newsletter:

  • Get out of debt, especially variable rate debt such as credit cards and any adjustable rate loans. If I’m right about the dollar, vastly higher interest rates are on the way.
  • Get some exposure to assets that tend to vary inversely with the dollar. Gold, silver, oil, natural gas, and foreign currencies are my favorites.
  • Build up some cash reserves (savings) to get you through a potentially severe recession.
  • Be prepared for a serious decline in equity and bond values.

I stand by all of these and will try to make the case below that now is a time calling for additional fiscal prudence and caution.

Unfortunately, there’s so much juicy stuff going on right now that I am forced to limit this missive to a few of the tastier bits.

For starters, one of the central economic/investing conundrums seems to have been settled. Since I started giving The End of Money talks in November of 2004, I have been on the fence as to whether deflation (brought on by loan destruction first centered on residential real estate, next on commercial real estate, and finally on corporate bond defaults) or inflation would dominate our economic future (never underestimate what a determined government with a printing press can do, says Bernanke). Okay, I admit that I was not literally fifty-fifty ‘on the fence,’ but more like seventy-thirty, tipped in favor of inflation. So that’s central theme #1 of this article: Inflation now seems to have the upper hand.

Further, to those who’ve come to my seminars over the past three years, you know that I have been consistently harping on the dangers posed by a housing bubble, which bred with recklessly reduced lending standards to produce a toxic offspring of derivative products, which are now running about like feral children on a Halloween night. These past few weeks we’ve seen the first warning signs that the big banks are seriously exposed to these derivative bombs and already lobbying for a taxpayer bailout. So that’s theme #2: A housing-decline-fueled derivative crisis is approaching.

So, let’s get started with the rate cuts by the Fed.

On August 16th, when the stock market was taking a small tumble, the Fed overreacted and cut one of their two key interest rates by a half a point, or 0.50%. This cut was in the so-called “discount window” rate, but insiders call it the “penalty window,” because only dead-beat banks that can’t otherwise borrow from other banks use it. While this may seem like an innocuous move to you (I can see you shrugging and yawning), it was rightly read by insiders as a sign that the Fed was deeply worried about the credit markets in general (probably about a specific mortgage related bank in particular), and that it was going to continue Al Greenspan’s policy of bailing out poorly-run banks. The second rate cut on September 18th (actually a pair to both the Fed funds and discount window rates) just confirmed this view and added more fuel to the fire.

Once we strip away all the gobbledy-gook, what does a ‘bailout’ mean? It means that the Fed is determined to supply whatever liquidity is necessary to prevent any market declines from taking hold. And what does this mean? It means inflation. Lots of it.

Don’t believe me? Then take a look at this chart (below) of commodity prices, and take a nice close look at what happened there on August 16th (blue arrow) following the rate cut.

CCI Chart

Holy smokes! That’s a 14% gain in commodity prices in only 2 months! Oil is making the headlines, but literally everything is exploding in price – corn, wheat, zinc, gold, you name it. At this same rate, we can expect a 119% increase in commodities over the next year.

Or, as a Bloomberg article put it, September saw the biggest monthly gain in commodity prices in 32 years, leading one investment advisor to sum it all up thus:

[quote]”The Fed has signaled pretty clearly that they will answer the problem of a slowing economy with greater liquidity,” said Chip Hanlon, who manages $1 billion at Delta Global Advisors Inc. in Huntington Beach, California. “We’re in a bullish phase for commodities.” [/quote]

That’s euphemistic trader-speak meaning, “Commodities are gonna rip! Everybody who lives on a fixed income is in real, deep trouble.”

Speaking of which, the just-announced Social Security COLA adjustment for this year is a measly 2.3%, the smallest since 2003. (Hey! that’s $24 a month, on average!) As you know, I am highly critical of government inflation reporting (I still can’t decide, is it merely negligent, or is it overtly fraudulent?), but this 2.3% number just takes the cake. I guess I’m leaning towards fraud now, because there isn’t a single sentient person alive who can argue that inflation over the past 12 months was 2.3%. Why does the government do this? So it can redirect money that would go towards Social Security beneficiaries to other endeavors.

Hopefully, nobody on a fixed income needs to heat their house with oil, because oil is up 29% in the past 2 months (see chart below – can you spot August 16th???). Ouch.

Crude Oil

Of course, everybody from the middle class on down already knows that inflation is much, much higher than what our government admits. Here’s an AP article that came out this morning (10-19-07):

What used to last four days might last half that long now. Pay the gas bill, but skip breakfast. Eat less for lunch so the kids can have a healthy dinner.

“It even costs more to get the basics like soap and laundry detergent,” said Michelle Grassia, who lives with her husband and three teenage children in the Bedford-Stuyvesant section of Brooklyn, New York.

Her husband’s check from his job at a grocery store used to last four days. “Now, it lasts only two,” she said.

A paycheck that used to last four days now only lasts two? Does that sound like “2.3%” to you? No, obviously not, and the economic disconnect has never been more profound between the distorted version of reality that is being peddled by Washington DC and our daily shopping reality. Heck, even Newsweek is saying “There’s No Inflation (If you Ignore Facts).” The charade is pretty far gone by the time Newsweek is calling shenanigans on the government.

How sure am I that the Fed & US government have charted a course of dollar abandonment and reckless inflation? Very.

Take a look at this table showing the percentage gains in our money supply. Note that this is a table of something called “MZM” (Money of Zero Maturity), and it’s the best remaining measure, ever since the Fed scrapped reporting of the much more inclusive M3 measure, the most complete indicator of how much money was being created out of thin air. However, MZM is not a terrible measure, and it’s all we’ve officially got, so we’ll use it even though it misses about 35% of the total amount of money created.


Holy exponential expansion, Batman! Twenty five point three percent??? You might have expected that all the credit market woes would have stalled money creation, but instead, the Fed and its crony banks have somehow engineered a remarkable expansion of our money supply that is running at a better than 25% annualized rate over the last four weeks. If that rate continues, the Rule of 70 tells us that the total money supply will double in about three years. Let’s see here….if I compare that against economic growth…it means that there is 10 times more money being created than economic growth.

As you may remember from our seminar series, money created in surplus of economic growth leads to inflation. It always does, and it always will. If you are still uncertain, go back and take another look at the commodity chart above and re-read the anecdotes from the linked article.

Not to be outdone by the Fed, the US government, having burned through the last $800 billion debt expansion in record time, recently raised the debt ceiling by another by $850 billion (to $9.815 trillion, with a “t”). For those keeping score at home, US government debt has expanded by 50% in only ten years. All of this debt represents hot new money that can only lead to even more inflation.

At any rate, to make a long story endless, the Fed has tipped its hand and has set us all on a course that favors inflation, but risks hyperinflation and the possible destruction of the dollar as an accepted international monetary unit. They did this because they fear the alternative even more.

The recommendations I have been giving out for the past three years stand – every one of ’em. While it may seem like I really hit a few out of the park in my prognostications, all I did was observe that 3,800 paper currencies have been destroyed by virtually identical mechanisms. So I simply applied those histories to the situation in the US and predicted that our own leaders would suffer from the same weaknesses as other humans throughout history.

If you are not extremely rich, I sympathize, because these next few years are going to be difficult. You see, inflation is an unequal-opportunity destroyer. In the short term, inflation dramatically favors the already rich but is devastating to everyone else. In the long term, severe inflation is bad for everyone, because it erodes the entire social and economic framework of a country. However, “short-term-itis” rules the roost down in the halls of power, so I do not expect to see a sudden outbreak of fiscal or monetary sanity anytime soon. For those in power, the path of least resistance is one that attempts to preserve the status quo and provides maximum short-term benefits to those already in power. So, best get ready for some rip-roaring inflation.

Dollar Daze

The dollar is hitting 30-year lows against the currencies of our trading partners. Why has the dollar been so weak lately? Besides the fact that we’re printing massive, reckless quantities of them, you mean? Well, the actual mechanism by which the dollar rises or falls is really simple. It all depends on how many dollars are being bought vs. being sold, across, and outside of, our borders. One important report, the Treasury International Capital Flows report, which measures net foreign purchases of US paper assets, had a positively dreadful showing in August, indicating a net decline of $163 billion in US capital flows. This meant that foreigners sold a whopping $163 billion of US assets in a single month! And when foreigners sell US assets that are denominated in dollars, they then need to sell those US dollars for their native currency so they can bring their cash home. In short, a sell-off of US assets by foreigners typically means a decline in the dollar.

Which foreigners? Of particular note, Japan and China both cut their holdings of US Treasuries at the fastest pace in the last five years. Whoops.

At any rate, this report tells us that foreigners are not tip-toeing away from our markets, they are stampeding. Oh, to be a fly on the wall at the Fed, to know what’s really going on behind the scenes. Of course, August could have been anomalous, so we’ll be keeping a very close eye on the September figures due to be released November 16th. If that is also bad…look out below. And be sure to be holding some of your assets in foreign currencies, gold, and/or oil to protect against further dollar declines.

Bank Runs

You’ve probably heard about the bank runs that happened in the US and the UK. What? You didn’t? This means you don’t receive any foreign newspapers, because this was huge news and has been on the front page of the Financial Times (UK) for the past several weeks. For some reason, this news was minimized over here in the US.

Here’s a breakdown of the past month: First, there was a run on Countrywide Bank in Los Angeles. Then, a major run on Northern Rock in the UK, complete with large queues of people desperately waiting to retrieve their money from the bank. Next, a major German bank completely failed and had to be taken over. Then the FDIC seized and shut down Netbank in the US.

What was the common element for all these banks? They were all in trouble because of excessive exposure to mortgage defaults.

I raise the issue of bank runs because I see a very strong possibility of the emerging mortgage derivative disaster crippling quite a few US banks – possibly more than can be serviced by a completely inadequate FDIC reserve of ~$50 billion. It is my suggestion that you spend a bit of time to be sure your bank is highly rated and somewhat insulated from this whole mess. You can start by following this link to thestreet.com, selecting the Banks & Thrifts tab, entering your bank(s), and then checking out how it/they stand. I personally would not have anything to do with a bank with less than a “B” rating. A surprising number of banks are rated B- or lower. And, of course, do not keep more than $100,000 in any one bank account, ever.

If you have the time, this is an excellent article by Jon Markham at MSN that details just how large and exceptional the risks are to the entire financial system. After reading this, I became even more convinced of the possibility of a major financial catastrophe that may completely shutter whole portions of our banking and insurance industries. To be clear, I am not saying it is going to happen, I am saying the risk is there and has been growing larger, not smaller, over the past several months. Like a prudent person who carries fire insurance on their physical dwelling, you need to consider taking out insurance on your financial dwelling. The recommendations above would be a good set of first steps.

Oh, woe is me. I planned to keep this short, and I failed. Worse, I didn’t even get to the most recent housing data, which is both breathtaking and important. And there is more in the news in support of the notion that Peak Oil is already upon us. I will reserve both of these topics for special reports that will be coming out shortly.

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