On Wednesday, the Bank of Janet Yellen said it would continue to “taper” QE. Instead of counterfeiting $75 billion every month, it will counterfeit only $65 billion. At this rate, it will be out of the counterfeiting business completely by the end of summer.

On Thursday, the United State Department of Commerce said the US economy was growing at a 3.2% annual rate, which is satisfactory. Until you look at it more closely.

On Thursday, too, stocks went up – 109 points on the Dow.

The Fed had little choice. It has to pretend to go straight at least for a month or two more. Otherwise, it won’t have a shred of credibility left. And so far, so good. It looks like stocks will close the month of January down only 3%. Not catastrophic.

For what it is worth, our “Crash Alert” flag… the ol’ black and blue… flies over our worldwide headquarters. We say “for what it is worth,” because it hasn’t been worth very much. Not the last three years.

We brought it out on several occasions. The wind whipped it. The sun bleached it out. The rain soaked it. The markets didn’t crash. Finally, we brought it in because we felt sorry for it.

But it’s back on the job today – even though we expect the crash will come later.

Counterfeiters Anonymous

The Fed will continue attending its Counterfeiters Anonymous meetings – until the market really cracks. Then it will roll up its sleeves and get out the paper and ink. Janet Yellen will not want to preside over a crashing market any more than Ben Bernanke did.

Yes, the Fed has broken the US economy and its markets. Now, it owns them. It can no longer permit the stock market (and bond market, for that matter) to do what comes naturally to them – correct their mistakes.

And that means the mistakes will get worse.

“Oh, you are so negative,” writes a helpful dear reader. “The economy has some traction already. Can’t it withstand a gradual withdrawal of QE?”

No, is our answer.

The Fed’s zero-interest rate “wealth effect” is what keeps the economy’s head above water now. A real “poverty effect” would sink it.

Just take a look at this chart. It explains why consumer prices are still so sluggish… even with the Fed at work.

Money, like grease, gels up when an economy goes cold. When it heats up, on the other hand, it flows like water. Here’s the chart:

M2 Money Velocity

As you can see, the grease is stiff. The economy is cold. And our “Crash Alert” flag is on its pole.



Market Insight:

The Fed, Gold Money and Castles in the Sand…
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

Today, we answer a question from Diary reader Ben S., who writes:

In the article Why Things Will End Badly for Investors in US Stocks, Bill stated that there was very little inflation in the US until the Federal Reserve was created. Why was there so little up to that point if banks were able to create money as Bill explained? Or were they not able to do so before the Fed appeared? Just trying to understand.

The reason is simple. As Bill put it:

Gold is a limitation. It is real money… and limited in supply. As long as you are tied to gold the money supply can’t go up too much.


After the Fed was created in 1913… the dollar was gradually loosened from gold… with the final tether cut in 1971.

America’s slide off the gold standard fundamentally changed the nature of the US economy.

Anyone in doubt should pick up a copy of Richard Duncan’s The New Depression: The Breakdown of the Paper Money System… a book that is doing the rounds at Bonner & Partners. (You can find it on Amazon here.)

As Duncan explains, credit creation rose 50 times between 1964 (four months before President Johnson first severed the dollar’s ties with gold) and 2007, just before the global financial crisis.

This credit creation – made possible by the fiat money system LBJ and Nixon ushered in – changed everything. What was once an economy driven by capital accumulation became one driven by credit creation.

We now live in a world of massive credit stimulus in the form of ZIRP and QE. Real interest rates are negative. Savers are punished and speculators and borrowers are rewarded. And most important: The world’s reserve currency is anchored to nothing other than empty promises.

As economist Irving Fisher put it:

Irredeemable paper money has almost invariably proved a curse to the country employing it.

Vanishing Reserves

But it’s not just central bank money that is at stake. It’s also bank credit creation – which is now also unfettered from a physical commodity.

Here’s how the bank credit creation process would work under the gold standard… and the requirement that banks must hold 20% of their deposits in vaulted gold.

Bank “A” accepts a deposit of $100 and sets aside $20 of gold as reserves. It then loans out the remaining $80. The borrower of that $80 then deposits this amount in Bank “B,” which sets aside 20% of this amount – $16 – in gold. Bank “B” then loans the remaining $64 to Bank “C”… and so on.

Through this “fractional reserve” system, as it was known, the banking system could turn $100 into $500 of deposits… and $400 of credit.

But since leaving the gold standard, bank reserve requirements have plummeted – to the point at which the US financial system can create credit almost entirely unconstrained by reserves.

What does this mean for you?

It means an economy – and a financial market system – built on the sand of credit creation.

It means distorted financial market prices – everything from stocks, to bonds, to real estate.

As the legendary value investor Seth Klarman put it at the recent Grant’s Interest Rate Observer conference in New York last November:

None of us know what the level of stock prices would be, what the level of corporate earnings would be, or, of course, where interest rates would be.

Don’t get too comfortable with US stock positions. Markets are deeply distorted by central bank intervention.