You Can’t Handle the Economic Truth

It’s been a busy night on the data front. I’ll start with some of the headlines…

• US second quarter GDP rose at a 4% annualised pace (woohoo!)

• Fed to keep rates low for a ‘considerable time’ (woohoo!)

• Argentina defaults (Doh!)

• Portugal’s Banco Espirito Santo reveals US$5 billion loss (Doh!)

Before we get into the details, I have a sad announcement to make. Free speech, the hallmark of a civilised, proud and confident nation, is dead. It is in Australia anyway. We can’t tell you why, because we risk a jail sentence if we go into details.

I’ll just say that there are some things the Australian government doesn’t what you to know. Why? It’s in the national interest. The fourth estate is towing the line. A quick scan of the Fairfax websites reveals nothing. Only the ABC reports on what they can’t report on.

So carry on…go negatively gear an IP and tell your friends about it over a latte. Don’t worry about those muffled screams you hear in the background. It’s only free speech taking a kicking. Nothing to see here…

Right then, back to the markets. US economic growth for the second quarter looked strong, running at a 4% annualised pace. To get a better idea of underlying demand, it’s best to focus on ‘real final sales of domestic product’, which strip out the effect of inventory building or depletion. On this front, growth came in at 2.3%, compared to a 1% decline in the first quarter.

Over the first half of the year then, underlying demand in the US economy has been around 1.3%. In the past year, it’s averaged just over 2%. While reasonable, it’s nothing to get excited about. The US economy is neither booming nor busting.

The good news is that the economy is (sort of) generating its own growth. Government spending actually detracted from growth by nearly 1% over the first half, as the Federal Reserve’s slowly reduced their massive annual deficits.

Now for the Federal Reserve to get out of the way too. It took another baby step on that front overnight, reducing its monthly purchases of assets by another US$10 billion to US$25 billion. (The Fed’s balance sheet is now around US$4.4 trillion…and still growing.)

Within a couple of months, QE will be dead. Then the guessing game over rising interest rates will start. The Federal Reserve is sticking to its confusing, but soothing, ‘considerable time’ mantra. Governor Charles Plosser dissented on the wording of the statement. Given the ‘considerable’ progress made by the US economy recently, he reckons the Fed should tighten faster than they are currently implying.

The bond market certainly took notice. US ten year bond yields spiked higher on the news, as you can see in the chart below:

Source: Stockcharts

They are still well below the 3% yields reached at the start of the year, but given average nominal underlying growth for the US over the past 12 months was around 3.7%, yields look like they are heading higher…unless the US hits a recessionary wall following the end of QE.

Of course, there is China’s uneconomic, currency-manipulating buying of treasuries to consider when thinking about the future direction of bond yields. By all accounts the Middle Kingdom has been hoovering up treasuries this year in order to keep the yuan low.

But according to Treasury International Capital (TIC) data, foreign central banks were net sellers of treasuries in the year to May. Only the ‘private sector’ is buying.

Speaking of debt, the Financial Review reports today that Australia’s big four banks raised a record $125 billion from ‘wholesale’ debt markets last financial year. Thanks to idiotic monetary policy overseas, the cost of borrowing funds offshore is falling to record lows. And the banks are taking advantage, lowering borrowing costs on residential mortgages in order to shove dubious credit down the throats of Aussie households.

Now the general view is that cheaper credit is good. Well, it depends on how you look at it. I suppose it’s good for the speculators, as it allows them to leverage even more. It’s good for existing homeowners because it pushes up the ‘value’ of their home.

But it increases the risks to Australia overall. Foreign borrowing is the banks’ Achilles’ heel. It nearly brought them undone in 2008. Yet they are back with their snouts in the trough, simply because they’d be mad not too. The government, and therefore the taxpayer, underwrites their risk, and if nothing goes wrong the banks make hay.

It’s a sweet deal, and one the banks have availed themselves of throughout history. By the way, I’ve just finished reading the latest issue of Phil Anderson’s Cycles, Trends and Forecasts,  and it’s a cracker. Amongst other things, Phil gives a theory on Abraham Lincoln’s assassination.

Apparently, Abe was in the process of changing the rules about who gets to create money — the government or the banks. Abe wanted the government to have that sole right and responsibility. Weeks later, he was dead…shot by some ‘crazy’ lone gunman. (A bit like Kennedy’s ‘killer’.)

Banks are big and powerful because there is a lot of money at stake. Their primary profit function is not the provision of services or the intermediation of capital for productive services… No, as Phil shows, it’s capturing the economic rent through the increase in land prices.

I’ll give you an example. Say you want to buy a $550,000 home and have a $50,000 deposit. You borrow $500,000 from your friendly, all too eager to help bank. But it’s a lot of money, so you want to make it more affordable by borrowing over 30 years.

Let’s say your average interest rate over that time frame is 7%. According to the Commonwealth Bank’s mortgage calculator, over 30 years you’re interest bill alone will total nearly $700,000. In other words, you’re channelling a large portion of your labour to secure land, and you need a large amount of (bank provided) debt to do so. It’s a very, very sweet deal.

Until something goes wrong, that is. Like a nasty economic slowdown combined with bad lending decisions and a cash strapped sovereign. That’s what appears to be going on over in Portugal. It’s (formerly) largest listed bank, Espirito Santo, just announced a €3.6 billion first half loss, wiping out its capital buffer and putting it in a precarious position. If the risk is considered to be systemic, then someone will come to the rescue.

Thankfully, nothing like that can happen in Australia. After all, it wouldn’t be in the national interest.

Regards,

Greg Canavan
For The Daily Reckoning Australia

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