Mr. Market Sprinkled Paper Wealth, and Now Wants It Back

Mr. Market, the credit bubble's minion, has spent the last thirty years sprinkling paper wealth on all and sundry. Brokers, traders, bankers, investors, even short sellers preying on the greedy, even those that didn't play the game and simply sat on their homes: all were made rich.

There was nothing unique about this new economic era in which all won. The 1920s and 1960s also heeded the siren's call of wealth without toil, not to mention the Mississippi bubble, the South Sea bubble, the railroad bubble, among many others. But when a credit bubble deflates,as it must, Mr. Market must retrieve his master's money.

Contrary to popular belief, the crash of 1929 ruined only speculators on margin, much like the crash of 2008. The initial decline of 47% in 49 days merely returned the market to where it had been in March of 1927. But the crack discredited Irving Fisher's "permanently high plateau of prosperity." Short sellers realized the market had a lot lower to go, and they were right. The DOW would fall another 79% over the next two years. The problem for the shorts was it rallied 48% first.

Once the shorts had been broken, Mr. Market could take stocks down without making anyone rich, his main goal during a credit contraction. All lost. Even the man in his house and the depositor at the bank, as many banks closed and never reopened. Gold was a refuge, but Roosevelt criminalized ownership. The gold mining lifeboats were too small and, like the Titantic's, were mostly empty: who could take the risk?

Our own credit bubble peaked in 2008. Living with fiat currency instead of under a gold standard, it is harder to see. Debt is still growing on a nominal basis. When priced in GDP or gold, however, debt levels are declining. And they will decline further. Global debt - be it European bank debt, or Chinese corporate debt, or Western sovereign debt - is too large ever to be repaid in good money. Default, serious inflation, or a
combination of both fill the logical space of outcomes.

Continuous quantitative easing can maintain the semblance of normality in the markets for a time by boosting the price of debt, but there is nothing normal about printing tens of billions of dollars each month. All other economies utilizing this strategy have succumbed to hyperinflation.

Just ask Gideon Gono, chief of the Zimbabwean central bank, who, reflecting bitterly on the world's second-worst hyperinflation, wrote: "These interventions which were exactly in the mould of bail out packages and quantitative easing measures currently instituted in the US and the EU, were geared at evoking a positive supply response and arrest[sic] further economic decline."

Many financial commentators, especially in hard money circles, are perplexed that the quadrupling of U.S. base money has not resulted in massive inflation. They fail to see that although the liabilities of the Fed have quadrupled since 2008, so have its assets. Ultimately, it is the assets on any balance sheet that give value to the liabilities.

This was the conclusion of a paper written by Nobel Prize winning economist Thomas Sargent examining the balance sheets of the hyperinflating countries of the 1920s. As long as the central banks were buying worthless domestic bonds to support their respective banking systems, the inflations intensified. After stabilization, the central banks continued to expand their balance sheets, but they bought gold, short-term commercial paper, and foreign bonds, and there was no inflation.

The reason there has not been severe inflation in the dollar is that the Treasury bonds owned by the Federal Reserve remain well bid in the market. The problem is, it is the Fed itself supporting the price. If the Fed ever stops buying these bonds, as they are now threatening to do, Treasuries will seek their true value with dire consequences for the dollar.

Few have noticed that already the yield on the 10-year Treasury seems to have bottomed. Since hitting an absurd 1.43% last July, the yield has backed up over 2%. The increase may not seem large, but is noteworthy in the face of open-ended Fed purchases of $45 billion per month. And, the direction of yields matter more than their absolute level.

For the past thirty years, holding bonds has been preferable to cash: the holder received a yield plus a capital gain. As rates begin to rise, persistent capital losses will exceed the ridiculously low yield, and holding bonds will become expensive relative to cash. There will be a scramble to get out of Treasuries, boosting rates even higher.

This is when the severe inflation will hit. And, because financial assets are priced at a spread to the Treasury bond yield, rising rates will crush the broader markets. Starved of credit and capital, the economy will falter, shrinking tax revenue, further reducing the value of Treasuries, the asset class that backs the dollar. Devaluation is the inevitable conclusion of Gono/Bernanke policies.

Gold is the obvious defense, being the supreme arbitrator of value for thousands of years because of its liquidity profile. Gold has no yield, and so rising interest rates do not affect it. It will keep its value as the dollar and markets plunge in terms of purchasing power. For this reason, owning gold is the same as being short the Treasury complex, upon which nearly every global market is based. Gold mining shares add operational leverage to gold positions.

Our credit bubble, the largest in history, has passed its apex, attracting many to the gold sector. But Mr. Market is efficient at his work: only a few can escape. Just as in 1930, he must wipe out the shorts first, before he turns his attention to the main course. Balance sheets broken, the gold bugs will be mere Cassandras as the monetary temples fall.

Most of the large banks have recently published research calling for much lower gold prices. The theory is that when bonds fall and rates finally rise, the opportunity cost of holding gold instead of bonds will increase, and the market will sell gold. Indeed, gold has fallen, knocking out overexposed longs. Yet the latest bank participation report shows the big banks have now covered nearly all of their gold shorts, for the first time since the bottom in 2008.

Their research reports are meant only for their clients: they need someone to sell them gold. They know that when rates do rise, the assets on the Fed's balance sheet will collapse and the Treasury will face increasing difficulty financing trillion dollar deficits and rolling the $16.7 trillion debt.

Mr. Market is good at his work, but not perfect. The recent crash in gold will result in fewer but richer gold bugs at the Treasury bond denouement.