The new Federal Reserve ("Fed") Chairman Ben Bernanke believes that the current yield curve inversion does not signal an economic slowdown. He argues that in past inversions, i.e. when short-term interest rates have exceeded long-term rates, short-term real interest rates were high. Differently put, he says the Fed is merely in neutral territory and has not yet applied the brakes to the economy. Long-term interest rates are low because of a global "savings glut", because much of the rest of the world rather put their money into liquid US assets than to invest them into their economies with under-developed financial markets.
We agree with Bernanke that real interest rates continue to be low; indeed, one of the reasons gold has performed so well is because the Fed has allowed inflation to creep through the production pipeline, even if "core inflation" has not yet reached the consumer.
Bernanke also has a point that there is simply a lot of cash out in the markets that has not been invested. Partially this is due to the Fed's own policies that have created a sea of liquidity. Another contributing factor has been much of Asia creating their own bubbles by subsidizing growth with fixed exchange rates. The very high savings rate of China, often reported to be at 30%-40% of disposable income, is partially due to a lack of attractive investment alternatives. The Chinese stock market, for example, has not been able to attract Chinese retail investors in recent years.
But in our assessment, Bernanke is wrong. An inverted yield curve likely signals an economic slowdown, just as it has many times before. The US consumer is far more interest rate sensitive than in the past; consumer spending plays an ever greater role in economic growth; it is now approximately 70% of Gross Domestic Product (GDP). Although Americans have been known as the world's greatest consumers for some time, never before have consumers bought so many goods on credit. The Federal Reserve had to redefine how it measures household debt service payments in 2003 because consumers have come up with ever more creative way to buy not only homes and cars, but just about everything on credit. If you have watched TV commercials recently, you may have noticed that we have entered yet another phase as automotive (and many other) advertisements only state the monthly installment; with most ads, one can no longer even infer the full cost of the car, nor the terms of the lease.
Over the past couple of years, consumers have financed their spending by extracting equity out of their homes and by adding to their credit card debt. Real wage growth has been stagnant. High energy prices have thrown the American savings rate into negative territory. Globalization keeps a lid on wage growth as US companies have to accelerate their outsourcing in an effort to compete in an environment with high raw material prices and little pricing power.
Adding these factors together, we have a highly interest rate sensitive consumer. As interest rates creep up, spending must slow down sooner rather than later, unless real wages or asset prices rise. Bernanke acknowledges that the housing market will slow; extracting equity from homes through ever higher mortgages is coming to an end. Bernanke may hope that corporate USA will put its massive cash buildup to use, but we believe this US 'savings glut' is due to the fact that corporate America sees a fragile US consumer and better investment opportunities overseas. In our assessment, the US economy is too dependent on the consumer these days; other sectors of the economy will not make up for a slowdown.
US consumer spending has not declined in over a decade. The consumer was enticed to continue spending as the tech bubble burst, and after 9/11, through low interest rates, through low taxes and cheap imports. We are now faced with an exhausted consumer that required "employee discounts" last summer to buy cars; a consumer that was lured to the stores the day after Thanksgiving with unprecedented discount offers: and a consumer that is offered a "$100,000 discount" when buying a new home (Centex, one of the nation's largest homebuilders recently had a nationwide "special offer" on what we interpreted to be the bursting of the real estate bubble in real time).
It is our view that an inverted yield curve does indeed signal a slowing economy. We are afraid, however, that even as the Fed is likely to raise rates further, it will not forestall inflationary pressures. We are rather concerned that foreigners may be less inclined to finance the massive US current account deficit as the economy slows. In this environment, gold may continue to do well, and the dollar may continue to be under pressure.
Last spring, we launched the Merk Hard Currency Fund to allow investors to seek protection should we be right with our assessment. We would like to invite you to subscribe to our free newsletter at www.merkfund.com.
