By Felix Zulauf (via Itau Global Connections).

No Tapering

My reading of the world economy is not as strong as the consensus view, and I rather see some slowing in the US, continued stagnation at best in Europe and an extension of the excessive cyclical expansion in China, with Japan doing somewhat better but far below Abe’s expectations.

I thought the recent developments in the US bond market with the latest record issue of $49 billion by Verizon was signaling to the Fed that more liquidity would lead to more imbalances and excesses that have to be corrected later in a painful way. In addition I thought Bernanke was concerned about his legacy and therefore willing to dictate some exit for his successor, if even temporary, to cement his legacy as a success.

But how does one convince a drug addict to get off drugs because more of it will only make the situation worse? That’s in a nutshell what I thought after the no-tapering decision. And the consensus was dead wrong, as I was in my expectations, of tapering $10-15 billion per month.

It is now obvious that excessive monetary reflation will continue for a while longer. However, this behavior by major central banks – and who knows whether the ECB will eventually even join in – will simply exaggerate the current already big imbalances in the global financial system and real economy. Adding more liquidity here by the Fed will more likely increase the financial engineering rather than help the real economy or employment situation. It is supporting the replacement of equity with debt, which is pushing equities higher (charts 1 and 2 below).

Surprising China

But the biggest recent surprise to me was the improving economic statistics in China. I had expected a slower pace due to slowing construction as a result of increasing financing problems. But it seems China has opened another funding source via the Hong Kong banking system that allows the credit and investment boom to continue. In fact, price increases for real estate are continuing, as recently 66 of the largest 70 cities showed prices moving higher, and 69 showed an increase over the last 12 months. In the secondary market, the net number is only 53, with five cities showing falling prices year over year. As I mentioned last month, some of my family members travelled through Western China extensively for four weeks, and in every city they found plenty of empty high rise buildings and still a very high number of busy construction sites. As mountain climbers know, it is harder to climb down from a steep and dangerous mountain wall than to get to the peak. The same applies for credit and investment booms and busts. While China is obviously procrastinating successfully for a while longer, there is no question in my mind that China will eventually face reality. Most China bulls’ comments remind me of the Bernanke remark about the US housing market in early 2007, when he said that he did not see any imbalances. While I am not sure on timing, I like to remind investors that the pain in the down cycle is in direct relation to the magnitude of the up cycle – yin and yang.

Two elephants moving in a dangerous direction

The Fed obviously blew it, with the latest turnaround pushing monetary reflation further and thereby inflating imbalances into even further excesses. It is very concerning that China is doing the same thing by extending the credit and investment boom instead of implementing structural changes and correcting the excesses in the system. When the two elephants in the world economy move in the same dangerous direction, risks are increasing in a big way. In addition, the third largest economy is also pushing monetary reflation in an extreme way – which is not working the way it was expected by the government. And who knows, perhaps the ECB will soon be forced to join with liquidity to help struggling European banks again. The problem is timing, as we do not know whether this is mid-2006 or early 2007. All we know is that it is late in the cycle, and there is more excess. We are also aware that it will eventually be painful when the tide turns.


In the very short-term, bond yields may soften in the major markets, more so in the US than in Europe due to the Fed’s continuing purchasing and the relief for emerging market currencies and their abating necessity to sell Treasuries. Ten-year Treasury yields could soften to 2.40%-2.50%, but the primary trend remains up, and after this correction yields will most likely rise again and break the 3% level.

The US dollar will weaken further against most currencies. The euro has been quite strong lately and has adopted all the characteristics of the Japanese yen in recent years. In other words, it is strong for the wrong reasons, namely a deflationary set-up with current account surpluses but economic stagnation. If my thesis has any validity and the European economy relapses early next year, the unresolved structural problems of the euro, banking problems in particular, will surface again, and the ECB would be forced to provide more liquidity. Under such circumstances, the euro may then turn weaker. Hence, I would use levels between 1.35-1.40 to sell euros step by step.

The Japanese yen remains a short, as the Japanese are willing to pursue their extreme monetary reflation. Moreover, their economic game plan doesn’t seem to work to satisfaction and will soon force the hand of the BoJ to push for the next yen weakness. It has now congested for a while, and also it could take some more time. I expect it to weaken on a trend basis against virtually all currencies.

Most other currencies that have weakened against the US dollar since earlier this year are bouncing back to varying degrees. This bounce is driven in some cases by the previous oversold condition and short covering, or monetary tightening by those authorities or the belief that China is reaccelerating and the postponed tapering by the Fed, or a combination of those factors. Watch the currencies of weaker economies like Turkey, Indonesia or South Africa for hints of entering the next period of decline, as that should be an early warning of the US dollar turning stronger again.

Global equity markets are receiving an additional shot of stimulation from the Fed’s continued liquidity infusion to the financial system, and the rally could well last into later this year or early next. Despite the new news, the current rally is less powerful than previous ones in this bull market. While many divergences are visible, particularly in the US, in this aging bull market, it is still not the time to call for the top, yet. Europe is expected to outperform the US in this rally, driven by hopes of normalization in European economies and currency matters. I see the current rally this late in an aging cycle as an increasingly selective advance whereby industrial names will outperform the classic defensive leadership we have seen until a few months ago. Japan should also perform well in such a scenario and offers probably the best risk/reward potential in local currency terms, as the world is not heavily invested there. As the chart below shows, the US market has been the outperformer and trendsetter in this cycle, and therefore the Fed turnaround will help some other markets to catch up late in this cycle. While participating, be aware that risks are higher than communicated by the investment industry, and they keep rising.

Gold’s rebound lasted only two months and was driven by short covering. The yellow metal has not traded well, and the thesis of “economic normalization” was a burden for gold. However, the continued liquidity infusion by the Fed has injected another lifeline, and it is likely gold is now trying a second recovery attempt towards the upper $1,400s. It is very positive that gold is moving from weak to stronger hands, but that alone is not enough to trigger the next bull cycle. At present, real bond yields have moved into positive territory, and that is a hurdle for gold. Hence, gold investors should be patient, as a lengthy bottoming process is more likely than a sustained advance. The current action is part of a lengthy bottoming process that is a precondition for the next cyclical advance.


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