Random thoughts about the year ahead

Random thoughts about the year ahead

The following is excerpted from a commentary originally posted at on 26th January 2014.

1) The monetary backdrop continues to be very different in the US today than it was in earlier post-bubble periods. This is slowing the corrective process and introducing new price distortions that will have to be ‘resolved’ via another devastating economic bust. When will they ever learn?

2) Economic declines will become progressively more serious and economic recoveries will become progressively weaker until there is wide recognition that the central bank is a big part of the problem as opposed to part of the solution.

3) At this time last year, we wrote: “It has become clear that the Fed’s policy of throwing new money at the economy in a horribly misguided effort to generate real growth is not only going to continue in 2013, but also going to be applied more aggressively than was the case in 2012. This money-pumping could prevent widespread recognition of recessionary economic conditions for several more months, but only at a substantial long-term cost. For an economy to function efficiently, price signals must be genuine; that is, price signals must accurately reflect sustainable consumption and production trends.”

The Fed is now beginning to slow the pace of its money-pumping, but the damage has been done. The seeds of the next economic bust have been sown.

4) The economic data will probably be OK during the first few months of 2014, but if commercial-bank credit growth continues at its present slow pace then by the third quarter of this year there will probably be enough stock market weakness and enough signs of economic deterioration to prompt the Fed to step away from its “tapering” plan.

5) At the beginning of 2013, we wrote: “China has huge economic problems, but these problems will come to the fore gradually over the space of a few years and won’t likely be the cause of big moves in global financial markets during 2013.” The same statement applies to this year.

6) At the beginning of 2013 we thought that the euro-zone’s government debt disaster would return to “Page 1” during the second half of the year. It didn’t. Another euro-zone banking/debt crisis is inevitable, but there are currently no signs that it is imminent. For example, the yield on 10-year Spanish government bonds is near a 5-year low and the EURO STOXX Banks Index recently made a 2-year high. We will monitor European bonds and bank shares in an effort to determine the timing of the inevitable crisis. All we can say right now is that it probably won’t happen during the first half of 2014.

7) Last year we thought that unexpected weakness in the US economy was an intermediate-term threat worthy of attention, but not one of the top three risks. Unexpected weakness in the US economy is now one of the top three risks, although it is a risk that probably won’t materialise until the second half of the year.

8) As 2013 got underway we considered greater instability in the Middle East to be one of the biggest intermediate-term risks facing the financial markets. We also thought that if this risk was going to materialise it was more likely to do so during the second half than the first half of the year. Our reasoning was that the US government (by far the greatest threat to world peace) would be more inclined towards aggressive military intervention in the Middle East after it became clear that the US economy had sunk into recession, something that was unlikely to happen prior to the second half of 2013. To further explain, governments tend to view external threats as useful distractions during periods of economic weakness. Additionally, in a world dominated by “Keynesian” policy-makers and political advisors, large-scale military action can be perceived as a convenient excuse for more government spending and more monetary inflation.

The threat that the pot of territorial disputes, religious hatreds, political grievances and economic problems known as the Middle East will boil over is ever-present. However, with a deal now in the works regarding Iran’s nuclear program, with the start of the next US recession still lying more than 6 months into the future and with US mid-term elections scheduled for this November, the next Middle East ‘boil over’ of global importance is probably not going to happen in 2014.

9) Last year we wrote: “There’s a new big intermediate-term risk facing the financial world as 2013 gets underway: the risk that the government bond bubble will burst. The bursting of the government bond bubble is a more pressing concern today than it was, say, 6 months ago due to the immense political pressure being put on the Bank of Japan (BOJ) to reduce the purchasing power of the Yen.”

The government bond bubble probably did burst last year, but the other financial markets took the first phase of the new secular bond bear in stride. Furthermore, despite the actions taken by the BOJ to bring about higher “inflation” in Japan, the JGB market recovered from a sharp April-May sell-off to end the year with a gain. That is, the JGB yield was lower at the end of the year than at the start of the year.

Even though a secular bond bear has probably begun, for the reasons outlined in our 20th January commentary we don’t perceive much intermediate-term downside risk for US Treasury bonds. In fact, we suspect that the T-Bond market will end 2014 with a gain.

There is a lot more risk in Japanese Government Bonds. This is mostly because they have a much higher valuation (lower yield), but it is also because the JGB market is much further along in its long-term topping process.

10) Due to the downward trend in the US monetary inflation rate and the valuation-related downside potential in the US stock market, a US deflation scare is a realistic possibility for the second half of the year.

11) For speculators in commodities and commodity-related equities it will be much easier to make money on the ‘long’ side during 2014 than it was during 2012 and 2013. This is especially so for the year’s first half (the second half could contain a deflation scare) and for speculators in gold and gold-related equities.

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