ArabianMoney.Net

Nobel prize winning economist Joseph Stiglitz has warned that the Federal Reserve’s decision to end its $1.4 trillion mortgage debt purchase program this month is going to worsen the slump in the US housing market by driving up interest rates.

There has been no recovery in the US housing market this year, the biggest item of expenditure in the world’s biggest consumer market. New home and previously owned home sales are still falling. House prices continue to fall.

Mortgage rates to rise

In a Bloomberg interview in Tokyo Stiglitz said: ‘This withdrawal of the support risks increasing interest rates, increasing the number of foreclosures and exacerbating the strain, the stress, that American families are already facing’.

He claimed the main danger to the global economy presently is that central banks will ‘exit too rapidly’ from the emergency measures put in place to offset the financial crisis in 2008. He said it was ‘irrational’ to worry about inflation with consumer demand so subdued.

The former World Bank chief economist thinks there is a ’significant risk’ of a double dip recession with growth weakening towards the end of the year.

The US housing market is locked in a deep depression. Mortgage resets over the next couple of years already threaten three to four million more foreclosures that will keep the market depressed and put further pressure on US bank balance sheets.

US mortgage rates are linked to the headline Fed funds interest rate but remain significantly higher for borrowers. So while the Fed may not have raised its key target overnight rate at its meeting this week, the withdrawal of mortgage debt-repurchase programs is as good as doing the same thing.

US economic slump

‘The deeper risks I see for the global economy are continuing weakness in the American economy’, Stiglitz therefore concluded. Indeed, the US housing sector is an enormous driver for the world economy consuming huge quantities of industrial materials from timber to aluminium.

It is even clearly possible to attribute the global financial crisis and the recession that has followed to the collapse of the US housing market due to the subprime loan implosion.

To recover from the financial crisis the root cause will have to be addressed first, and that means getting the US housing market on the road to recovery, not derailing it again with higher interest rates.

Wall Street breathed a sigh of relief yesterday as the Fed confirmed that ultra-low interest rates would continue for ‘an extended period’, generally thought to be over six months, and rumors of a rate rise once again proved to be greatly exaggerated.

Some kind of a relief rally might be anticipated over the next few days. But there is also a contrarian view that says all the good news is now priced into the market.

Chart view

Certainly the chart from last March shows a picture of a strong initial recovery, a flatter upturn later in the year and then a dome pattern. Breakouts might now indicate another leg up but the deteriorating quality of news suggests this may not follow.

The Chinese monthly purchasing managers’ index showed its smallest expansion in manufacturing activity in a year. Meanwhile, a hike in inflation has put Chinese savers into negative real interest rates. An inflection point seems close in the Chinese economy with a scaling back of last year’s colossal stimulus package.

Then again the European Union lifeline for Greece is just the first in a long queue, with Spain a much larger problem and other indebted nations also in need of a bailout. Business is not good in Europe. Germany just published revised figures showing a heart-stopping 17.9 per cent fall in exports in 2009, with China taking over its position as the world’s biggest exporter.

Czech retail sales declined the most in four months in February. Spanish home prices fell for the ninth quarter in a row through December. Japan is caught in a debt trap. The UK and USA are facing possible loss of their triple-A credit ratings. US housing and auto sales are way down.

V-shaped recovery?

None of this supports the V-shaped recovery thesis now priced into global stock markets. The world economy has fallen into a trough and shows very little sign of being able to dig itself out anytime soon.

Where is the magic catalyst to make it happen? Interest rates can hardly go any lower. Government spending causes more debt and is ultimately a burden on an economy, draining money from far more productive private enterprise.

No a further shake out of asset prices to reflect the reality of a world of falling profits over a number of years, and a series of further economic shocks is inevitable. Try to present the reverse argument and you really struggle because there is no credible counter view.

All eyes will be on the Federal Reserve interest rate statement tonight, and whether or not the rate actually rises there can be no doubt that ultra-low interest rates are not going to last forever, even if financial markets sometime seem to behave as though this was the case.

So what will happen to the gold price as interest rates go up? The most superficial analysis is to say that gold does not pay interest so investors will take their money out of gold and put it into cash.

Investment logic

But this is a complete nonsense. Investors will also look at why interest rates are going up. Is it because money printing by the Fed now threatens a deluge of inflation? Is it because the bond market looks unstable and investors are demanding a higher risk premium?

Indeed, you have to consider the underlying security of cash as an asset in such circumstances. Will the dollar devalue as inflation erodes its buying power? And how do you hedge against that?

George Soros got it right recently when he said that gold was the ‘ultimate bubble’, that is to say the last asset class in the chain to become a bubble before the whole cycle starts again. For in past financial crises the clear pattern has been bank failures then a bond market crash and a rush into precious metals.

Government intervention

Government intervention on a historic scale has mitigated the bank failures but led to an even greater issuance of government paper, and merely delayed the inevitable bond market crash that will come as – wait for it – interest rates go up.

Gold then becomes the final safe haven asset and the limited supply of gold means that its value will surge to unheard of levels. Dr Marc Faber recently suggested that $1,000 gold might be seen as similar to the Dow crossing 1,000 in 1982.

Arabianmoney.net editor and publisher Peter Cooper explains in far more detail how gold price could pass $5,000 and head even higher over the next few years in his latest book published on Amazon.com this week. (click on this link to buy a copy)