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Peter Schiff: Could Soaring Twin Deficits Bring on an October Surprise?

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As we head into the month of October, it’s interesting to note that two of the worst stock market crashes in history during this month. Of course, we had the 1929 Wall Street crash that kicked off the Great Depression, and there was also the Black Monday stock market crash in 1987.

As Peter Schiff noted in his latest podcast, given that stock market valuations are higher today then they were at those prior peaks, you would think there would be more concern about the possibility of another October surprise. But there seems to be very little worry out there. Nevertheless, Peter raised an interesting question, could the twin deficits in trade and the federal budget portend another October crash?

The dollar remained strong after the Federal Reserve hiked rates last week. Peter said he kind of expected an after-the-fact selloff in the greenback, but continued euro weakness as the EU wrestles with Italy’s debt problem kept the dollar on the rise. Currently, Italy’s deficit to GDP ratio is slightly above the 2% threshold allowed by the EU. Interestingly, Peter noted that the American debt problem is far worse than Italy’s.

If America tried to get into the EU, we couldn’t, because our debt-to-GDP is about 5%. And that’s now. It’s going to soar over 10%, well over 10%, in the next recession. But our debt is twice as high relative to our GDP as Italy’s. So, we don’t have a shot at getting into the European Union, although obviously, we don’t have to try.”

Meanwhile, the trade deficit keeps going up. Peter said if we keep running these kinds of trade deficits, we are eventually going to have a serious crisis in the dollar. And of course, it was concern about the trade deficits and concerns about the dollar that precipitated the 1987 stock market crash.

We got the August trade deficit numbers last week. The expectation was that there would be an improvement from the July number of 72.1. There wasn’t. It rose, coming in at 75.8. It marked the largest trade deficit in merchandise since the summer of 2008. And what happened right after the summer of 2008? The collapse of 2008.

The reason the trade deficit got that big is before the collapse, we had a bubble. We had a consumer debt binge where all the cheap money that was being created was feeding imports because Americans were taking their incomes, or their cheap money, and buying imported products. And so the big trade deficit was evidence of the bubble. And of course, the big trade deficits in and of themselves are unstainable.”

The big difference between then and now was that the dollar had been falling and was at record lows. Since we have a stronger dollar, you might expect the trade deficits to be smaller because the dollar should buy a lot more.

If the trade deficit is so big now with the dollar strong, imagine what’s going to happen with the trade deficit when the dollar soars and all of our imports become that much more expensive.”

Remember, when the 2008 crash happened, the dollar strengthened. Between the dollar rising and the drop in consumption, the trade deficit narrowed during the crisis.

I think when the markets come down next time, even though there will be a reduction in consumption, and clearly a loss of wealth, I think the trade deficits are initially going to get even bigger because of the decline in the value of the dollar because the dollar has been ignoring the increase in the trade deficits. Traders and speculators have bid the dollar higher …  They’re all oblivious, thinking about how strong the economy is and how much the Fed is going to keep raising rates and how they’re going to shrink their balance sheets, and so everybody’s been buying the dollar and they’re going to get caught blindsided when the economy turns down.”

Peter said there is really no reason to be blindsided when you actually look at the economic numbers. Even the Fed has revised down growth estimates in recent days.

Ultimately, it seems likely we’re heading for trouble. We’re on pace for all-time high twin deficits – budget and trade. Again, those big twin deficits were a big part of the 1987 stock market crash. And they were actually lower then. It’s just that people cared. Right now, they don’t. The question is how long will that last?

At some point, the focus is going to go back in these deficits, especially once the dollar starts to turn down and inflation turns up, and the Federal Reserve starts to ease monetary policy in the face of increasing inflation and a weakening dollar … As the markets perceive that the Fed is basically surrendering to inflation, ignoring inflation, that they are going back to zero percent rates, and I believe the next time the Fed cuts rates, they’re going to go straight to zero. They’re not even going to pass go. Because first of all, they’re not even that high. They’re barely above two. But if things start to turn down, they’re going to go quickly because they’re going to give it all they got. But then, of course, that’s not much. So, I think big thing is going to be quantitative easing. I think they’re ready to play that card as soon as they perceive that they need it. But when the markets are prepared for the opposite of that, when the markets are prepared for rate hikes and quantitative tightening, and they’re caught completely by surprise with the Fed doing the opposite of what they had been expected, that is when you see these abrupt moves in markets like what we had in 1987.”

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