“A Total Illusion from QE and Financial Engineering”

The 10-Year Treasury Is Less Than You Think

By Harry Dent, Economy & Markets

When the Fed was created in 1914, it was set to task of controlling short-term interest rates in an attempt to iron out financial cycles. It succeeded for many years. But by avoiding the natural rebalancing (and occasional pain) from free markets, we just got a bigger bubble into 1929. Then, when it finally burst, we got the greatest depression in all of modern history!

Since the Fed and other central banks were created, they have always manipulated short-term interest rates to try to encourage borrowing and spending in slowdowns – to make the natural economic cycle “go away.”

And every time, it suppresses the economic cycles that were already in place, until finally they come roaring back.

So it always strikes me as funny to see highly educated, seemingly reasonable people in pin-striped suits and pantsuits stand in front of us and basically say that there’s a free lunch after all – that we can get something for nothing!

To them, economics is no longer a matter of supply and demand, free markets and rebalancing. They think we’ve found a way to program the economy so we never have a recession again.

All the apparent education and sophistication of these top economists, financial officials and central bankers boils down to this simple automaton explanation: if we don’t keep taking more of the financial drug that we used to keep the bubble going, like zero interest rates and QE, we will collapse and go into detox.

It’s the same logic of any extreme addict. When a serious drug addict comes off a high, he realizes the only non-painful choice is to take more of the drug.

As Charlie Sheen said: “the key to drinking is to not stop.”

My interpretation: you don’t get something for nothing, and by going into denial and doing things that make you feel better today while ignoring the consequences, you simply make the inevitable comedown worse.

And that’s exactly what central banks have done today. They’ve always meddled with short-term interest rates. But outside of emergency times like in World War II, they have never substantially printed money to buy their own bonds to suppress longer-term interest rates as well. Look at this chart that shows the 10-year, risk-free Treasury bond rate. Today, it stands around 1.79%. When adjusted for three-year average inflation rates, it’s much lower:


After years of non-stop QE, its yields had actually fallen to 0% in late 2014, and today it’s still only around 0.4% – practically zero!

Most people don’t understand that all other financial assets are heavily influenced by the 10-Year Treasury bond rate (or similar sovereign bonds in other countries). Higher-risk bonds from AAA corporate to junk are valued as a risk premium for default above the risk-free rate. Lower risk-free rates mean lower bond yields and higher bond values all the way up the junk bond scale.

Loans for mortgages and auto loans, etc. go down in rates, with a risk premium that is very low on government guaranteed mortgages. That pumps up prices of real estate and other highly financed assets, as everyone can buy more for the same monthly payment.

Lower rates mean higher stock values as well. Stocks are basically valued by projecting earnings 10 years out, and then discounting their value to the present by adjusting for the interest on the 10-year, risk-free rate.

At lower long-term rates, companies can borrow at near zero adjusted for inflation, and buy back their own stocks to increase earnings per share – even if earnings are not growing. Or, they can buy out or merge with a company financed by cheap debt… the list goes on.

It’s all about financial engineering – not about productive investment in future assets and employment.

This final bubble since 2009 is a total illusion from QE and financial engineering – not the normal fundamentals of rising demographics, innovation and productivity. And as an illusion, it will disappear much faster than it was created when it finally bursts. Now you see it… now you don’t. Learn about the true State of our Economy – without the sugarcoating. Put all the pieces of the economic puzzle together with Economy & Marketsnew FREE eBook! Click here to get it.

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  34 comments for ““A Total Illusion from QE and Financial Engineering”

  1. Thomas Malthus says:

    The problems is…. growth has ended… all that remains are increasingly desperate measure to fend off the end of days.

    The problem is — the cost to extract oil has sky-rocketed — which destroys growth — but if oil drops in price (as it has) that bankrupts the producers.

    Rock and hard place.

    The central bankers are responding s one would expect to such a situation – they are doing ‘whatever it takes’

    They will of course fail. And then civilization – which has been powered by cheap to extract oil — will end.

    It’s been a wonderful 100 years or so though :)

    According to the OECD Economics Department and the International Monetary Fund Research Department, a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second years of higher prices. http://www.iea.org/textbase/npsum/high_oil04sum.pdf

    For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil production has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies. http://www.bloomberg.com/news/articles/2012-09-23/how-high-oil-prices-will-permanently-cap-economic-growth

    Steven Kopits from Douglas-Westwood said the productivity of new capital spending has fallen by a factor of five since 2000. “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programmes. Nearly half of the industry needs more than $120,” he said http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11024845/Oil-and-gas-company-debt-soars-to-danger-levels-to-cover-shortfall-in-cash.html

    • Petunia says:

      Something tells me that if you discounted the salaries of the executives to 10x the average company wage, then limited interest payments to the libor rate, all these oil companies would be profitable. They want bigger profits but I don’t think they need them to operate.

      • Chip Javert says:

        …and you would be wrong for 2 reasons:

        1) Generally speaking, CEO get paid in stock, not cash;

        2) Try hiring a CEO on the cheap and see what you get (and what happens to your company, employees and stockholders).

        If you think being a CEO is so easy, try getting one of those jobs (competition is fierce and longevity is shrinking). Once you get a CEO job, you better be able to produce (aka: make money).

        Example: Exxon CEO gets about $40m, 0.27% of $15B annual profit.

        Companies don’t decide, out of the blue, to make more profit – shareholders (eg: individuals, pension funds, mutual funds, hedge funds, etc) absolutely force them to increase profit. Lag behind what shareholders expect and you’re out of a job. Companies do other things with profits than simply “operate” – for example, paying dividends to shareholders.

        I won’t even comment on the fantasy of a company attempting to unilaterally set interest rates on their debt (Mr Market will simply not play that game, except in China).

        • Petunia says:

          My point was that if you reduce expenses to the lowest level possible, you can make the company profitable. The level of profit may not be attractive to a CEO with expensive habits, but that only proves that an expensive CEO hurts profits.

          As for interest rates, the rate a company gets charged is affected by the perceived competence of the CEO. A CEO that is willing to take a hit today to grow his company is one that can negotiate the best rate. A CEO that will cut expenses to the bone to keep the company afloat is perceived to be a good risk.

          I actually met the CEO of Mobil back in the 80’s. Even though he offered me a job after having spoken to me briefly on a flight, I wasn’t impressed enough to accept.

        • walter map says:

          “Try hiring a CEO on the cheap and see what you get”

          CEOs in the US make orders of magnitude what they make in other countries because US CEO pay, like everything else having to do with money in the US, is rigged, and the history of that corruption is available for all to see.

          Unscrupulous advocates naturally say otherwise, but some of us are not so easily lied to.

    • interesting says:

      i think the price of oil is a red herring, the real issue is incomes have just not kept pace with the cost if living (not the bogus massaged inflation rate) in the united states. I know my hasn’t even come close, even when adjusting for the bogus inflation rate my income is about 1/2 of what it was in 1993….or in other words i make the same money now as i did in 1993…..can you see a problem there? a customer just hired a new your guy that they are going to train in our industry (engineering) and adjusting for the bogus inflation rate, when i was that person, this person should be starting out at ~$33 an hour……..they hired him at $20.

      i’m self employed and there is just no way to raise prices so i’m stuck in a race without a driver.

      also, financial engineering has also played a role as well, there is no longer any real money in developing a better mouse trap it’s all about shuffling debt from one pile to another and taking your cut along the way. that’s why were still flying in the same planes that were developed in the 1960’s IMHO.

      and finally, the oil shock of the 70’s didn’t end the world and conservation would negate any consequences of a large oil spike but there’s no money in developing that so……

      ramble over,

      p.s. i hate to post this with no access to an edit button…. :(

      • Thomas Malthus says:

        It’s a combination for sure.

        When oil was $147 that caused turmoil — because when businesses need to pay more for everything because everything at the end of the day costs more when oil goes up in price — they are obviously not going to pay workers more.

        In fact they are likely to slash expenses wherever possible — and that means worker wages stagnate or decrease.

        That is where stimulus comes into play — if the consumer slows consumption due to falling wages you gotta due something or you get a deflationary death spiral (we buy less = more layoffs = buy even less = more layoffs = bankruptcies = more layoffs = collapse)

        So what we saw around 2001 when the price of oil started to climb over $30 bucks was the Fed targeting the housing market — lending standards dropped — and eventually there were none at all (Liar Loans…)

        That offset the impact of high oil prices for some years until 2008… the system blew up … and the Fed really got into gear with QE ZIRP…

        Now we are seeing the stimulus aimed at offsetting the end of growth starting to fail.

        All these policies have consequences — there is no perpetual economic motion machine.

        We have massive credit crises lurking in the background — we have plummeting corporate profits — with the central banks continuing to step in to create Potemkin villages all around the world…

        And worst of all – we are seeing a collapse in commodity prices – including oil.

        Now when oil drops in price that usually spurs growth. This time is different.

        It is spurring nothing because the world is saturated in debt — demand is wilting — in spite of massive infusions of stimulus.

        This is troubling because it would appear to indicate that the central banks are running out of ideas.

        Peak oil is bullshit – because it implies we will run out of oil. That will NEVER happen.

        Peak Cheap to Extract oil is another matter — as we can see even when oil is relatively low in price – demand is not picking up.

        Imagine if oil went to $100+ again – the price that is needed to continue production.

        Eventually what will happen is the global economy will collapse — and the oil that is in the ground at that point – will remain in the ground.

        Because to happen, oil extraction requires a fully functioning global economy — I think it is quite obvious that we are not going to have much of anything at some point soon.

        Not oil specific — but worth reading — there is a case study explaining what is likely to happen if a key pillar of the financial system breaks on page 56 or so…. the example involves the breakup of the EU


  2. Sally Snyder says:

    Like the other policies that the Fed has adapted since the Great Recession, the effectiveness of this untried policy at prodding the economy back to life is unquantifiable and the risks may outweigh the benefits.

  3. Paulo says:

    Thomas, your points are certainly correct, but few will believe them. In fact, I would hazard a guess that most folks in the US actually belive their country is energy self-sufficient, or damn close to it.

    While Canada is self-sufficient in energy, in every other way the attitude is similar. “up, up and way, all the boosters say”.

    Of course both of our countries way of living is consumption and buying crap we don’t need. Sad,there is so much else that needs doing.

    from: http://www.moonofalabama.org/2009/01/the-never-changeing-way-of-life.html

    The Never Changing Way of Life?

    At the Earth Summit in 1992, George H.W. Bush forcefully declared, “The American way of life is not negotiable.”
    It’s the End of the World as We Know It, Baltimore Chronicle, Aug. 3, 2004

    My principle focus as vice president has been to protect the American people in our way of life
    Transcript: Vice President Cheney on ‘FOX News Sunday’, Dec. 222, 2008

    We will not apologize for our way of life nor will we waver in its defense.
    Barack Obama’s Inaugural Address, Jan. 20, 2008

  4. Brian Richards says:

    Regarding the cost to extract oil, Saudi Arabia, Iraq, Kuwait, Russia and Iran all have very low extraction costs, at somewhere in the range of US$10 to $15 per barrel. The costs to extract oil from deep sea, Canadian oil sands, Venezuelan heavy oil deposits are much higher, probably near US$30-$40 per barrel. I’ve read that many US fracking wells are actually profitable at US$30 per barrel, but some cost a lot more. In other words there are producers that can profit at US$20 a barrel and those who will starve to death at $50 a barrel. Whether a producer “needs” US$100 per barrel is irrelevant Mr. Dent, and is a sensationalist statement without meaning. The market dictates price.

    • ERG says:

      They ‘need’ $100/bbl oil when the Fed is pumping QE into the financial system at $80 billion/month destroying the value of the dollar that also happens to be the international exchange medium for oil purchases. ‘Hey, you wanna pay us in a currency that is deliberately having its value destroyed? No problem: then we want more of it.’ Not a surprise!

      When QE stops (mostly stops, anyway), then its more like…um…where it is now at about $40/bbl.

    • Thomas Malthus says:

      You need to read the FT.com article.

      Extraction costs at the well head are one thing. But overall costs are far higher.

      Think of it this way:

      Apple’s actual production costs out of the factory for an iphone (well-head) are say $30.

      Can Apple sell an iphone for $31 and make money?

      Of course not. They have loads of other costs – R&D, distribution, royalties, taxes, dividends etc etc etc…

      With respect to oil — places like Saudi Arabia that rely almost exclusively on oil revenues to run their countries (and to bribe their citizens to keep them from tearing the heads of the leaders off) are actually in WORSE positions in terms of what they need oil to be priced at.

      Well-head costs are what the MSM points to as the cost of oil — as we know the MSM lies or obfuscates – they need to keep the masses calm — they soothe the sheeple with wonderful stories of electric vehicles and solar panels — these stories are the equivalent of Xanax…

      The global economy runs on cheap to extract oil. There is nothing that can replace it. Nothing.

      We are not at Peak Oil.

      We are at Peak CHEAP TO EXTRACT Oil.

      As we have seen with shale Fed policies of massive amounts of cheap money have made the ‘dream’ possible — it has allowed the US to tap into what was previously a non-starter — sucking the dregs from the bottoms of dead or dying fields.

      That bought us 8 years so far… but as we know dregs are the last slurps in the cup, and the dream will end soon.

      The flip side to that is the policies that the central banks are using to try to keep the system ticking are suicidal. They are blowing up the system to save it — well not save it – to desperately fend off collapse.

      Look around you at the madness. ZIRP and negative interest rates. Plunge protection teams around the world stopping the collapse of markets. Nearly HALF of all new debt in China this year issued to companies that need the cash to make good on interest payments on loans they will never pay back. Central banks shoveling money into the maws of companies that are failing – to be used to buy back shares.

      This is seemingly insane. Why are central banks doing these things? Do they want to destroy the global economy? Are they oblivious to what the consequences of their actions?

      Of course not!!! They know full well that this ends badly.

      So ask yourself – What do they fear?????

      It has to be something pretty god damn bad for them to go down this path – no?

      I used to think as many on this site do – I ranted and railed at the central banks – I hated Bernanke — but then I though hand on… there must be something I am missing

      One of the first keys to putting the puzzle together was finding this research paper.

      Before you read on it is important to understand who wrote it. It was not written by a green group or a ranting peak oiler.

      It was written by the head of global research at this company http://www.tullettprebon.com/strategyinsights/ and put in front of their investment banking clients.

      You do not put something like this in front of a client (nor allow it to be published by the FT) unless you are bloody well confident of your conclusions.

      Now one can go on howling into the wind at the central bankers or you can endeavour to understand the true nature of the situation we are facing.

      It is dire.

      THE PERFECT STORM (see p. 58 onwards)

      The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy.

      But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.


      Oh … and reducing salaries of oil executives will have almost no effect on the overall production costs of a barrel of oil – because the salaries are a tiny fraction of the total costs.

      • Jerry Bear says:

        you are obsessed to the point of monomania with this topic of loss-of-cheap-oil equals end-of-th-world. It blinds you to the possibilities of anything else in reality. You are like a man with a hammer who sees everything else as a nail.
        Maybe what you say is a strong argument for socialism…..

        • Thomas Malthus says:

          And you are obsessed with repeating the same old bullshit about ‘central bankers are corrupt – central bankers are stupid – central bankers are incompetent’ as the reasons for why we are in this disastrous situation.

          I’ve been hearing the same bullshit year after year after year after year…. 8 years counting now.

          Like donkeys banging their heads against walls — over and over and over.

          If you’d just take the blinkers off and think about this a little – you’d understand that the central bankers are none of the above.

          They are doing ‘whatever it takes’ to keep this system alive.

          And you should applaud them for buying you nearly another decade of civilization

          As for socialism I am as hard core a capitalist/entrepreneur as you will ever meet. I run various business in Greater China.

          This has ZERO to do with capitalism or socialism – and everything to do with the fact that the overall production costs of oil are over $100 — the fact that if oil is sold at a profit the economy will collapse (see 2008 $147 oil) — but if the price of oil drops below $100 oil producers stop looking for oil and eventually end up bankrupt.

          That’s about as simple an equation as 1=1=2

          What is it you don’t understand?

          Instead of simply accusing me of being a socialist why don’t you instead explain how I am wrong here.

          It is rather difficult to engage in a debate when the other side screams insults.

          Or perhaps you are simply demonstrating your intellectual limits when you do that?

  5. Merlin says:

    Prudent operators have always made money in O&G as they conduct daily activities within cash flow or well within their borrowed cash based on proven reserves. These price-prophets are feckless fools who have likely never worked a day in the patch, or if they did, they must have worked for a big, bloated major that operates like our government, or they think all companies are highly-leveraged to Wall Street cartels.

  6. Winston says:

    “When the Fed was created in 1914, it was set to task of controlling short-term interest rates in an attempt to iron out financial cycles. It succeeded for many years.”

    What?! What about the Great Depression starting only 15 years after the creation of the Fed?

  7. nick kelly says:

    I remember at the height of the Greenspan reign reading that he had ‘tamed the economic cycle’ and thinking, this will end badly.
    It’s taking a while though- I guess it does to fully mortgage a great power.
    Imagine the UK in 1974, which 60 years earlier had ruled half the world, trying to borrow money from West Germany- actually almost begging- the UK minister TWICE approached the German at a banquet. Rejected, Had to go to the IMF and was shocked when there were conditions.
    What was it Shelley wrote on seeing the ancient stone monument half buried in sand that bragged : ‘Look on my works!’

  8. Kam says:

    “It’s all about financial engineering ”

    I object to the term “engineering”. The implication from that is well-thought out mathematical precision for a stable structure.

    Financial con job is a better descriptor.

    • Thomas Malthus says:

      Financial engineering is what made shale possible. If not for the Fed’s policies that oil would never have been touched.

      • david says:

        If not for the Fed destroying what is desperately needed…the market to price the cost of money….we wouldn’t be in such deep doodoo. They won’t let markets correct, prop up bubbles, destroyed an entire income stream for savers, retirees, pension funds, insurance companies, etc and in general have made a mess of debt.

        It did prop up a lot of the oil industry with too cheap debt, resulting in oversupply and the bankruptcies we see today. All this NIRP/ZIRP nonsense is plain craziness and extremely harmful.

        • Thomas Malthus says:

          If the central banks had not done what they had done — we would not be having this debate right now.

          Civilization would have collapsed in 2008.

          Don’t get me wrong – it is going to collapse – but if there are things we can do that delay that even another year or month – or better still a couple of more years – then I am all for them.

          I am 100% behind the fact that the PBOC just ran up another $4 trillion in debt – 45% of which is being loaned to insolvent companies to delay their bankruptcies. http://davidstockmanscontracorner.com/the-lemmings-of-wall-street/

          I am all for more QE in Europe and Japan – I am all for negative interest rates if they keep the system alive awhile longer.

          I am all for hundreds of billions being made available to failing companies to prop up their stock prices.

          I am all for subprime autos if that keeps the auto industry alive awhile longer.

          I don’t care how insane a policy seems – so long as it pushes the end game out.

          And thankfully – the central banks know what I know – that the end of growth is upon us — caused by the end of cheap to extract oil

          Sadly the central banks cannot print cheap to extract oil — but they do have a few tricks up their sleeves that allow the engine to run (coughing and sputtering) on expensive to extract oil.

          However this oil is toxic to the engine — it will destroy it.

          Every single seemingly ‘insane’ policy you are seeing is aimed at one thing — delaying the death of the engine.

          Surely that must be obvious? Why would the central banks blow up their wonderful system unless they knew it was on its last legs anyway?

          It’s kinda like you’ve got an old mule and he’s dying — you could just him lie down and die – or you could pump him full of HGH, steroids, and speed… and get a few more miles out of him before he dies

  9. rich says:

    “Those who seek to question the illusions are, Socrates warned, usually attacked and killed by the mob, which does not want its comforting myths punctured. When reality is too painful to bear, a population does not seek freedom or truth; it becomes an accomplice to its own enslavement.”

  10. Chicken says:

    “And every time, it suppresses the economic cycles that were already in place, until finally they come roaring back.”

    Please just call it what it is, the sooner everyone realizes the faster we can eliminate the problem of theft via transfer of wealth.

    End the slight of hand designed to allow offloading bad assets onto the unsuspecting.

    I don’t see the parallel with Weimar, this seems to be disinflation and PMs have rallied b/c Treasury rates offer no return and too much risk but low rates are the longer time horizon normal, not false short-term inflation caused by consumption enticement pulling demand from the future?

    See what happened early today in terms of the oil patch for example, fear of falling production caused a scramble for higher prices but the trend hasn’t changed in the longer horizon, demand is falling and with it goes production. Demand is falling in about everything due to the policy of guiding down economic growth in favor of climate change.

    • Jerry Bear says:

      People also ought to remember that it wasn’t the hyperinflation of the early Weimar Republic that created the Third Reich. That was quite efficiently brought under control by sound economic policies. What brought Hitler to power was first and foremost the Great Depression that the Weimar government was unable to ameliorate in any way. When you have mass numbers of destitute, hungry people and tell them that the social contract no longer means anything and that they have no way to better their situation then you have the start of a very dangerous revolution. Never underestimate the tremendous power of bringing hope to the hopeless!

  11. walter map says:

    QE and financial engineering are not intended to restore the real economy. That would empower the masses and would contradict policy. They are intended to enrich the wealthy at the expense of the general population. Duh.

    The overall policy goal is to squeeze the economies of high-wage countries until they die and then rob the corpses until there’s nothing left to steal, leaving the world with low-wage countries under the tight control of financial oligarchs. If some other result was intended they would obviously pursue other policy goals.

    These guys are anything but stupid and they have already won the class war. What you’re looking at is just the mopping up operations.

    Deal with it.

  12. Ptb says:

    The Problem with the 1% is that they don’t consume enough, yet they own most things. Cheap money tends to lead to asset price increases. The 1% keeps buying assets while the 99% buy less and less consumables.

    • Chicken says:

      Funny you should say that, there are some who think differently than you apparently, it seems. I’m saying the problem I see is, lower classes consume too much and policies are evolving to stop that.

      We can’t expect anything else, they’re telling us this is the goal just as they told us their goal was to export the “dirty jobs Americans don’t want”

      You know this I expect, by examining recent history. Transferring wealth rapidly, is the primary tool.


    • Jerry Bear says:

      The ultimate goal of any upper class is to stop being in any way productive but by crooked means ends up owning everything and supporting themselves by the exorbitant rents they want to charge anybody who does anything productive. They want to, in other words, to establish themselves as a class of supremely privileged parasites that drain the efforts of everybody else and commandeer the income as well as the wealth of a society. This is the basic situation you find in most 3rd world societies and why they are often so wretched. All of the old style economists. not just Marx, recognized this “rent seeking ” was the greatest long term threat to Capitalism and they understood its real goal was to reverse the entire Capitalist revolution and re-institute Feudalism. The American must understand what a dire threat these villains represent and deal with them accordingly. Like Thomas Jefferson aid, you occasionally need a revolution to keep the democracy fresh.

  13. J P Frogbottom says:

    It would appear to me, with the Boomer’s just past their prime buying years, no matter WHAT the interest rates are (FREE to absurdly high), the demand side of this equation will taper down, down, down, until the Millennial generation (slightly larger than us Boomers) is their peak earning / spending years.

    Why is this reality SO hard to grasp? I realize we have been contained to expect “growth” and “more” every year, but unfortunately, there is no more ‘there’ in ‘there.’

    Demographics, though not liked, is a truth none the less.

  14. Atticus Finch says:

    The problem with the discussion is the description of a problem in the current system, when each problem is only a symptom of the disease. The core issue is that the system is dysfunctional and it needs to be replaced. Discussions limited to symptoms of the actual disease are confined to the allowable envelope within a failed system. It’s like repainting a car when the engine is dead. There can be no resolution until the current system ends.

    Bottom line; sovereign countries do not need to borrow money from a private, for-profit banking corporations. Sovereign countries print their own money and do not owe anyone, anything — there is no deficit. And a sovereign does not need permission to do it.

  15. Chicken says:

    Makes me wonder what else is an illusion, you must wonder as well?

Comments are closed.