Below is another great article from John Mauldin via his weekly newsletter.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

–Old Scottish Prayer

Where the Wild Things Are is a beloved children’s book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve’s low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let’s quickly set the background.

It Is Not Just Japan

Let’s look at today’s interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can’t make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China’s Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has ’seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"’I'm scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration’s willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron’s just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

Source

Where the Wild Things Are – John Mauldin

Related posts:

• Chart of the day: Aussie – Yen cross
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Japan’s easy money policy was the trigger for the tech wreck
• Mea culpa on the need for a new currency
• The dollar is rising against floating currencies

This is a post I just wrote over at Yves Smith’s site Naked Capitalism in response to a reader request. Marshall Auerback has already written a reply as well and I will post this later today.

A reader at Naked Capitalism asked us to respond to a recent article from the Christian Science Monitor asking Does US need a second stimulus to create jobs?

Marshall Auerback has already done some heavy lifting. He says emphatically yes. Now I want to take a crack at this. My short answer is no. But before I go into this, as an aside, I wanted to mention Marshall’s new smiling, happy picture up at the great blog New Deal 2.0 where he now writes.  Earlier, when Credit Writedowns was hosted at Blogger, he used a picture best described as a mug shot in his profile, but he has changed that one too (although he smiles there a little less). He thinks we haven’t noticed this sleight of hand.  Well I have! Once upon a time, Marshall wrote with a man I called all bearish, all the time this summer. Take a look at that post; you don’t see him smiling now do you? We have Lynn Parramore, New Deal 2.0’s editor to thank for making Marshall Auerback into an optimist.

Different policy choices

But all teasing aside, I do want to take the opposite side of this trade.  You see I too was a deficit hawk. And while I may have been backing fiscal stimulus, I have felt conflicted for doing so. Here’s how I see it. 

You have four options:

1. No stimulus. Let the chips fall where they may. Yves Smith calls this the ‘Mellonite liquidationist mode.’ The thinking here is that trying to avoid the inevitable bust only makes it that much larger. And the economic policies during recessions in 1991 and 2001 seem to bear that out. The Harding Recession of 1921 is commonly seen as gold standard response.
2. Monetary stimulus only. Quantitative easing mania. My understanding is this is what Ambrose Evans-Pritchard has been advocating.   The thinking here is that the flood of money and the low rates will eventually jump start the economy. No deficit spending needed.
3. Monetary and fiscal stimulus.  Full tilt Keynesian. This is the Krugman view. The thinking here is that one needs to credibly commit to higher inflation and close the output gap to avoid a deflationary spiral. If that is insufficient, then one needs to go full bore on fiscal stimulus aka deficit spending. And if that doesn’t work, subsidize jobs. The New Deal is commonly seen as the gold standard response.
4. Fiscal stimulus only. Deficit spending. I have been talking up this view. The thinking here is that we need to both close the output gap to prevent a deflationary spiral and revive private sector savings in order to promote deleveraging.

There is no magic bullet here.  We are living through a situation unique in time with few historical precedents. And there are a lot of competing ideas being tossed about. So policy makers are groping around, desperately seeking the holy grail of depression-busting economic policy.  In that regard, I don’t envy them. They are certainly going to make a lot of mistakes. It may seem at times that I don’t realize this given the harshness of my critiques, but I do.

Deficit hawks are misguided

However, there are some policies which could work and others which are flat out wrong.  One policy which is flat out wrong is the concept that we need to reduce deficit spending in order to avoid a double dip recession. This flies in the face of basic economics which says that more spending and less taxes equals greater demand and recovery/boom. More taxes and less spending equals less demand and recession/depression.

Now, it’s not as if we didn’t see this line of argument coming. As far back as November 2008, I heard the chatter (see my post here). So you knew this we-have-to-stop-or-we’ll be-bankrupt nonsense was coming. The problem is it’s just not true.  Here are a few data points:

• Private sector debt (incl. financial firms) was 292% of GDP as of Q2 but public sector debt (incl. state and local municipalities) was 67.2%. Who’s more indebted – the private sector by a factor of 4.
• Adding unfunded liabilities to any public debt number when talking about spiking treasury rates is inaccurate and artificially inflates the number. A lot of people do this to make the public debt scenario look worse. The issue at hand is whether a supply/demand imbalance in Treasury securities spikes interest rates. Unfunded liabilities have absolutely nothing to do with this.
• Cash and bonds are fungible. They are both obligations of the federal government to be repaid in full with a specific sum of fiat money. The Treasury could literally stop issuing government debt altogether and just start crediting accounts electronically to ‘fund’ its purchases. There is no operational constraint to government spending. The U.S. government is not going broke involuntarily. See my post here.

The real issue with deficits causing a double-dip has to do with inflation and overheating. If inflation increases because the economy begins to overheat, interest rates spike and the Fed raises rates to choke off inflation. That’s not going to happen any time soon – although it may be a problem down the line.  The issue at hand now is deflation not inflation. At least Morgan Stanley understands this when they take a deficit hawk position.

And as for the Chinese, they are not going to pull the plug on Treasuries unless they want to tank their export boom. The reason they must buy Treasuries is the dollar peg; they must re-invest in U.S.-based assets in order to prevent their currency from appreciating. This has caused a huge rise in their U.S. dollar reserves. If they changed the peg, their currency would almost certainly rise and this would choke off exports.

No more stimulus, just jobs

I have said my piece about the need for stimulus in the past. So I won’t repeat it here. If you are interested, see my December 2008 posts “Confessions of an Austrian economist,” “What does Mises say about trying to stimulate the economy out of recession,” and “A brief philosophical argument about the role of government.”

But, on the whole, I look at long-term deficits in a dubious light. There are practical constraints to deficit spending – and they lead to inflation, currency depreciation and lower standards of living. This is not national bankruptcy, but it is what Murray Rothbard called default by inflation and it makes you and me less well off.

This, of course, is over the long-run. In the short run, it is the spectre of a deflationary spiral we care about. Stimulus was important to stop this. I said in February that Obama was making a big mistake with his stimulus measures.

My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.

If you are going to deficit spend you need to do it in a big way. You need to stop the deflationary spiral.  That means hitting the reset button by promoting private sector savings and deleveraging and purging all built-up malinvestments. The risk in addressing the situation this way, of course, is replacing the imperfect invisible hand of markets with the imperfect hand of politicians and legislative fiat.

This is a risk I no longer see as worth taking. I have bailout and deficit fatigue just like most Americans. It is abundantly clear that this Administration has absolutely zero intention of purging any malinvestment or promoting any deleveraging. All they want to do is continue business as usual and go back to the asset-based economy that caused this mess. This is why we have seen bailout after bailout coupled with easy money. It makes for record profits on Wall Street but it does nothing for the unemployed.

Moreover, the political process in the U.S. is such that any stimulus money will be diverted to pet projects and used to pay off political constituents. While this may increase aggregate demand, it does so at the risk of serious social unrest as the outrage will certainly spill over into populism.

So I say no to a second (third) stimulus package.  What the President needs to focus on is jobs. The reason Obama’s poll numbers are shrinking is because he now owns this economy.  And people are not benefitting from this fake recovery.  They are angry at the bailouts and distrustful of government – and with good reason.

Cut payroll taxes, subsidize job creation, divert some military spending to direct job creation by ending the foreign wars. But stop the madness.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Don’t underestimate the power of printing money, part 2
• Inflation: The strategy that dare not state its name
• The inflation-deflation debate
• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

Morgan Stanley’s piece on Treasuries Priced for Perfection…for Now! is pretty bearish. The basic gist is that while the ten-year represents fair value today, because inflation expectations have become unanchored, Morgan Stanley expects the yield to rise from 3.3% to 5.5%. That’s a disaster of 1994 proportions. Obviously, given some of my recent comments, this is not what I expect to happen, but be well aware of the risk; in this economic environment, it would be fatal.

Here’s an excerpt of what Manoj Pradhan had to say (emphasis added):

Fed Chairman Bernanke’s speech on Monday could not have been better tailored to keep bond markets happy. The commitment to keep policy rates "exceptionally low" for an "extended period" and the benign outlook for inflation were both very well received by bond markets, as well as other risky assets… Our proprietary model, MS FAYRE, shows a current fair value of 3.3% for the US 10-year Treasury yield – bang in line with actual yields…

Priced for perfection… MS FAYRE generates its fair value estimate using the real fed funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the fed funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.

…for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks..

Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 – an increase of 220bp that outstrips the 137bp increase in the fed funds rate expected over the same horizon (see Don’t Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009)…

Inflation expectations don’t seem to be anchored… The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However…

…our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.

Obviously, Morgan Stanley is bullish on the economy because they are talking about a bear steepener across the Treasury curve. Their thinking on Treasuries is one reason you see Barack Obama talking about reeling in deficit spending. He obviously believes that an increase in interest rates would trigger a double dip recession.

My thinking goes more to bull flatteners where the two-year – ten-year spread decreases as expectations of a fed rate hike are countered by weak economic fundamentals.  This dichotomy points out some very real risks in the bond market right now.

Bill Gross his on the record expecting Treasuries to rally because he is cautious on the economic environment.

Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’).  In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.

But we know that Gross loves to talk his book and he made billions from the Fannie/Freddie bailout doing so.  You have to make your own call here. It’s Morgan Stanley on one side of the trade and Pimco on the other.

Realistically, if rates spike to 5.5%, it would be a blood bath for insurers, and probably for pension funds (and hence municipalities as well). Mortgage rates would skyrocket and this would stop any housing recovery dead in its tracks. That sounds like double dip and depression to me; this is not an early 1990s economic environment. 

Ironically, 5.5% rates would sow the seeds of future 3.3% rates or lower. If you hold – and do not sell at the bottom – I don’t see how this induces a capital loss.

Related posts:

• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Morgan Stanley sees U.K. downturn worse than Great Depression
• Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds
• Another take on the treasuries bubble
• Bill Gross: Fed on hold through 2010

I pick up Bill Gross where I left him on Friday.  He said in his monthly newsletter that the Fed is going to keep interest rates at zero percent through 2010. But, he is not willing to stick his neck out in a liquidity seeking return kind of way even though this is what reflation is all about. He advises lower risk assets over higher risk ones cognizant that this could mean under-performance.

What I found interesting is that Gross highlighted only two bits in his piece. That should lead you to believe these are the most important points he makes.  The first bit is the rationale behind why he thinks the Fed is on hold through 2010:

The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until.

This is what’s called an asset-based recovery and is exactly the same model we followed in 1992 and 2002. the Federal reserve lowers rates so much that the cash in your pocket burns a hole in it. Grandma may be stuffing her dollars in a mattress, but investors judged against an investment benchmark get fired if they don’t seek returns.  how did Chuck Prince put it: When the music’s playing…

If you are an insurance company, you have a ton of money invested expecting 6-7% nominal returns.  But, in a deflationary environment you have to be smoking something if you think you’ll get that return in low risk assets. So everyone is running the liquidity-seeking-return play. 

The Wall Street Journal mentioned this today:

Though insurers continue to buy bonds, the rally does "make it challenging in terms of getting yield," Steven Kandarian, chief investment officer at MetLife Inc., told analysts in an Oct. 30 earnings call.

Life insurers have long been one of the nation’s biggest bond buyers, currently holding about $1.78 trillion in corporate debt, or 16% of the total outstanding, according to industry group American Council of Life Insurers.

Their frustrations in finding investment opportunities signal how far and fast the bond market has recovered from the dark days when markets were frozen and insurers were diverting almost all incoming premiums and investment income into cash accounts.

But, it sounds like Gross is having none of this.  He asks a rhetorical question about overpriced assets in nearly every asset class:

Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis?

Answering his own question is the only other part he highlights in his essay – one doubting the elevated price of risk assets. He says:

In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity.

Gross goes on to recommend high dividend safe stocks like utilities.  But, I did get the sense he was talking out of both sides of his mouth.  For months now, Gross has been advocating reflation as an economic policy. He has advocated massive deficit spending too.  Back in June of 2008, he was the first one I knew who was talking about deficits in the trillions. Yet, here he is cautioning us about inflated asset prices.  Well, zero rates and inflated asset prices go hand in hand. And I’m sure Bill Gross knows this.

Source

Anything but .01% – Bill Gross, Pimco

Related posts:

• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• High yield is back in business in Europe
• Another take on the treasuries bubble
• Bill Gross: “almost all assets appear to be overvalued on a long-term basis”

Here’s another interesting piece from Randall Wray, the economics professor from University of Missouri-Kansas City (that same school which employs Bill Black of “The Best Way to Rob a bank is to own one” fame).

Wray has a lot to say most, but not all, of which I found convincing – but that’s a story for another day.

This is what I found most interesting:

Here is what I propose: let’s support Senator Bayh’s proposal to “just say no” to raising the debt ceiling. Once the federal debt reaches $12.1 trillion, the Treasury would be prohibited from selling any more bonds. Treasury would continue to spend by crediting bank accounts of recipients, and reserve accounts of their banks. Banks would offer excess reserves in overnight markets, but would find no takers—hence would have to be content holding reserves and earning whatever rate the Fed wants to pay. But as Chairman Bernanke told Congress, this is no problem because the Fed spends simply by crediting bank accounts.

This would allow Senator Bayh and other deficit warriors to stop worrying about Treasury debt and move on to something important like the loss of millions of jobs.

What the good Professor is suggesting is that the Treasury doesn’t have to issue bonds at all.  In fact, since the Treasury does control the electronic printing press, it could legitimately buy stuff with money it prints out of thin air.

Sounds a bit like counterfeiting, doesn’t it?  But, let’s step back for a second:  what is the functional difference for the federal government between Treasury securities and bank notes? Both are liabilities of the federal government. But liabilities of what? The only obligation they enforce on the government is the promise to repay with more paper (or electronic bank credits, if you will). For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency.

I’m looking at a five dollar bill right now.  It says “Federal Reserve Note" across the top. It has an oversized picture of Abraham Lincoln in the middle.  It also says “this note is legal tender for all debt, public and private” in the lower left, signed “Anna Escobedo Cabral, Treasurer of the United States.”  On the back, I see “The United States of America” up top and “In God We Trust” underneath with a picture of the Lincoln Memorial in the middle, labelled “Lincoln Memorial” for those who don’t know what it is. But, I’m trying to figure out why Geithner and the gang couldn’t just reel off a bunch of these and some Jacksons and Benjamins and pay people?

Now I’m looking at a Canadian Twenty. It sure is colourful. It has a bunch of French on it and a picture of the Queen. But, other than that, it’s really no different than the American fiver. “Ce billet a cours legal/ This note is legal tender.”

I have some Euros and Mexican pesos too. But these central banks don’t say anything about their obligations.  Very dubious! At least they’re colourful like the Canadian money.

How ‘bout a British tenner? Dickens on the front, and the Queen on the back (she’s everywhere). A-ha. Here’s what I’m looking for. It says “Bank of England. I promise to pay the bearer on demand the sum of ten pounds.” 

I think that gets me to my point, actually.  From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to.  When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

Am I missing something?

Source

Memo to Congress: Don’t Increase the Government’s Debt Limit! – L. Randall Wray

Related posts:

• Russia, sovereign debt defaults, and fiat currency
• Interest rates up in the US as investors choke on supply
• Quote of the day: Stephen Roach
• Another take on the treasuries bubble
• Mea Culpa: The Fed is not going to buy treasuries

Marc Faber is in a bullish mindset, particularly on gold. In a wide-ranging interview with CNBC TV-18 in India, Faber talked about where he sees markets headed and why he thinks gold will never drop below $1,000 an ounce.

Private sector contracting while public sector expanding

This is the frame that Marc Faber puts on recent events post 2008 panic, namely that we are likely to see an era of increased government intervention. This is an echo of comments Bill Gross has been making for some time. We are seeing this stimulus on both the fiscal and monetary sides through fiscal stimulus programmes and quantitative easing worldwide.

The economy has not responded robustly given the size of stimulus, Faber says. Asset markets, on the other hand have. This sets up a clear dichotomy between ordinary citizens and those who benefit most from asset price appreciation on Wall Street and elsewhere in the financial sector. Moreover, the spill-over of asset price appreciation into commodity prices further constrains purchasing power for ordinary citizens.

Less certain about carry trade

Faber is less certain about the U.S. dollar carry trade. He sees a dollar overhang due to the enormous U.S. current account deficit and $7.7 trillion in U.S. dollar reserves as more the issue. Many are looking to sell these dollars and hedge their exposure in precious metals and other currencies.

Treasury bearish

The one area where Faber is bearish is U.S. treasuries. He says:

There is a risk that at some stage in 2010, the government bond markets (would) weaken considerably because I don’t understand why anyone who would now buy a 10-year US treasury at a yield of less than 3.5%. It’s a losing proposition. I also don’t understand why anyone could buy a 30-year US treasury at a yield of 4.4%. So I think that eventually yields will go up and this could disturb the stock market.

Not as bullish on equities

Given the huge uptick in share prices globally, Faber believes there is now limited upside going forward.  He says the risk/reward in equity markets at present is not favourable. Moreover, profit margins are cyclically high due to cost-cutting. Faber anticipates weakness in profits in 2010, causing earnings to disappoint and precipitating a correction.

Bullish on commodities and precious metals

His logic is as follows: cash is now trash with zero interest rates. So holding cash means underperforming.  Bonds present an unfavourable risk/reward.  Therefore, commodities and precious metals look attractive. One must also have equities exposure.

Interestingly, he makes a fairly explicit statement in favour of peak oil from about 1:40 in the second video below. The world is adding less in oil reserves than it consumes. That necessarily means a tighter supply/demand dynamic, especially given the demand in emerging economies for oil.

He uses a technical argument to make his money quote (in bold):

I believe that whereas in the past the USD 1000 per ounce level was kind of a resistance level, now it becomes a support level. I don’t think that you’ll see gold below a USD 1000 per ounce probably ever again.

So I’m actually quite positive. Maybe gold at this level is a better buy than it was at USD 300 per ounce in 2001.

Much, much more below.

(videos embedded below)

Marc Faber Interview: Part 1 (6:19)

Marc Faber Interview: Part 2 (5:42)

Sources

Gold will never fall below $1,000 an ounce: Faber – Live Mint

Gold won’t fall below $1000/oz level ever again: Marc Faber – Money Control

Related posts:

• Marc Faber says avoid financials and buy gold
• Marc Faber: I advise every American to hold his gold outside of the United States
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”

Bill Gross of Pimco spoke on Bloomberg with Tom Keene and Ken Prewitt. He thinks the U.S. is entering a new normal of low nominal GDP growth. However, financial bets have been made on 6-7 percent nominal GDP (think pension liabilities).  Unless we get 5-6% nominal GDP growth debt deflation and deleveraging dynamics (the D-process)will take hold, Gross says.

This is not a bullish scenario for equities as revenue growth is based on nominal GDP, meaning profit growth must come from trimming expenses and a secular increase in already high profit margins. Lower interest rates are the only other way to improve the net present value of future profit streams.

Pimco is dipping a toe into equities, however.  Gross remains cautious on high yield, which he sees as fully priced (buyer beware) a.k.a. overvalued. Mortgage backed securities are also overpriced in his view.  That leaves you emerging markets, corporates, and treasuries in the bond area.

So the Fed will be on hold because they need to see at least 4-5% steady nominal GDP growth, something unlikely to occur before the end of 2010, Gross says.

Video below.

Se also: Bill Gross Says Value Diminishing in Credit Markets – Bloomberg

Related posts:

• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• Bill Gross: Government intervention in markets will last
• The $1 trillion deficit: has Bill Gross gone crazy?

I have really started to dislike municipal bonds as an asset class. They have seen a huge rally along with almost every other financial asset but the underlying fundamentals are weak because of financial distress at states and municipalities.

Last week, I wrote a first piece on this topic, based on some work by Philip Greenspun and Fred Sheehan. I also just wrote a piece about Ambac Financial’s likely bankruptcy, which will impact this market because of Ambac’s municipal bond guarantees. But, a Barron’s piece about Jim Chanos of Kynikos called “Short Seller: Dump Munis” piqued my interest and precipitated this particular article.

Chanos is bearish

The Barron’s piece by Tom Sullivan said:

James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market — in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron’s staffer Susan Witty, adding that he wouldn’t touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It’s not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It’s all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state’s bonds will likely lose their federal tax exemption, he adds.

Sullivan went on to use New York and New Jersey as other examples of what is amiss for state bonds.

Revenue shortfalls

A New York Times article which I linked to this morning makes the situation in New York plain, ending with this:

The comptroller’s office numbers are more pessimistic than those from Mr. Paterson’s budget office. They project that the deficit for the remainder of the current fiscal year stands at $4.1 billion, with deficits of $7.8 billion and $15.7 billion in the succeeding years.

Mr. Ravitch, who helped steer New York City through its financial crisis in the 1970s, said, “The numbers are real and my own personal view is that they’re going to get worse.”

New York and New Jersey are suffering the same problems that California suffered, namely a huge fall in income and property tax revenue. This is true all over the country in places as far apart as Oklahoma, Hawaii, Texas, and Georgia.

Assets falling, liabilities ballooning

But, it’s not just about revenues versus outlays – the income statement. It’s also about assets and liabilities – the balance sheet. recently I spoke to Peter Schweich, a retired vice president of Boston University and founder of Boston University Academy, who had done some research on municipalities in Massachusetts and he explained that his research indicated that municipalities had seen a 30% fall in investment portfolio values during the credit crisis (much obviously gained back since). Even worse, he pointed me to enormous looming liabilities not reflected on balance sheet or considered by the ratings agencies.  In a recent Forbes article, he wrote:

While municipalities are able to raise property taxes to cover current salaries, not without considerable pain to the taxpayer, few of them, if any, are prepared for the future financial demands of their grossly underfunded or completely unfunded Other Post Employment Benefits (OPEB) obligation. OPEB obligations are primarily associated with health benefits for retirees.

In 2006, the Federal Reserve Bank of Chicago held a pension conference. In a short note, it reported that a "back of the envelope guess" for OPEB was $700 billion and that "other estimates suggest that OPEB exposure could range from five to 10 times current outlays for retiree health care."…

Cambridge, Mass., now known to most Americans as the city where a homeowner can be arrested for "breaking into" his own home, serves as a good example of the overwhelming burden residential and business property owners across the country are about to confront. Current and future Cambridge residents are now facing a completely unfunded OPEB obligation of $602 million. That figure, alone, is nearly one-and-a-half half times greater than the city’s entire 2009 budget. In addition, like most municipalities, the recent economic downturn has resulted in a significant loss to Cambridge’s regular pension fund: a 28.6% loss in 2008 in the amount of $225 million.

In addition, Cambridge has an unfunded liability for its regular pension fund (distinct from the OPEB fund) to the tune of nearly $70 million, and, of course, Cambridge also carries bond obligations, as do many municipalities. The Cambridge bond obligation exceeds $300 million. This means Cambridge, with approximately 75,000 permanent non-university student residents, one municipal employee for every 22 residents, and 22,000 taxable parcels, has current financial liabilities of nearly $1.2 billion…

Not surprisingly, the Cambridge city manager boasts of Cambridge’s financial stability each year in the introductory letter to his submitted budget. To bolster his claim, he proudly points to the Triple A bond ratings that Cambridge holds from Moody’s, Fitch and S&P. Cambridge, therefore, has 75,000 residents, 22,000 taxable parcels, $1.2 billion in financial liabilities–and a Triple A bond rating from Moody’s, S&P and Fitch.

These are circumstances that are being repeated across the United States. Expect scandals involving alleged improprieties to mount when financial distress hits. One notable example in the news is San Diego, where the top pension administrator is exiting after last year’s over 25% loss and where the fund is also being buffeted by two separate scandals: a conflict of interest scandal and a scandal where overtime pay was counted toward the formula in firefighters’ pension overtime. San Diego was also in the news a few years back because of a separate scandal where an alleged special pension benefit for the fire chief was under attack. See also San Diego’s Pension Scandal for Dummies from 2005, which details the conflict of interest case to that date.

Ratings agency problems

Then there are the rating agencies. Remember the whistleblower scandal from last month? It was all about municipal bonds and the Moody’s allegedly putting their revenue generating relationship with municipalities ahead of the rating function. If you recall, it was exactly this conflict of interest which led to Arthur Andersen’s downfall in the Enron scandal.

This is what Reuters said about the Moody’s whisteblower scandal last month:

Two former Moody’s executives — Scott McCleskey and Eric Kolchinsky — testified that senior managers were willing to silence employees who raised concerns about the ratings process or compliance efforts.

McCleskey said that while he was the head of compliance at Moody’s, he voiced concerns that the firm was not properly monitoring ratings on municipal debt. McCleskey, who was dismissed by Moody’s in 2008, said he was instructed not to mention the issue in e-mails or writing.

Kolchinsky, a Moody’s managing director who was recently suspended by the firm, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

The two whistleblowers were flanked by Moody’s current chief credit officer, Richard Cantor. Cantor sat impassively, staring straight ahead as his former colleagues described their concerns to the lawmakers.

In his testimony, Cantor said Moody’s had recently hired an independent law firm to review Kolchinsky’s allegations.

That was criticized as an empty gesture by Chairman Towns, who said the law firm had no deadline and would not produce a written report.

Kolchinsky told lawmakers that Moody’s compliance group was understaffed and lacked independence. He also alleged Moody’s knowingly issued misleading ratings on complex securities and that analysts were "bullied" by managers, who overrode their decisions to protect revenue.  Kolchinsky said he would soon meet with the SEC to discuss his charges. SEC officials said the regulator had contacted Kolchinsky about his concerns in March 2009.

McCleskey, meanwhile, sent the SEC a letter in March 2009 warning about Moody’s weak compliance department and ratings process. He said Moody’s management had ignored his warnings that the company failed to properly monitor municipal bond ratings.

The company also spurned his suggestion to erect a firewall between the compliance department and its revenue-generating units, he said.

No doubt, there are those who are still recommending munis because of their tax-free status, as a recent WSJ article demonstrated. But, the fundamentals are weak and getting worse – both in terms of the income statement and the balance sheet. These governments are soon to lose their guarantees from Ambac (and eventually MBIA despite hiving off the muni business). To my surprise, these governments are getting no federal government backstop as the California situation has demonstrated. And the Fed and Treasury are on record as saying they will not guarantee any municipal bonds. Finally, I question whether one should rely on the ratings these bonds have to make an informed investment decision. Even the junk-bond king Michael Milken, a credit analyst of note, is now warning that credit ratings are inflated.

Municipal bonds are a clear case of buyer beware.

Related posts:

• The coming collapse of the municipal bond market
• MBIA and Ambac sued by LA
• Ambac may file bankruptcy soon
• California starts issuing IOUs as bankruptcy nears
• State and local government weighed down by housing

Bond insurer Ambac Financial has warned bankruptcy is a distinct possibility, sending its shares plummeting more than 30% today.

What is intriguing about this pending bankruptcy is how this company escaped bankruptcy in 2008, was downgraded continually in 2009, yet just reported billions in profit 5 days ago. Now it warns of bankruptcy? 

This story also is related to municipal bonds.

Rewind to July of last year and Ambac was headed to zero fast after having been downgraded by S&P the month before. Basically, their business model of using a AAA rating to guarantee bonds (a sort of credit default insurance) was rendered non-viable by the credit crunch.

But in November, Ambac was able to forestall the inevitable. On November 19th, MarketWatch reported:

Ambac said late Wednesday that it commuted, or tore up, roughly $3.5 billion worth of guarantees on complex mortgage-related vehicles known as collateralized debt obligations. The company’s main bond insurance unit paid counterparties $1 billion in cash to settle the contracts.

The deal will improve the capital position of the bond insurance unit for rating agencies, Ambac said.

Later the insurance subsidiary eliminated its dividend to the parent company.

When the company rejected an unsolicited offer by Warren Buffett to reinsure $800 billion in municipal bonds insured by Ambac and MBIA in December, this was generally seen as a sign of strength. But, the company was holding on by a thread.

Then came the potential for a big bailout in March. MarketWatch again:

Life and bond insurers soared after the announcement Monday that they will be eligible to participate in the Treasury Department’s Public Private Partnership Investment Program.

Bond insurer Ambac Financial Group is one that will investigate Treasury’s offer to backstop a market for securities it holds in its investments, said Ambac spokeswoman Vandana Sharma.

The public-private program will use $75 billion to $100 billion in money from the Troubled Asset Relief Program called TARP to generate $500 billion in purchasing power to buy legacy assets held by investors, with a government backstop encouraging private sector investors to purchase the assets.

"A broad array of investors are expected to participate in the Legacy Loans Program," the Treasury said in a fact sheet it provided Monday. "The participation of individual investors, pension plans, insurance companies and other long-term investors is particularly encouraged."

Up to now, insurers such as Ambac have unsuccessfully lobbied for inclusion in government programs that have offered capital to help make up for losses tied to mortgage loans.

Ambac did not get TARP money.  All the while, the two companies MBIA and Ambac continued to be downgraded by the ratings agencies – dead men walking.

But just five days ago, Housing Wire reported the following:

Bond insurer Ambac Financial Group posted net income of $2.2bn, or $7.58 per share, in Q309, compared with a net loss of $2.4bn in the year-ago quarter.

Quarterly results were impacted by unrealized mark-to-market gains in the New York City-based financial services and insurance firm’s credit derivatives portfolio and gains from Q309 reinsurance cancellations.

The firm experienced a positive $2.1bn change in fair value of credit derivatives, driven by the adjustment made under Financial Accounting Standard (FAS) 157 relating to Ambac’s widening credit spread…

“We continue to make progress in de-risking the balance sheet via negotiated reinsurance buy-backs, CDO of ABS commutations, settlements related to defaulted RMBS transactions as well as expanded analysis of expected recoveries relating to RMBS representation and warranty breaches,” said president and CEO David Wallis.

Nice, right?  Well, now they could be filing for bankruptcy.

The muni connection comes from the fact that Ambac was a large guarantor in the municipal bond market. Witness this ill-timed article from Fortune in February 2008:

Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis’ tax advantages. Throw in munis’ microscopic default rates, and you’ve got an ideal landing spot for investors weary of the stock market roller coaster…

As we said, the default rate on munis is minuscule, especially for GOs, water-and-sewer revenue bonds, and the other plain-vanilla offerings that make up the majority of the muni market. Even triple-B-rated munis – the lowest rung of investment grade – have a default rate of only 0.06 percent…

Over the years, this incongruity has fueled the growth of Ambac (ABK), MBIA (MBI) and other bond insurance companies. By selling states and cities insurance that turns triple-B and single-A bond issues into triple-A’s – reducing government borrowing costs in the process – the bond insurers manage to pocket much of the extra yield that would otherwise go to investors. Best of all, bond insurers rarely had to pay claims, certainly not on the plain-vanilla GOs and water-and-sewer bonds. "In my opinion," says Paul Disdier, who oversees the municipal bond fund division at Dreyfus, "the worst thing to happen to the muni market is the spread of bond insurance."

I’m sure you know that the spread is actually not the worst thing here. It’s that risk was being underpriced. That’s why Ambac is hitting the wall. And so it is again.

By the way, the Fed and the Treasury are on record as being leery of guaranteeing anything in the municipal bond market. So, with Ambac crumbling and no Federal government backstop, there is no safety net for bad investments in munis. Caveat Emptor.

Update: To be clear – Ambac Financial, the parent entity is filing for bankruptcy. But Ambac Assurance, which is the insurance subsidiary is not. Nevertheless, Ambac Assurance still has a Caa2/CC rating and we should anticipate it will be soon to be out of business.

Update 2: see the following Bloomberg article for detailed information on the potential bankruptcy filing and associated market action: Ambac, MBIA Tumble as Losses May Overwhelm Bond Insurers.

Related posts:

• MBIA and Ambac sued by LA
• MBIA, Ambac, $1 Trillion of Debt, Lose S&P AAA Rating
• Ambac is going to zero fast
• The coming collapse of the municipal bond market
• AIG: looking to raise $20 billion

Why aren’t more municipal bonds being downgraded by the ratings agencies Fitch, Moody’s and S&P?  If you look at sovereign debt in revenue-constrained countries like Greece, Portugal or Ireland, the ratings agencies are issuing warnings. 

But, states and municipalities are suffering from the same revenue constraints. Tax revenues have plunged. Governments have shut down services to save cash. And they have cut staff. There are dozens of articles in the national press daily detailing the difficulties municipalities, cities and states are having.

You wouldn’t know that if you looked at the charts of some of the major municipal bond funds. Take a look at Nuveen Municipal Value Fund (NUV) for example.  It bottomed in December last year. Now, 11 months later it is up 31%. How about BlackRock’s MuniHoldings Insured Investment Fund (MFL). It bottomed in December as well. But is up over 70% since then. Pretty nice return. But, I don’t think it can last.

California’s summer struggles made it is the poster child of the distress in the finances of US states and municipalities. But, there are many states, cities and municipalities on the brink. That’s why I found the excerpt from the post “The Coming Collapse of the Municipal Bond Market” at Phillip Greenspun’s blog over at Harvard Law School interesting. Note the highlighted sections

A money manager friend showed me an interesting research report by Frederick J. Sheehan titled “Dark Vision: The Coming Collapse of the Municipal Bond Market. This is a product of weedenco.com and available only to subscribers, but I will summarize it here.

Sheehan starts off by noting that a lack of panic by the ratings and government agencies does not indicate health for a financial market. He cites the fact that the Fed did not anticipate how bad the subprime collapse was likely to be and obviously the Moody’s and Standard and Poor’s ratings were ridiculous.

Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker.

Municipalities dealt with the separation between taxes and expenses by borrowing. In the mid-1990s, states and cities were retiring as much debt as they were incurring. During the 2000s, though, they borrowed about $150 billion per year in aggregate, peaking at $215 billion in 2007 by which time $2.7 trillion in debt was outstanding, more than two years’ worth of tax receipts.

Barring some sort of miraculous boom in the economy and pension fund investment returns, state and local governments are headed for insolvency and default. This means that valuing a municipal bond becomes a matter for a legal expert rather than an accountant. Even for the legal expert, it is apparently tough to predict what will happen. Let’s start with the Wikipedia article on Chapter 9 bankruptcy: “Previous to the creation of Chapter 9 bankruptcy the only remedy when a municipality was unable to pay its creditors was for the creditors to pursue an action of mandamus, and compel the municipality to raise taxes. During the Great Depression this approach proved impossible so in 1934 the Bankruptcy Act was amended to extend to municipalities.”

Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds).

Municipal bonds are still perceived as almost risk-free by most investors and consequently offer a low yield, according to Sheehan. He points out that if the municipalities don’t default, the investor gets only a slightly better return than in Treasuries. Why take the risk if you’re not getting paid for it?

This ends my summary of Sheehan’s report. My own opinion is that the main lesson of subprime is that an investor cannot rely on the ratings agencies or the government to protect his or her interests.  The never-employed guy in Cleveland with the house in a crummy neighborhood and no down payment? The risk that he would never make a payment should have been apparent to any investor who dug underneath the asset-backed security. Similarly, an investor in muni bonds can look at the municipality. Does the state have a shrinking population, high public employee salaries, and a big pension obligation overhang from when the population was larger? They probably will eventually default. And if an insurance company was dumb enough to insure the bonds, they’ll probably be bankrupt too.

If you’re waiting until the ratings agencies give you a heads up, thinking this will happen before these problems get reflected in lower muni bond prices, you better think again.

Related posts:

• Chanos says dump munis as distress mounts and ratings attacked
• State and local government weighed down by housing
• Ambac may file bankruptcy soon
• MBIA and Ambac sued by LA
• State and local governments: budget cuts likely

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners. You can reach the firm by email at info@arpllp.com.

This post on taxes and budget deficits should remind one of three recent posts here which take varying views of the fiscal position in Japan. See "Marshall Auerback’s "Japan does not demonstrate the failure of stimulus" and “The new Japan, domestic consumption, and the neo-liberal thought machine “ and my “Japan: stimulus without reform leads to a policy cul de sac.”

While I am personally no fan of supply-side economics or Arthur Laffer (actually, in full disclosure, I have to admit to being generally anti-Reagan/Thatcher as well – in large part due to a lax regulatory environment on both counts and some heinous racial politics in Reagan’s case), I do favour lower taxes as a way to stimulate the economy (through a payroll tax cut, for example).

“The only thing worse than rescuing the system would have been not to do so.”   – Martin Wolf

Welcome to the third letter in our four letter series about major trends defining the future of the world we live in. I kicked off back in September with a piece on energy supplies and last month I took a closer look at the demographic outlook. This month my focus will be on government and why our leaders need to think outside the box to solve the crisis we find ourselves in. I have found this topic particularly difficult to handle – probably because I am somewhat outside of my comfort zone. I sincerely hope you enjoy it anyway.

Let me introduce the main characters: First, the banks which are veering out of control (again!). Next, our central bankers and regulators who are doing a better job than broadly perceived; however, they lack the political support to tackle a financial system which thrives on excesses. And, just to complete the picture, we are up against a political system which is institutionally corrupt and politicians who are hopelessly narrow-minded and unable to look beyond the next election.

Less means more

Since the early 1980s, we (or at least those of us living in an Anglo-Saxon country) have lived in a world where less has carried the meaning of more. Reagan and Thatcher both genuinely believed in small government. Fundamentally, they shared the view that people respond to economic incentives, but it was not only about tax. The public sectors in both countries were slimmed down and much red tape removed. Even the City of London underwent drastic transformation – the so-called Big Bang. The economy reacted favourably in both countries and stock markets began a journey which lasted more than two decades and delivered the most powerful bull market of all times.

But, as we all know now, it ended in tears. Like children in a candy shop, we couldn’t control ourselves. Greed took over and whatever control mechanisms there were in place failed miserably when we needed them the most. It is therefore perfectly understandable that both regulators and politicians want more control. I just wish that our elected leaders would put their self-interest to the side for once and do what is right for the country. Unfortunately, that is about as likely as the sun not rising tomorrow morning.

Too big to fail or…?

Central to the discussion is the role of our banks. Are some banks really too big to fail or are they just too politically connected to fail? Following last year’s near Armageddon, most banks desperately need fresh capital and our monetary authorities – with plenty of encouragement from our Government – have created an environment which has handed banks a license to print money. In a budget constrained world, such a policy was always considered a more palatable way to re-finance the banking sector than the alternative – pumping more hard earned tax payer money into the banking system. So far so good.

Unfortunately, little seems to have been learned from the excesses of recent years. As we have seen time and again, easy money leads to carelessness, paving the way for future bubbles, and why should it be any different this time? A system where profits are privatised and losses socialised is destined to fail. It is the old moral hazard argument all over again and it encourages extreme risk taking. It is nevertheless the system which is being practised all over the world at the moment. And if politicians believe they can solve the problem by capping bonuses, they are less intelligent than even I thought.

In a recent article in the Financial Times, Willem Buiter made some interesting observations on this subject:

Will things be different during the next boom/bubble?  The next credit and asset market boom will generate massive profits and generous tax revenues.  The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government.  New and exciting financial instruments – superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecedented potential for diversifying, sharing and extinguishing risk.  It will be different from every other boom in the past.  It will be a truly sustainable euphoria – a high for humanity.  And the regulators/supervisors will be convinced, seduced, intimidated or co-opted.

Bank of England Governor Mervyn King recognises the problem:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.

As a possible solution, King has proposed a re-introduction of the rules which used to be in place, prohibiting retail and investment banking activities under the same roof. For speaking his mind, he was publicly reprimanded by the Prime Minister, who deemed such a policy response “simplistic and out-of-date”. Perhaps I should mention that banks are amongst the largest contributors to the political parties in this country. So much for integrity.

It is time to move on

A friend of mine attended an investment conference recently, where one of the speakers was the CEO of a world famous investment bank. When the talk turned to bonuses, the CEO stated flatly that “it is time to move on” (no prizes for guessing which bank). Perhaps it is time to move on, but not in the direction he wants to go. When US tax payers were forced to cough up $185 billion last year to save AIG which in turn saved an entire industry bar Lehman Brothers, the man on the street would be forgiven for expecting a touch more humility and sensitivity from those running our banks.

I am not for one second arguing that bonuses should be regulated. It is simply the wrong way to address the problem. But society is faced with a much broader problem when bankers carry on living in their ivory towers whilst the canyon between them and the rest of society grows bigger and bigger. “Take risks and you will be amply rewarded; fail and the tax payer will bail you out” is about the only lesson they seem to have learned from the past two years. The solution? Force banks to take less risk. It is absurd that many of our banks are still levered 30, 40 and some even 50 times. With less risk, their profits in good times will be much lower (and their losses in bad times correspondingly smaller), and the reduced profits will automatically drive down bonuses.

Here in the UK, two banks (Royal Bank of Scotland and Lloyds Banking Group) are being forced to break up their businesses. If you are too big to fail, you are too big to exist, seems to be the philosophy. However, the government deserves little or no credit for that decision. It is in fact the EU Commission which is forcing the government to take this draconian step. Who said nothing good comes out of Brussels? It is a much more constructive move than the pathetic focus on bonuses, but it doesn’t address the basic problem – banks must reduce their gearing.

The Laffer curve

Regulating banks more effectively is only half the story, though. As already alluded to, governments all over the world are faced with rising debt, threatening to bankrupt many countries. Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.

Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.

  Chart 1:  The Laffer Curve

Source:

http://www.heritage.org/research/taxes/bg1765.cfm

It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).

Chart 2:  US Marginal Tax Rates

Source: http://www.heritage.org/research/taxes/bg1765.cfm

Compelling evidence

So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented, US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.

Table 1:  US Tax Revenues around Major Income Tax Cuts

Source:  http://www.heritage.org/research/taxes/bg1765.cfm.

All numbers are inflation-adjusted.

Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling.

Other factors to be considered

It is not always one-way traffic, though. In his first term as President Clinton actually increased taxes in 1993 and what followed? One of the biggest economic booms of all times. Other factors impact tax revenues as well. In the case of Clinton, he presided over an economy which benefited immensely from globalisation and an IT boom, the likes of which had never been seen before.

Here in Europe, total tax revenue as a % of GDP is, on average, much higher than it is in the United States (chart 3). Whilst European growth rates have, admittedly, been modestly below US growth rates in recent years, there is no evidence to suggest that the higher tax rates have done significant damage to European growth. If that were the case, Denmark and Sweden should suffer the lowest growth rates amongst developed nations. In fact, the two Scandinavian countries have enjoyed comparatively high economic growth in recent years.

Also, corporate earnings have been as strong here in Europe as is the case in the US, and European stock markets have actually vastly outperformed the US market in recent years. So it is hard to drive the argument that lower taxes always lead to higher economic growth and stronger stock market performance. However, it is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?

The canary in the coal mine?

One thing is sure, though. Given the rapidly rising public debt all over the OECD area, economic growth must be secured at any price. Anything else will be devastating longer term. Japan stands out as the black sheep with public debt-to-GDP reaching 218% this year. Japan has tried many things to drag itself out of the quicksand but to no avail.

Chart 3:  Total Tax Revenues as % of GDP (2006)

Source: OECD

Its stimulus programme has been very Keynesian with a multiple of public spending projects over the past couple of decades, most of which have been a terrible waste. Now, 20 years later, Japan is falling into the precise trap our economic adviser Woody Brock is warning so vehemently about. GDP growth is slow or non-existent. Debt continues to grow rapidly and sticky deflation makes an already difficult situation almost impossible to deal with.

So far, Japan has just about gotten away with it because they have had easy and cheap access to credit. But what will happen if (when) that changes? It is no longer inconceivable that Japan will default on its sovereign debt at some point over the next decade. Ambrose Evans-Pritchard has written an excellent piece in the Daily Telegraph recently about Japan’s predicament, which you can read here.

Woody Brock did a study earlier this year where he pointed out the danger of allowing public debt to grow much faster than GDP for an extended period of time. As is evident from chart 4, should the United States (or any other nation for that matter) fall into that trap, the implications could be very dire indeed. Think Zimbabwe. Therefore, given the large escalation of public debt, policy makers should aggressively pursue a pro-growth policy. Anything else could have fatal consequences.

Chart 4:  US Federal Debt Outlook

Source: www.sedinc.com

Cut income taxes! 

Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite. And the Swiss will be laughing all the way to the bank as more and more disenchanted people in this country flee Britain and Gordon Brown’s strait jacket to start a new life in Switzerland.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance.  Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009
• A Country for Old Men and a Bit of Samba – Oct 2009

Related posts:

• Japan does not demonstrate the failure of stimulus
• Obama takes middle road on stimulus and taxes that leads nowhere
• Are US corporations feeding at the trough of low taxes?
• Japan: stimulus without reform leads to a policy cul de sac
• A note on Japan’s experiment with quantitative easing

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-.  That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin’s finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit.  It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland’s rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month’s Budget may set the economy back further, but without it the country’s national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month’s Budget into account, because the details are not yet known.

"Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded," the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy’s problems might give more support to consumption and investment by helping confidence.

The Government’s plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission’s estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn’t rule out temporarily nationalising the country’s banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

“Further recapitalisation may be necessary as assets are being purchased below book value,” the Paris-based OECD said in a report today. “Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether.”

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

“Substantial” banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the “utmost reluctance,” the OECD said.

The FT’s Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today’s bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

Related posts:

• Ireland: Next stop – IMF
• Ireland guarantees bank deposits at six banks
• Irish government unveils plan to recapitalise banks
• Ireland nationalizes Anglo Irish bank
• Is Ireland the next Iceland?

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

Yesterday, Moody’s cut the outlook for the sovereign debt of Portugal and put Greece on negative watch for a downgrade, signaling growing concern over spiraling debts. Just as with Spain and Ireland which I discussed yesterday, Portugal and Greece are smaller countries within the Eurozone with large fiscal problems due to the recession. For example, the Wall Street Journal says that Greece expects a budget deficit of 12.5% of GDP this year – that’s more than 4 times larger than the limit set by the Maastricht treaty.

Bonds sold off on the news. The Wall Street Journal reports:

The news spooked investors in government bond markets. The yield spread between 10-year Greek government bonds and comparable German government bonds, or bunds, widened to 1.42 percentage points from 1.36 points. The impact was milder on Portuguese yield spreads, which widened to 0.56 point from 0.54 point against German bunds, because a possible downgrade appeared less imminent.

Moody’s said it hoped to complete the review process promptly, and within three months in the case of Greece. It added that it might keep Greece on a negative outlook even if it decides upon a downgrade.

Standard & Poor’s downgraded both Portugal and Greece in January, while Fitch downgraded Greece last week and revised its outlook on Portugal to negative in September.

And we should certainly expect these downgrades to continue. Back in January, when Portugal was downgraded, the spread to German Bunds moved out to a 12-year high of 146 bps. We are now only 4 beeps lower than that. So, that sounds bearish for their bonds. However, their is a silver lining as Peter Schaffrik of Commerzbank explains in the video below.  Bond investors are incredibly starved for yield and that means there is a good bid for these sovereign issues as they offer relatively more yield pickup than German Bunds.

On the other hand, Chris Wyllie of Iveagh says he is zero weight in bonds now because even these bonds and corporate issues simply do not have enough yield to make them attractive.

You should see this as further evidence that stocks are being artificially buoyed by an increased risk appetite driven by low interest rates.

Related posts:

• Spain can’t sell its bonds
• More trouble in the Baltics as S&P downgrades
• Treasury yields go below zero
• Baltics: Fitch downgrade and more downgrades to come
• Corporate defaults mean more hedge fund blow-ups

Former Morgan Stanley economist Andy Xie joins other famed prognosticators like Nouriel Roubini in worrying about an incipient asset bubble. The Rosetta Stone Advisors board member sees the huge increase in money supply created by central banks as fuel to an asset bubble fire. He even goes so far as to call the central banks ‘arsonists.’

The financial crisis exposed gross inefficiencies in the massive amounts of money financial institutions received from central banks. Supplying so much money to the same people who caused the crisis — and with the same incentives — does not feel right. The argument in favor of this policy is that, when the house is on fire, you have to do whatever to extinguish the fire and find the culprit later. The problem is that, in this case, the arsonists have been asked to put out the fire. How can we be sure they won’t start another fire?

Most argue that the answer is not to limit the money supply but to reform the financial system. In this way, future demand for money would be efficient. But so far, no corrective reforms have been implemented in response to the financial crisis. Why? Because the global financial system became so big over the past decade that it has co-opted central banks, legislators and entire governments. Any reforms that do come will not address the main factors leading to the current crisis.

Even the best reforms will never resolve a problem based on the fact that financial professionals generally risk other people’s money: They get big rewards when bets go right and don’t have to pay when bets go wrong. The problem with this incentive system suggests the global financial system is structurally biased toward taking on more risk than what would be taken in an efficient market. The only way to counter this is for central banks to limit money supplies. Asset inflation over the past 10 years and the catastrophe incurred when it burst lend credibility to this argument.

Xie sees stagflation as a threat and a double dip coming, as a result. He warns bond market speculators, “you’ll want to run for your life” when the bond market tanks.

A word of caution for all would-be speculators: You’ll want to run for your life as soon as the bond market takes a big fall. And the case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimuli are behind the current economic recovery, and when these run out of steam next year, the odds are quite low that western consumers will take over. High unemployment rates will keep incomes too weak to support spending. And consumers are unlikely to borrow and spend again.

Many analysts argue that, as long as unemployment rates are high, more stimuli should be applied. As I have argued before, a supply-demand mismatch rather than demand weakness per se is the main reason for high unemployment. More stimuli would only trigger inflation and financial instability.

The post is very entertaining, if scary. (“monetary growth is being used to support leverage, mostly in the financial sector.”) While I am not in the stagflation camp, I agree that money supply growth is fuelling unsustainable increases in asset prices globally. Xie concentrates on China where retail investors dominate the equity markets, operating under the assumption that government will not let assets prices fall. My view is that prices must eventually fall if they are too high relative to the income streams that underpin that price. The resultant crash in prices will be deflationary. Xie believes that this discrepancy between price and value will be closed via inflation.

However, you see it, I recommend reading this article. It asks some very important questions for investors, businesspeople and economists alike, the most important of which is a variation on theme of the Stephen Roach article:

While workers and businesses struggle, asset players are reaping substantial paper profits again. As the central bank’s monetary policy is behind the asset boom, we should ask whether the policy is achieving its goal by helping the real economy, or whether it is just helping speculators and hoping they have something left over for the real economy.

Much, much more here.

Related posts:

• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Inflation: The strategy that dare not state its name
• Central banks will face a Scylla and Charybdis flation challenge for years
• Is this the way to fight inflation?

In January, Ben Bernanke gave a very important speech at the London School of Economics where he laid out the Federal Reserve’s strategy in fighting the forces of deflation and market illiquidity (see post with videos here).  His was a strategy that took the Japanese variant of quantitative easing one further – toward what I call qualitative easing.

Earlier this decade the Japanese faced deflation in the wake of the recession after the Tech Bubble.  Interest rates were already zero percent (they conducted a never before tried Zero Interest Rate Policy – ZIRP, but this proved inadequate in the face of massive deleveraging). With the recession, outright deflation was sure to follow as interest rates could be cut no more. As a result, the Japanese started quantitative easing, a technobabble term for printing money.  The goal was to flood the economy with money which created inflation as the mountains of debt in Japan meant deflation could cause a downward spiral.

Fast forward to 2009 and we see Bernanke embarking on the same path. The twist however is that he has focused on the asset side of things. So while the Fed balance sheet has ballooned in both assets and liabilities, the mix of assets has changed considerably from almost all Treasuries to a bunch of Treasuries and a lot of assets of more dubious quality as well. (This chart, courtesy of Zero Hedge, shows the change). Clearly, this should leave you with a sense of unease as it is the collapse in value of these same assets which was largely responsible for the global panic last year.

One Fed President, Philadelphia’s Charles Plosser, is fed up with this and wants change.

Bloomberg reports:

Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should limit the securities on its balance sheet to Treasuries and create a policy for serving as lender of last resort.

The Fed’s emergency-credit programs and inconsistency in bailout decisions created confusion and showed the central bank “lacked a well-communicated, systematic approach,” Plosser said yesterday in a panel discussion at Palo Alto, California. Policy rules “would yield better economic outcomes for both monetary policy and financial stability policy,” he said.

Plosser’s comments rank him among the strong internal critics of the Fed’s efforts to stem the worst financial crisis in seven decades. The Fed “strayed into credit allocation” that should be the purview of fiscal authorities, not the central bank, he said at Stanford University.

“Developing such a systematic approach is not easy,” Plosser said at a forum hosted by the Stanford Institute for Economic Policy Research.

“Making a credible commitment to stick to such a lending policy in good times and bad is even more difficult,” he said. “Nevertheless, that is what we must tackle if we are going to achieve better results the next time a crisis arises.”

In effect, Charles Plosser is saying that the Federal Reserve become the handmaiden of the executive branch, conducting fiscal policy on its behalf. This is a clear no-no and the major reason the federal reserve has received so much scrutiny.

In my July post “Is quantitative easing really inflationary,” I said the following:

Because the Federal Reserve has been acting in concert with the executive branch since the credit crisis began, many are beginning to question its quasi-fiscal role in supporting the wider financial system with bailouts, subsidized borrowing, guarantees and liquidity. Add in the QE and a ballooning Fed balance sheet as the central government deficit spends and you have an organization that seems to be acting on behalf of the executive branch.

I gather Plosser agrees with this assessment given his recent remarks. If the Fed wants to remain independent, or at a minimum resist the legislative branch’s desire for greater oversight, it needs to get rid of these toxic assets and stay out of fiscal policy for good.  How the Fed disposes of these junk assets is the $1.25 trillion question.

Related posts:

• Is quantitative easing really inflationary?
• Credit conditions
• Don’t underestimate the power of printing money
• Pushing on a string and similar notions on monetary policy ineffectiveness
• Is Japan next on the road to quantitative easing?

In today’s morning with Dave article, Gluskin Sheff’s Chief Economist and Strategist says the macro environment makes it look like 2007 all over again – as if the crisis never happened.

It’s like 2008 and early 2009 never happened. Hong Kong’s Hang Seng index just hit a 14-month high as the island benefits from Chinese growth, U.S, interest rates and competitively supercharged currency link. In fact, the entire MSCI Asia-Pac index added 1.0% today, with broad-based gains and taking the index to its highest level since September 1, 2008.

The VIX index, at 21.49, is back to where it was on September 3, 2008, when most economists didn’t even know we were knee deep in recession, strategists believed we were only in for a mild correction and the Fed still thought it was fighting a liquidity battle as opposed to a credit contraction. In fact, to show just how complacent the market is now regarding that dirty, but now forgotten four letter word called “risk”, the VIX index is flirting near levels we saw back in October 2007, when the S&P 500 was just coming off its all-time high of 1,565 and market pundits were dreaming up new ways to redefine ‘global liquidity’.

Meanwhile, the DXY (USD index) is still recovering a bit but still on very shaky ground (Japan reiterated that it will not intervene in the FX market) and the commodity complex is bid with copper enjoying a nice session yesterday (though off a tad this morning) and oil heading for $80/bbl. It is amazing that the surge in oil prices and the challenge to the economic outlook isn’t making front page news, but it is arguably very tough to push Dow 10,000 off the front pages of the morning papers. The market seems to like Apple’s earnings — my kids sure love its products — and Texas Instrument’s too with futures up and the tech sector on a big roll right now — the Nasdaq is up 38% so far for the year!

Corporate bond spreads have continued to tighten (even in the face of a massive supply boom, a record $1 trillion of new U.S. issuance has hit the market this year) and the “undervaluation gap” in this once-very-cheap sector has now closed given that it is de facto discounting 2.5% U.S. economic growth in the coming year (equities now are close to 5% — not far off from what they were pricing back at the October 2007 peak). Question that still must be asked is that if we are into some big reflationary trade here, why are U.S. Treasuries not getting absolutely smoked? In the last couple of sessions, they have rallied (10-year T-note yield at 3.38%) and being led lower by real rates, which is generally not consistent with pro-growth cyclical beta performance.

It’s what’s called reflation!  And it will end in a very bad way.

More here.

Related posts:

• Rosenberg: The Grinch who stole Christmas
• Rosenberg: Market rally is just multiple expansion
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
• UK real wages falling
• Rosenberg: Still a bear market rally

There is an enormous dichotomy in foreign exchange markets that has wide-ranging implications for the global economy.  In Europe, most currencies float freely against the U.S. dollar. In Asia and the Mideast, most do not.

What this has meant in practice is two things. First, as the U.S. dollar has weakened, it has done so only against those currencies which are free floating. This has meant the lion’s share of any adjustments in global imbalances have fallen on the likes of Japan and Germany. Second, those countries which are pegged have had to resort to currency intervention and a massive build-up of foreign reserves to stop their currencies from appreciating.  This is inflationary for those countries, and is one reason there is a housing and equities boom in Asia right now.

But, as the dollar continues to weaken, those countries with pegs will be under pressure to drop their peg or to revalue their pegs higher.  The Bloomberg video linked below explains. The dichotomy whereby the adjustment process is done only through free-floating currencies is inherently unstable – and invites a nationalistic response.

A busted peg in any major U.S. trading partner’s currency is likely to have a very negative psychological impact on currency markets and severe knock-on effects.  These are what I call digital events.  It’s all or nothing, on or off. Either the peg is revalued enormously or there will be continuing pressure.

As an example, look back to 1998 when the Russians attempted to devalue the ruble.  The immediate effect was a sense that the ruble was not devalued enough, leading to an all-out assault on the currency and a much more massive devaluation which in turn triggered default.

I would anticipate a similar albeit less pronounced dynamic were the Chinese or the Saudis to revalue significantly.  There would be tremendous downward pressure on the greenback globally, more pressure on the busted pegs and increasing pressure on other pegged currencies to revalue. The result, of course, would be higher interest rates in the United States and a likely double dip.

Busted pegs are not something I necessarily expect. However, this is the type of exogenous shock that is a clear downside risk to my more benign muddle through baseline scenario – and one reason to prefer gold over bonds in reducing exposure to equities.

Currencies Pegged to Dollar May Abandon Greenback: Video – You Tube

Related posts:

• The dollar is rising against floating currencies
• The Big Mac Index
• The Dollar
• Is the Fed just jawboning?
• U.S. Dollar: Cliff Diving Again

Marshall Auerback here with a few thoughts on employment policy and the limit to government spending in a fiat currency regime.

The Detroit story Edward just posted illustrates that we should start by eliminating the notion that society requires a buffer stock of unemployed people to discipline wage demands and protect profits.  Not only is this immoral and inhumane, but economically inefficient.  We can have both full employment and price stability via a Government as Employer of Last Resort.

This new class of government employees, which could be called supplementary, would function as an automatic stabilizer, the way unemployment currently does. A strong economy with rising labor costs would result in supplementary employees leaving their government jobs, as the private sector lures them with higher wages. (The government must allow this to happen, and not increases wages to compete.)

The reduction of government expenditures is a contractionary fiscal bias. If the economy slows, and workers are laid off from the private sector, they will immediately assume supplementary government employment. The resulting increase in government expenditures is an expansionary bias. As long as the government does not change the supplementary wage, it becomes the defining factor for the currency- the price around which free market prices in the private sector evolve.  It will also enhance the effectiveness of traditional policies designed to improve aggregate demand because it will create a buffer stock of EMPLOYED personnel for the private sector to draw upon, rather than a reserve army of unemployed.

There is no reason for President Obama and his economic advisors blithely to repeat truisms that “unemployment is a lagging indicator” as a means of justifying further government spending (the truisms you cite here should reflect the myths you’ve mentioned, not introduce entirely new ones).  The reality of a double digit unemployment rate is de facto proof that government spending is too restrictive.  His concern for the welfare of America and for the nation’s future is no doubt genuine. However, in the haste to renounce financing decisions which would, in fact, be very harmful if not impossible for a private business or a household, in their eagerness to accept uncritically the myths of neo-classical economics, the Obama Administration is overlooking the important differences between private finance and public finance. Only a misunderstanding of money and accounting prevents Americans from achieving a higher quality of life that is readily available.

Apropos money, we need to get over this notion that the government can’t “afford” something. Functionally, dollars have the same value to our government that Super Bowl tickets have for the stadium.

As you go into the stadium, you hand the man a ticket that was worth maybe $1000, and then he tears it up and throws it away. Why? Because the ticket has served its function: it has enabled you to gain entry to the event in question; similarly, a tax is paid to extinguish a state liability, but as soon as the tax is paid, it has no further value to the government. The tax receipt can be sent to the shredder. How does the govt taking your cash and throwing it in a shredder pay for anything?

The answer is that it doesn’t.

Taxes function to reduce aggregate demand, also known as spending power, and not to collect what the govt needs to spend on something else. As a matter of conceptual clarity, it makes no sense to say that a government ever “builds up a store of savings” that allows for higher spending capacity in the future. The govt neither has or doesn’t have any dollars.It spends by changing numbers upwards in our bank accounts.  Government is the score keeper for the monetary system.  Just like the stadium is the score keeper for the football game.

Awarding 6 points for a touchdown doesn’t use up some stock of points held by the stadium. We can always get another “3 points” each time a team kicks a field goal. We don’t have to “pay it back”.

You don’t “save” what you have the option of creating or not creating (i.e. fiat currency). Not spending, not “creating currency” via crediting bank accounts, simply means less present day economic output.

We all learned this as the paradox of thrift. There is nothing to “save” . The government is never revenue constrained. This is in contradistinction to the way users of the currency, vs. the issuer of a currency, such as a household functions. For them, spending is constrained by income. their checks will bounce if there is no money in their accounts. And for users of the currency monetary savings can be stored to permit higher consumption in the future.

Related posts:

• Unemployment claims stuck at 570,000
• Unemployment numbers still point to partial recovery
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• ADP report shows 371,000 jobs lost
• Rosenberg: U.S. unemployment rate headed for 12.0-13.0%

Bill Gross is a bond man.  In fact, he is often called the “Bond King” because Pimco, the organization where he is founder and Co-Chief Investment Officer, is the largest bond fund in the world. In Bondland, what Gross says has a lot of weight.

And Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’).  In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.

But, Gross is also reducing risk.  There has been a huge run-up in corporate bonds, especially in high yield bonds. And Gross believes now is the time to take profits and reduce exposure to riskier assets, a view he first put forth in his monthly newsletter at the beginning of July (see my post, “Bill Gross: the new normal means investors should shun risk”).  And Gross is re-balancing his portfolio quite heavily to reflect this “glass half-empty” bias. His portfolio has its heaviest concentration in five years of Treasuries, considered the U.S.’s risk-free financial assets.

Below is a video of Gross talking on CNBC along with two other market experts, Bob Doll and Dan Tishman, regarding their view of the economy and financial markets. Gross goes as far as to say point blank that one should sell equities and other riskier assets like high-yield bonds.

Before you watch the video, be aware that two other formerly bearish analysts, Richard Bernstein and Jim Grant, have flipped to bullish recently.  Gross mentions Grant by name and disagrees with his take on the economy, calling it “disingenuous.” Articles by or on Bernstein and Grant’s view’s are below the video.

This is the third in a series of posts about reducing risk. See also:

• Sell equities
• Way too much risk in the equity market

Related articles
From Bear to Bull: James Grant on Recession and Recovery – Jim Grant, WSJ.com
Bernstein: Best Value In Junky Names – CNBC.com

Related posts:

• Bill Gross: Fed on hold through 2010
• Sell equities
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In the latest move toward China’s long-term strategy of internationalising its currency, the Chinese Ministry of Finance announced today it will issue government bonds valued at 6 billion yuan in Hong Kong.

The last article I wrote on this subject was a little over a week ago when the Chinese Vice-Premier Wang opined that the government was looking for ways to make the Yuan a more international currency.  I see this statement by the Finance Ministry as putting paid to those words.

The yuan bond issue, worth about $879 million, will ‘‘promote the RMB in neighboring countries,’’ referring to the renminbi currency, ‘‘and improve the yuan’s international status,’’ the Finance Ministry
said in the statement on its Web site.

‘‘The first step toward internationalization is regionalization,’’ Shi Lei, a foreign currency analyst at Bank of China in Beijing, said in an interview. ‘‘China wants to develop the offshore market in Hong Kong.’’

While domestic banks like Bank of China and the Export-Import Bank of China have already been issuing yuan-denominated bonds in Hong Kong for a couple of years, at the encouragement of Beijing, this is the first time that government bonds, the equivalent of treasuries, are to be issued. The bond sale is set for Sept. 28.

Source

China to Sell Government Yuan Bonds in Hong Kong – Deal Book – NY Times

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The conventional wisdom is that the US is beholden to foreign agents as they hold much of the US government debt.  In this view, if these agents sell their securities, interest rates in America should increase as demand for US public debt evaporates.

Now comes evidence that China is indeed selling.  The BBC reports.

China reduced its holdings of US government debt by the largest margin in nearly nine years in June, according to data from the US Treasury.

China holds more US government debt than any other country and cut its holdings of US securities by more that 3% in June, said the BBC’s Chris Hogg…

The sales were made as the US treasury secretary was visiting Beijing to try to reassure the Chinese that their investment in his country’s government debt is safe…

In 2008, the Chinese increased their holdings in US debt by 52% over 12 months.

“China has said it would like to establish an alternative to the US dollar as the world’s favoured currency for foreign exchange reserves,” said our correspondent.

“So far there is no evidence that there is a suitable alternative. But these figures suggest they are exploring ways to diversify their investments where they can.”

But, as you have probably noticed, interest rates have not increased appreciably.  What gives?  Two ideas:

1. The Chinese aren’t selling because there aren’t enough alternatives.  Just yesterday, there was a Bloomberg article indicating the Chinese are still very much interested in buying US public debt. They may even be moving out on the long-end of the curve.
2. The premise that interest rates will increase is false.  If the US economy slows, this automatically decreases the current account deficit, meaning the US becomes less dependent on foreign sources to buy Treasury securities.  Increased private sector savings suggests more domestic sources of Treasury funding are now available.

On the whole, I would expect interest rates to rise as government budget deficits increase.  However, I have just presented you two reasons why this might not be so.

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10-Year TIPS were sold with a Bid/Cover ratio of 2.51.  Almost half of the securities went to indirect bidders, meaning central banks are still bidding for U.S. government debt.

Obviously, there is no problem for Treasuries despite the huge supply.

The positive interpretation here is that there is still a significant bid for U.S. debt despite all the talk of loose fiscal policy hurting demand.  The negative interpretation is that concern about the probability of recovery is starting a flight to quality.

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It seems like a long time off, but the Fed is going to eventually have to withdraw all of the excess liquidity it has created when the economy recovers.  However, doing so will prove tricky.  First, we have debt deflationary situation in the United States which could lead to a serious double-dip if a restrictive monetary policy is applied too early.  Moreover, the Federal Reserve has added a considerable amount of non-Treasury assets to its balance sheet.  Selling these assets on or even returning to their rightful owners those assets used as collateral for loans from the Fed will be a mean feat.  This is one reason that many are pointing to inflation as a worry already.

In that vein, David Greenlaw at Morgan Stanley had a few good comments today about a timetable for withdrawing the excess liquidity.

Three phases of an exit strategy. In our view, there are three phases of an exit strategy: passive, active and rate hikes. Some of the special liquidity facilities that were introduced by the Fed in response to the credit turmoil will wind down of their own accord – indeed, several of the largest programs are already showing such a pattern. This is what we refer to as a ‘passive’ exit. Other programs, such as the Treasury, agency and MBS open market purchases, will require a more active approach. While we view outright sales as unlikely due to potential significant market disruption and political constraints tied to recognizing loses, there are several other tools that might be employed (such as reverse RPs, expanded SFP bill issuance, reserve requirement changes, etc.). The Fed can and should provide specifics on its approach to the ‘active’ portion of the exit strategy in the not-too-distant future, in our view. Also, the Fed will likely need to adopt tools that will allow it to push the fed funds rate higher prior to complete exit from QE. As we learned in late 2008, the interest on reserves program does not necessarily put a hard floor under the federal funds rate. Although the Fed believes – and we concur – that this was partly related to unusual pressures on bank balance sheets, the Fed’s credibility could receive a boost if it took steps aimed at avoiding a repeat of this problem. This might be done, for example, via an expansion of the interest on reserves program to non-bank institutions or by prohibiting some entities from participating in the federal funds market.

While the FOMC could conceivable include a reference to the exit strategy in the official statement, it might be best to deal with any substantive communication on this front at Bernanke’s upcoming Monetary Policy Report to Congress, scheduled for July 21.

Given the difficulty that both qualitative easing and debt deflation present to the Fed in withdrawing liquidity, Greenlaw is correct that we would all be well served if the Fed telegraphed its intentions.  Recent gyrations in the Treasury market demonstrate that many participants expect future inflation to rise considerably from present levels.  The Fed’s mapping out a path to policy normalization would be a bolster to Treasuries, and consequently to mortgage holders and corporate bonds as well.

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As I write this, the U.S. dollar has fallen to new 8-month lows against the British Pound and oil.  Sterling is up over 2 big figures to 1.6371 while oil (WTI crude front month contract) has marched up near $68 a barrel.  Clearly the sell the dollar meme is still in effect in this new month.  I should also mention that treasuries are getting crushed again with the yields on the 5-, 10- and 30-year all increasing 10 basis points.  Treasuries had rallied at the end of last week.

The currency team of Brown Brothers Harriman had this to say ahead of the market open:

Momentum traders have contributed to the dollar’s sharp losses in recent weeks exacerbating the fall. This is important because it suggests that the dollar’s move is not being driven by fundamentals at the start of a longer term US dollar trend lower but by market participants jumping on board a moving train.  This also suggests the move is likely to come to an abrupt end at some point.  Evidence that momentum traders have played a key role in the dollars slump appears in IMM data.  Since the end of the first quarter IMM speculators have shifted from being short a net -135,902 of foreign currency contracts held against the dollar to a net long position of 84,848 of foreign currency contracts in the week ended last Tuesday, a 220,750 shift in positions.   Details show that net long euro positions, at 15,584 contracts in the latest week, are now at their longest since July 2008 and close to the 2-year average.  However, position size does not imply that the market will correct lower.  Net long euro positions remained above current levels for much of 2006 through early 2008 as the euro trended higher.  One notable factor is that momentum indicators are beginning to diverge.  The euro hit a new high today but the RSI remains below Friday’s high. Still, the euro has continued to advance and as we noted in our piece “Questioning the Dollar” the euro could rise toward $1.4600-$1.4800.  For the Swiss franc, the RSI diverged last Thursday when the currency hit a new high but the RSI did not.  That is not the case with most other major currencies however.

There is no evidence so far that momentum indicators are pointing to a correction for the dollar bloc currencies which all set new highs for the year today even though Australian dollar positions which quadrupled to 32,469 contracts from the end of March to the highest since August 2008, are now above the 2-year moving average; Net long New Zealand dollar positions, at 12,532 contracts (up from -2885 at the end of March) are at the highest since March 2008.  Divergence indicators are also pointing up for the Canadian dollar and British pound.  Both currencies have posted gains in April and May as the market cut short Canadian dollar and short sterling positions with net long Canadian dollar positions only emerging in May, a shift of 32,304 contracts from the end of March.  The market remains short sterling though net shorts have been reduced 19% from the end of March.  Sterling is trading at its highest level in 7 months and with momentum indicators still pointing higher, the pound could reach the mid-$1.60’s before turning lower.

This week’s events, particularly anticipation of US jobs data at the end of the week,  may contribute to a shift in momentum indicators in favor of the US dollar. Central bank meetings may have less impact but do create risk events.  For today, the data have been upbeat with much better than expected euro zone PMI manufacturing data providing further incentive to buy the euro – in addition to the euro zone PMI, regional PMIs from Germany, France, Italy, Spain and the UK all came in above expectations although below the 50/50 boom/bust level.  Similarly, today’s US ISM manufacturing index is also expected to improve after a sting of mostly firmer regional indices.  One number that could be somewhat negative is personal income excluding transfer payments such as unemployment.

There should be little evidence of inflation in today’s core PCE data. The report is likely to remain almost rock sold, diverging only slightly from the long term average of 1.8% y/y.  The consensus is for 1.9%.  Other recent inflation indicators have also shown little sign for concern.  Euro zone May CPI came in at zero last week while the five year inflation expectation reported in the Michigan consumer confidence release rose marginally to 2.9% from 2.85% averaged over the past 10 months.

As I indicated in an earlier post last weekend, TIPS are a much better play than Treasuries if you want to be long U.S. government bonds, and the short-end of the curve is much better than the long-end because the likes of the Chinese are now avoiding long-dated Treasuries. The rally in U.S. government bonds was a relief rally because auctions went better than expected suggesting there is still appetite for U.S. paper, but the renewed pressure today demonstrates that the inflation trade is well under way, and that is bad for the U.S. dollar and dollar-based asset markets. This inflation trade seems to be pre-mature as deflationary forces are still of over-riding concern.  However, clearly, the Fed will have its work cut out to stop inflation once the reflationary mechanisms gather steam.

In today’s links, I linked out to an FT Alphaville article by Stacy-Marie Ishmael which notes that Nassim Taleb suggests hyper-inflation as a ‘Black Swan’ hedge trade.  This is a view that has gained currency via Marc Faber ( see my post here.)  Personally, I think Faber is making a statement for effect.  Nevertheless, the concept of taking out a small hyper-inflation hedge via out-of-the money puts might be a trade of value.

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