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”

On the eve of U.S. President Barack Obama’s visit to China, a major Chinese official has criticized U.S. monetary policy in unusually harsh language. Liu Mingkang, China Banking Regulatory Commission chairman said the zero interest rate policy of the U.S. Federal Reserve posed a “new systemic risk.”

Liu, using language reminiscent of warnings by NYU economist Nouriel Roubini and speaking at a financial forum in China’s capital Beijing, said:

This situation has already encouraged a huge dollar carry trade and had a massive impact on global asset prices… It is boosting speculative investment in stock and property markets and will pose new, insurmountable risks to the global recovery and, particularly, to the recovery in emerging markets.

In my view, this is pure political posturing by the Chinese in order to defuse any U.S. criticisms of Beijing’s currency peg. Call it a pre-emptive strike. The U.S. has seen the unemployment rate rise to 10.2% and the trade deficit rise quite dramatically as well. Many are blaming the Chinese and their currency peg to the U.S. dollar.

When Barack Obama visits China this week, the Chinese expect him to focus on the yuan dollar peg. His administration will find it increasingly difficult to hold protectionist pressures at bay given the yuan’s firm peg to the U.S. dollar even while the dollar has plummeted.  To prevent the U.S. from successfully painting the Chinese peg as the sole major risk to the global economic recovery, the Chinese must therefore point to the destabilizing effects from measures taken by the U.S. to reflate its domestic economy.

The Chinese have shown success thus far. Last week, Tim Geithner penned an Op-Ed in the Wall Street Journal along with the Finance Ministers of Indonesia and Singapore which pointed a critical finger at China by asking for “market-oriented exchange rates.” Yet when the APEC (Asian Pacific Economic Cooperation) summit in Singapore ended that same language was cut from the final commiunique.

On the other hand, there has been little change in the prospects of a revaluation of the yuan peg.

Reuters reports:

Chinese Vice Commerce Minister Chen Jian on Sunday played down talk of a shift in the central bank’s currency policy as well as mounting expectations of a rise in the yuan’s exchange rate.

Speculation that China might let the yuan resume its climb after a 16-month pause swirled after a change last Wednesday in the long-standing wording used by the People’s Bank of China to describe its currency stance.

In its third quarter monetary policy report, the central bank failed to refer to keeping the yuan "basically stable at a reasonable and balanced level" when discussing the outlook for the exchange rate.

Asked whether the PBOC was heralding a return to the gradual appreciation of the yuan against the dollar seen from July 2005-July 2008, Chen told Reuters: "I don’t think the central bank meant to say that."

And all indications suggest that we are now returning to the same unbalanced pre-crisis growth model – but with the global economy in a considerably more fragile state. In this climate, the issues of the yuan currency peg and low interest rates in the U.S. will continue to be front and center for some time to come.

Related posts:

• Chinese to start settling trade in Yuan
• China issues bonds to “promote the RMB in neighbouring countries”
• US angling to get Chinese to revalue renminbi
• China slams U.S. profligacy
• Is China avoiding using US dollars?

This is the second straight month that the RBA has raised interest rates. From the Sydney Morning Herald:

The Reserve Bank has lifted its key interest rate for a second month in a row as it attempts to keep Australia’s economy on track for sustained growth.

Today’s widely tipped 25-basis-point increase raises the central bank’s cash rate to 3.5 per cent, marking the first back-to-back monthly increase by the RBA board since March last year when rates peaked at 7.25 per cent.

I remember seeing data showing that once central banks start raising rates, they continue to do so for months. They do not raise rates one month, then lower them the next and then reverse course. Does anyone have the data? This makes me suspect that rates are due to go higher globally rather than lower.

If you think this rate increase will lead to a global double dip because of underlying economic weakness, you should expect the yield curve to flatten. Operation Twist anyone?

Related posts:

• Norway makes three
• Interest rates, the pound and good news for Brits
• Credit markets are easing again
• RBA hikes rates 25 basis points in Australia
• Australia is set for a slowdown

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

The Norwegian central bank has hiked rates 25 basis points, making it the third central bank and first European central bank to do so since the global recovery process started.

The Financial Times says:

Norway’s central bank increased its key interest rate by a quarter point to 1.5 per cent on Wednesday – Europe’s first monetary policy tightening since the global economic crisis bit hard last year.

Norges Bank said it would gradually continue more rises, holding with its main rate at between 1.25 and 2.25 per cent until the next monetary policy report in late March.

Analysts believe the central bank seeks to keep rates around the mid-point of the range, signalling another 25 basis point rise.

Israel and Australia have also raised rates, with the Australian rate rise coming somewhat unexpectedly.  Australia and Norway are particularly geared to commodities exports. As such, it is hard to say that these rate hikes have any significance for the rest of the developed world. At a minimum, they show that interest rates are not going lower; interest rate risk is now clearly to the upside.

Of particular note, should be the fact that the central bank cited asset prices as a driving motivation behind the increase in rates. Norges Bank head Svein Gjedrem recently warned that house prices were back to their summer 2007 peak and that the market risked overheating.

Related posts:

• Reserve Bank of Australia lifts rates again
• The ECB cuts rates 50 basis points to 2 percent
• BoE makes a dramatic 1 1/2 point cut
• Paul Krugman: Liquidity trap makes future ‘more or less speculation’
• Roubini: How to avoid the horrors of ‘stag-deflation’

Nouriel Roubini seems to think so. In remarks quoted via Bloomberg, he called the enormous increase in asset prices “the mother of all carry trades.”

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

If you recall, this is the same trade the world’s punters were putting on via the Japanese yen when the Japanese were pumping out huge amounts of liquidity earlier in this decade.  The yen’s real effective exchange rate only hit post Plaza Accord trade-weighted lows in 2007 when the carry trade was all the rage and just when all hell was breaking loose in subprime.

Reuters said then:

The yen’s real trade-weighted value slipped in October as the Federal Reserve’s interest rate cuts gave a boost to global stock markets and prompted investors to sell the Japanese currency in carry trades.

Bank of Japan data on Friday showed its index of the yen’s real effective exchange rate fell 1.9 percent in October to 96.7 JPYEEXR=J.

The retreat in the BOJ’s REER index took it closer to a 22-year low of 92.8 hit in both June and July, when the currency was sliding as carry trades flourished.

That was the weakest since the September 1985 Plaza Accord in which the five biggest industrialised countries agreed to depreciate the dollar against the German mark and the yen via intervention, aiming to correct the giant U.S. trade deficit at the time.

For the year the yen’s real value has lost 3.6 percent despite periodic bouts of strength as the credit market crunch this year and worries about the U.S. economy prompted market players to unwind risky carry trades.

The yen has suffered in the past few years from carry trades in which investors use the low-yielding Japanese currency as a cheap source of funds to buy higher-yielding currencies or rising assets, such as stocks or commodities.

My view has been that the Japanese yen carry trade was a major contributor to asset bubbles globally as the Bank of Japan’s excess liquidity found its way to other asset markets via the carry trade.  Last August, in my post “Japan’s easy money policy was the trigger for the tech wreck” I also pointed to the yen carry trade as a major factor in the Internet bubble. And I certainly see it as a major factor in this decade’s housing bubbles.

Now the U.S. dollar is the carry trade currency of choice, with zero percent interest rates funding asset purchases globally. This play is certainly pumping up all manner of asset prices. But as with the yen carry trade before it, I do not see this ending well.

Roubini takes a similar tack:

The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.

Source

Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble – Bloomberg

Related posts:

• China slams U.S. for inflating global asset prices via carry trade
• U.S. Bailout: the mother of all carry trades?
• Hong Kong: “America is doing exactly what Japan did last time”
• Japan’s easy money policy was the trigger for the tech wreck
• Chart of the day: Aussie – Yen cross

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

I tend to think so. Yesterday, Ben Bernanke made what some media outlets are calling hawkish statements.  This, combined with heavy currency intervention by Asian central banks, helped to strengthen the U.S. dollar. However one must ask if there is anything fundamental about these moves.

Just a few days ago, we got a sensational article via the British Daily the Independent in which a well-respected journalist suggested that a move was afoot to move away from the greenback as the globe’s main reserve currency.  This sent the dollar into freefall against a host of major free-floating currencies and gold to an all-time high. I wrote a skeptical post about the report at the time (see my post here). And I think the currency intervention demonstrates why.

Many of the Asian currencies are pegged to the U.S. dollar.  So when the greenback declines in value, they are forced to intervene in currency markets to maintain their pegs.  if they do not and allow their currencies to appreciate, this hurts export growth in Asia.  So clearly, the central banks in Asia do want to upset the apple cart by permitting a freefall in the value of the dollar.  Asia is too dependent on export to the U.S. for this to be a preferred policy at this juncture.

Meanwhile, the U.S. does not want a freefall either. Certainly, they want inflation (via a currency depreciation if necessary) but they do not want higher interest rates which is what a freefall would mean. So the Fed is jawboning the market.  First, we saw Kohn and Fisher out making hawkish statements. now it’s Bernanke’s turn. 

What Bernanke actually said is that the federal reserve was prepared to withdraw liquidity in a number of ways, the most interesting of which was the so-called reverse repo by which the Fed finances its own portfolio via the banks instead of the of the way around (see story here). Bernanke also mentioned paying interest on reserve deposits, a topic he has broached before.  But, the bottom line is this:

My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period.

This is what Bernanke said in his presentation.

Translation: We are keeping rates at zero percent for the indefinite future, something Bill Dudley at the New York Fed has said as well. The bottom line is that despite what hawks like Hoenig or Fisher might say, we are going to be on easy street for some time to come.

Related posts:

• Asian inflation in the pipeline
• The dollar is rising against floating currencies
• Big Mac Index: Europe overvalued, Asia undervalued
• Currencies pegged to the dollar under pressure to drop peg
• Federal Reserve’s Fisher says tightening will be aggressive

The Reserve Bank of Australia unexpectedly raised rates by 25 basis points to cool down its economy. It will “gradually reduce stimulus” in anticipation of sustained recovery. Australia has probably been the major economy least affected by the global economic slowdown, so one would expect the RBA to be the first major central bank to increase rates. However, the question now is whether other central banks will follow.

In the U.S., Donald Kohn and Richard Fisher have made fairly hawkish statements suggesting that the Federal Reserve is going to be more anti-inflation now than in the Greenspan era.  However, New York Federal Reserve Chairman William Dudley obviously didn’t get the memo about jawboning the market in a hawkish way.  Yesterday, he indicated that the U.S. Federal Reserve is likely to keep rates very low for a prolonged period for fear of choking off a tenuous recovery.

So while the RBA is raising rates, the Fed and the ECB may not follow anytime soon. That is certainly supportive of the Australian dollar.

Below is a CNBC video that gives you a chance to see the real-time reaction to the RBA’s decision and another with some commentary on the Aussie dollar.

Related posts:

• Reserve Bank of Australia lifts rates again
• The ECB cuts rates 50 basis points to 2 percent
• Is the Fed just jawboning?
• Chart of the day: interest rates
• Norway makes three

Marshall Auerback pointed out a statement from Dallas Fed Chief Richard Fisher today that is not getting a lot of attention despite its importance.  He said:

I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that with which we pursued monetary accommodation.

This is extremely hawkish language from Fisher. If true, it would be an upward move more akin to 1993-1994 than to 2004-2007. If you recall, the Fed Funds rate bottomed at 3% in May 1993. The Fed then aggressively raised rates to 6% in the next two years. This was not the ”measured” interest-rate hike campaign that the Federal Reserve followed after the Dot.com bubble.

The mid-nineties rise in rates led to a major bust at investment banks which were long treasuries like Goldman Sachs and also led to the so-called Tequila crisis (see my write-up on this in a post called “1995.”). This was the first full blown financial crisis of the Greenspan era and it seems the lesson the Fed took from the event was that it needed an asymmetric monetary policy in which rate cuts are more aggressive and quicker than hikes.

We have seen the folly in this policy, euphemistically known as ‘the Greenspan Put’ as gigantic asset bubbles ballooned out of control following cuts in 1998-1999 and 2002-2003. Fisher, a well-known inflation hawk, might be speaking for himself.  Or he might be signaling there will be no Bernanke Put.

Source

Fisher Sees Limit to Fed’s ‘Life Support’ for Housing – Bloomberg

Related posts:

• Quote of the day – Richard Fisher, head of the Dallas Fed
• The unkindest cut: the BoE got it wrong
• The Fed leads a global rate cut by central banks
• BoE dilemma highlights difficulty of turning points
• Is the Fed just jawboning?

One other reason to sell the dollar is interest rates.  Why not borrow in dollars where interest rates are low and invest elsewhere where yields are high?  This is what is known as the carry trade.

In the past decade, the Japanese yen and the Swiss franc were favorites for the carry trade because of their low yields.  But now, the U.S. dollar presents the same opportunity due to the likelihood that rates will stay low for a long time to come.

The video below explains.

See also Is the Dollar Set to Become the New Yen? from Market Beat.

Related posts:

• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• U.S. Bailout: the mother of all carry trades?
• Chart of the day: Aussie – Yen cross
• The carry trade unwinds and it’s not pretty
• Reverse carry trade borrowing is deadly

Yesterday I mentioned the announcement by the FDIC to end its debt guarantee program and opined that this was the first sign of tightening/liquidity withdrawal by the U.S. government.  Today the evidence is mounting that this is indeed an orchestrated move toward policy normalization.

The FT spoke to treasury officials who confirmed this interpretation:

A senior Treasury official said “we are pivoting and starting to pull back on certain programmes.” The administration will allow the money market mutual fund guarantee programme to expire as scheduled on September 18, and is backing a review by the Federal Deposit Insurance Corporation that is likely to see funding guarantees for bank debt either ended or restricted to emergency cases on penal terms.

How the Federal Reserve acts is the key missing component here, both in terms of returning repoed assets to the banks which own them and in terms of eventual interest rate decisions. My guess at this point is that the Fed will look to reduce its balance sheet well before it looks to increase interest rates.

In addition, the Fed had provided up to $650 billion in swap lines to other central banks at the height of the financial crisis.  Those swap lines are now down to $70 billion (source: Marc Chandler, Brown Brothers Harriman). This reduction in a liquidity-induced appetite for U.S. dollars may be a major reason the Dollar is falling right now even against the Pound and the Swiss Franc where the central banks are engaging in quantitative easing.

Update 1530ET: See also Bailouts Are Shrinking, Geithner Says from DealBook:

One of President Obama’s top economic strategists said on Thursday that the government was now starting to shrink many parts of its gigantic financial bailout following the collapse of Lehman Brothers last September, The New York Times’s Edmund L. Andrews reports.

“We must begin winding down some of the extraordinary support we put in place for the financial system,” said the Treasury Secretary, Timothy F. Geithner, in written testimony prepared for the Congressional Oversight Panel on the Treasury’s $700 billion rescue program. (Go to a Webcast of Thursday’s hearing.)

Related posts:

• U.S. has begun to drain liquidity
• Treasury yields go below zero
• How will the Fed withdraw all that liquidity?
• Signs of recovery in credit markets
• If the Fed were a commercial bank, it might be declared insolvent

Earlier today I posted an article about how accounting was favourable to banks in that it could help them weather the storm and appear well-capitalized until a recovery is underway.  Afterwards, a buoyant economy would increase earnings enough to allow the massive writedowns that need to flow through the income statement to be taken in stride.  As an addendum to the previous post, I added a note regarding how this turn-of-events can take place even though the housing market is considerably worse than most pundits felt it would be.

Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post "JP Morgan Chase buys WaMu out").  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

I have another tack regarding bank earnings to share.  Feel free to express your agreement or doubt in the comments regarding this line of argument.  As a result of the securitization model of mortgage finance having replaced the traditional model, banks with large retail customer bases are geared to transactions and volume as a way of making money.  This means banks like high mortgage transaction volumes, whether through actual purchases or refinancing.  Some of the the banks geared in that direction include Wells Fargo and Wachovia, Bank of America and Countrywide Financial, and JPMorgan and Washington Mutual. All of these banks will benefit from having bought other bankrupt organizations with large mortgage operations. 

For example, say you buy a house in 2004 that is not underwater. Having seen your 5-year ARM reach the end of the ARM period, you are looking to refinance now in 2009.  Using some of the homeowner-oriented bailout schemes, your bank can lower your monthly payment but in return they get an incentive payment:

• A straight out cash incentive payment of say $1000 for doing a loan modification on a still current loan as the lender (say Wells Fargo) AND another cash payment as a servicer (say, Countrywide, now BofA).
• A amortized payment equal to half of the savings you just received (as long as you stay current, which 40% of loan-mods are not doing). So you save $100, but the bank gets $50 a month for the next five years as a lender. The servicer will get annual payments here as well.

Nice, huh?  Well read this from the Mortgage Bankers Association from last week’s Weekly Mortgage Applications Survey.  I have highlighted the points you should pay attention to.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending May 15, 2009.  The Market Composite Index, a measure of mortgage loan application volume, was 915.9, an increase of 2.3 percent on a seasonally adjusted basis from 895.6 one week earlier.  On an unadjusted basis, the Index increased 2.0 percent compared with the previous week and increased 42.0 percent compared with the same week one year earlier.

The Refinance Index increased 4.5 percent to 4794.4 from 4588.6 the previous week and the seasonally adjusted Purchase Index decreased 4.4 percent to 254.0 from 265.7 one week earlier. 

The four week moving average for the seasonally adjusted Market Index is down 6.4 percent.  The four week moving average is up 0.1 percent for the seasonally adjusted Purchase Index, while this average is down 8.2 percent for the Refinance Index.

The refinance share of mortgage activity increased to 73.6 percent of total applications from 71.9 percent the previous week. The adjustable-rate mortgage (ARM) share of activity increased to 2.4 percent from 2.3 percent of total applications from the previous week.

The fact is bankers are looking to get A LOT of refinancing volume because both servicers and lenders stand to increase current net income significantly if refinancing volumes are high.  An increased refinancing transaction volume is a backdoor way of re-capitalizing banks.  Now, just in case you are interested, here is what the same MBA Weekly report looked like on Oct 8th, just after Lehman filed for bankruptcy.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending October 3, 2008.  The Market Composite Index, a measure of mortgage loan application volume, was 465.5, an increase of 2.2 percent on a seasonally adjusted basis from 455.4 one week earlier.  On an unadjusted basis, the Index increased 2.2 percent compared with the previous week and was down 28.6 percent compared with the same week one year earlier.

The Refinance Index increased 0.9 percent to 1345.8 from the previous week and the seasonally adjusted Purchase Index increased 3.2 percent to 314.5 from one week earlier.  The Conventional Purchase Index increased 0.7 percent while the Government Purchase Index (largely FHA) increased 9.9 percent.
The four week moving average for the seasonally adjusted Market Index is down 1.4 percent.  The four week moving average for the seasonally adjusted Purchase Index is down 4.1 percent, while this average is up 1.8 percent for the Refinance Index.

The refinance share of mortgage activity decreased to 43.4 percent of total applications from 44.0 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 2.3 percent from 2.5 percent of total applications from the previous week.

Clearly refinancing volume is through the roof as zero percent interest rates are an incentive for all mortgage-holders to refinance.  This increased volume of transactions will be very helpful to banks’ earnings over the near-term.  Notice that I haven’t mentioned Citigroup anywhere here because they lost out in the Wachovia transaction and they have a fairly small retail operation domestically.

Source

Mortgage Applications Increase in Latest MBA Weekly Survey: 20 May 2009 – MBA website

Mortgage Applications Increase Slightly In Latest MBA Weekly Survey: 8 Oct 2008 – MBA website

Related posts:

• More on Fannie and Freddie – Signs of life in the Refi Market?
• How much money is Wells Fargo really making?
• Fixed rate mortgages at a nine-month high
• Merrill – Bank of America deal
• WaMu: Mr. Smith goes to Washington and turns predatory

This analysis comes via Brown Brothers Harriman (I have bolded a few lines):

Mexico’s central bank is widely expected to cut its overnight rate by 25 bp today. That would bring it to 7.25%. Last month it delivered a 25 bp rate cut too. The market had expected a 50 bp cut and punished the peso in disappointment. However, the peso has strengthened sharply in recent days-up until yesterday–and this has renewed some speculation of a 50 bp move today. This seems unlikely. Consumer inflation remains stubborn. It was 6.2% in Feb, having peaked at 6.53% at the end of last year.

Mexico’s economy is contracting. Domestic demand is weak and of course foreign demand (primarily the US) is poor. The main sources of capital inflows into Mexico–exports, worker remittances and tourism are drying up. Oil prices are roughly a third of where they were 9 months ago.

Mexico has spent some $20 bln to slow the peso’s descent or roughly 5% of its reserves. Central Banker Ortiz is unlikely to risk the new found stability in the currency may cutting rates more aggressively. Given the pass through of a weaker peso on imported inflation and then domestic inflation, means that policy makers think that the stability of the peso is the key to capping inflation.

Mark Twain once said that history doesn’t repeat itself but that sometimes it rhymes. In this context, it would suggest that the peso may not sell-off on a 25 bp rate cut like last month. On the other hand, K Marx said that history repeats itself–the first time as tragedy the second time as farce. That would suggest that the peso might in fact sell-off again. Technicals are more aligned with the latter scenario. Hourly technical indicators suggest the overnight recovery in the peso has left it over-extended. Look for the dollar to bounce back from a test on MXN14.10.

Clearly there is downside risk here.  Remittances are down.  Oil revenue is down. Tourism is down.

Apropos tourism, the Mexican travel industry is extremely worried about the bad press the country has been receiving in the U.S. about the drug trade and murders of late.  I am going on holiday in Mexico next month and my resort sent me the following e-mail two days ago:

Dear Customer,

While millions of U.S. and Canadian citizens safely visit Mexico each year, including thousands who cross the land border every day for study, tourism or business, the display of travel warnings as well as details of unexpected events has increased recently.

That being so, we would like to clarify as well as to reassure that our company has strict security measures such as 24 hour security surveillance and guards. Additionally, access to the hotel is strictly controlled and limited to guests only. We must stress that our priority is to ensure that all of our members will be provided with the highest safety and security while visiting our Resorts.

Please be advised that the majority of the news of violence refer to the drug war, an unfortunate situation occurring mostly in the northern border states of Mexico, and does not significantly affect any tourist destinations.

Furthermore, our concierge and hotel manager will be more than happy to answer any questions you may have prior or during your arrival. Please keep in mind that we are working hard to ensure that you and your family have a safe and pleasant vacation.

If you need further assistance, please do not hesitate to call us at any of the numbers listed below.

I have never been worried about safety at this resort – it is a lovely place. But, this message actually had the perverse effet of making me think twice.

Update 1120ET: The Mexicans went super-aggressive and cut 75 beeps. Obviously, they do not want a repeat of last go round. Perhaps they are taking cues from Ben Bernanke on how to get this downturn sorted? Anyway, BBH has this to say after the fact:

The Mexican central bank surprised the market by delivering a larger than expected rate cut. The 75 bp cut brings the overnight rate to 6.75%. Last month the central bank disappointed expectations and the peso fell. This time it surpassed expectations and the peso rallied. The central bank justified the rate cut on grounds that inflation expectations have been anchored and the downside risks to the economy are growing. The official concern is more about the growth trajectory than price pressures, which it thinks has been easing in recent months. The dollar fell to about MXN14.00 on the news from near MXN14.20. The greenback has recovered quickly back to MXN14.10. With the finance ministry making it clear that it is not oppposed to the peso being weaker than MXN14.00 and news the Cemex has postponed their earnings until late next month should see the peso weaken as the impact of the unexpectedly large rate cut wears off quickly.

Related posts:

• Mexico goes hat in hand to the IMF
• What’s a central bank to do?
• Is Mexico imploding?
• U.K. central bank does not follow Fed to ZIRP
• Will Mexico suffer contagion?

Thirty years ago, it was “Anarchy in the U.K.” as Britain tried to get away from its role as the sick man of Europe.  That meant civil unrest, high inflation and a weak economy. Margaret Thatcher was seen by many as the solution. Today, the British economy is sick again and there is anotherready solution to hand: quantitative easing a.k.a printing money:

Everyone knows a shiny new bridge when they see one. Quantitative easing, on the other hand, has been a mystery to all but hardened anoraks until zero interest rates started to loom late last year. Policymakers worldwide now pin their hopes on quantitative easing’s ability to complement traditional fiscal stimuli as a means of boosting demand. Even if they feel boosting money supply worth a try, few have a genuine conviction that it will work. There are three big problems with central banks buying unsterilised financial assets. The first is signalling. The normal process of tinkering with interest rates is based on eons of data on the effect on growth and inflation. That in turn provides a framework round which future rate moves can be forecast. Quantitative easing, however, is messy. That calls for clear targets. But based on what? Targeting particular measures of money supply, bank lending (as Japan did) or long-dated gilt yields is tricky.

Even with targets, the second problem is working out exactly how much quantitative easing is enough. Very simply, whether raising the money in circulation boosts incomes depends also on what economists call the “velocity” of money. If those selling assets to the central bank simply put their spoils on deposit, for example, the potential boost from the increase in money will be tempered. Knowing the velocity of money therefore is crucial. Yet this number is hard to pin down.

The final headache lies in selecting which assets to buy. As the Bank of England showed last week, most central banks go for government bonds. But these tend to be owned by financial institutions, not the ailing companies and households that need the money most. Besides, government bonds are already super liquid. It would be preferable for central banks to swap cash for harder-to-shift assets such as commercial paper. Another plus would be that purchases of such assets would remove their liquidity discount, giving the likes of the Bank at least a fighting chance of recovering their money when things finally recover enough to sell again.

So now we know that the U.K. is down with the printing money programme. So what? What will that mean to the average British citizen? Well, if the price action in today’s market is any judge it means two things clearly: a weak British pound and lower interest rates. First, there is Sterling:

The pound fell against the dollar and the euro as HSBC Holdings Plc, Europe’s largest bank, dropped to a 12-year low on concern over bad loans at its U.S. unit.

The British currency also weakened against the Japanese yen and the Swiss franc as HSBC declined as much as 14 percent, driving the FTSE 350 Banks Index as much as 10 percent lower. Lloyds Banking Group Plc said March 7 it would place 260 billion pounds ($367 billion) of assets into a state insurance program, capping losses and giving the government a stake that may rise to 75 percent.

“Banking stocks in the U.K. are under pressure today,” said Steven Barrow, head of G10 currency research at Standard Bank Plc in London. “That backdrop is negative for sterling.”

The pound fell to $1.3948 as of 9:16 a.m. in London, from $1.4094 yesterday. It weakened to 90.42 pence per euro, from 89.78 pence. The U.K. currency fell to 137.45 yen from 138.49 and to 1.6199 Swiss francs from 1.6326.

The Bloomberg article points to HSBC’s woes as a cause for Sterling’s weakness. Don’t be fooled. Everyone knows that printing money and strong currencies don’t mix. Because Mervyn King is going out back to his garden to his money tree to pluck off a few billion in notes to pay for Gilts, currency traders expect higher inflation down the line.   And that means the British currency is worth less.

On the other hand, that does not necessarily mean that interest rates must rise. After all, the BoE is buying up gilts and artificially suppressing their yield. Yet again, Bloomberg seems to miss this connection.

U.K. 10-year gilt yields slid to the lowest level in at least 20 years and the pound fell as bank shares tumbled and policy makers prepared to buy government bonds to inject cash into the shrinking economy.

Yields on gilts maturing from five years to 30 years dropped after Lloyds Banking Group Plc ceded control to the government and HSBC Holdings Plc sank as much as 14 percent in London trading. The Bank of England said March 5 it plans to spend 75 billion pounds ($104 billion) buying corporate debt and government assets that have between five and 25 years to mature.

“This banking-nationalization talk is keeping banking stocks well depressed and that’s supportive for gilts,” said Orlando Green, a fixed-income strategist in London at Calyon, the investment-banking unit of France’s Credit Agricole SA. “The five- to 25-year part of the curve is going to be well supported given that quantitative easing is going to be centering around the 10-year region.”

The 10-year gilt yield dropped as much as 11 basis points to 2.95 percent, the lowest level since Bloomberg began tracking the data in 1989. The security yielded 3.05 percent as of 1:18 p.m. in London. The 4.5 percent note due March 2019 rose 0.05, or 50 pence per 1,000-pound face amount, to 112.37.

The yield on the security posted its biggest two-day drop since at least 1989 in the final two days of last week, shedding 58 basis points, after policy makers announced the asset-buying program on March 5 and cut the main interest rate to 0.50 percent, the lowest level in the bank’s 315-year history.

To my mind the price action in currencies and Gilts has everything to do with quantitative easing and much less to do with bank stocks. The Bank of England is committed to supporting its economy by lowering the price of credit.  Quantitative easing means a depreciating currency and lower interest rates.

Let’s see what effect this has down the line.

Sources
Quantitative easing – FT.com
Pound Falls Against Dollar, Euro as HSBC Drops on Loans Concern – Bloomberg.com
U.K. 10-Year Yield Drops to Lowest Since 1989 on Bank Concern – Bloomberg.com

Related posts:

• The U.S. dollar plunges due to quantitative easing
• Connecting Fed cuts with credit writedowns and quantitative easing
• When will Sterling hit Euro parity?
• China warns that the west’s quantitative easing is inflationary
• U.K. central bank does not follow Fed to ZIRP

The European Central Bank cut its benchmark rate 50 basis points (0.50%) to 2% because of weakness in the Eurozone.  While a cut was widely anticipated, it was not known whether the ECB would cut 25 or 50 basis points.  However, the cut of 50 basis points ended up confirming the prevailing view that the ECB is behind the curve. As a result, the Euro weakened against the Japanese Yen and the U.S. Dollar.

I have said I expected the Euro to rise to as high as $1.55 this year.  However, it is now at $1.31, largely because it is now generally believed that the ECB will join the BoE, BOJ, and the Fed in a zero interest rate policy as the Eurozone has become weak. So the prevailing calculus now is that economic weakness is giving the lie to the ECB’s prior position of being “trapped” by low interest rates.

For now, I am sticking with my forecast – predicated on the ECB not going to zero.  However, if the ECB does join Japan, the U.K., Switzerland and the U.S. at zero, the Euro is probably not going higher.

Related posts:

• Don Kohn says Fed policy has kept rates down 100 basis points
• Denmark wants in on the Euro
• Reserve Bank of Australia lifts rates again
• The Eurozone and the spectre of banking collapse
• The case against the Euro

Is this an unorderly decline for the dollar?

These last two days have been bad for the dollar. We are seeing heavy losses against the Swiss Franc, the Euro, the Australian Dollar, and The Japanese Yen. (The Pound is going down even more).

After Bernanke lowered rates to effectively zero and said he was starting up the helicopters, currency traders decided the U.S. Dollar is a weak currency.

Take a look at these two charts. The Top one is from today and the bottom one is the one I posted yesterday. Not good.

Related posts:

• U.S. Dollar: Cliff Diving
• Chart of the day: US Dollar
• The U.S. dollar plunges due to quantitative easing
• Chart of the day: Japanese Yen
• The dollar is rising against floating currencies

The U.S. Dollar got more bad news today when the Bank of England (BoE) decided to not follow the U.S. Federal Reserve’s lead to a Zero Interest Rate Policy (ZIRP). The BoE was seen as the most likely to follow in the Fed’s footsteps as i suffers from the same debilitating economic problems a popped housing bubble and record writedowns followed by job losses, a lack of consumption, and economic stagnation. Most importantly, U.K. banks simply are not lending. But that does not mean they want to follow the U.S. to zero.

Bank of England policy makers voted unanimously to cut the benchmark interest rate to 2 percent this month and refrained from a bigger reduction on concern it may prompt about an “excessive” drop in the pound.

The Monetary Policy Committee, led by Governor Mervyn King, voted 9-0 to bring the rate to the lowest since 1951, minutes of the Dec. 4 decision published in London today show. While the economic outlook had worsened, a cut of more than one point may push the currency down too far and “undermine confidence in the economy more widely,” the minutes said.

The pound dropped to a record low against the euro after data showed unemployment rose in November at the fastest pace since 1991. King has signaled that the bank will cut the interest rate further if needed and the U.S. Federal Reserve yesterday lowered its rate close to zero.

You should note that the British Pound has not fallen against the Dollar. Taking rates to zero percent can have bad unintended consequences as Financial Times pointed out yesterday (hat tip Yves Smith).

When rates tumble to low levels, it reduces the economic incentive to lend securities. The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close.

The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year.

“Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries,” said Michael Cloherty, strategist at Banc of America Securities. “We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.

“In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern.”

Problems in repo impair general trading across the Treasury market. A rise in so-called failed trades, where a borrowed security is not returned in a timely fashion, becomes a drain on the balance sheets of dealers. Low interest rates are also hampering the ability of dealers in financing positions by matching the different needs of clients, known as matching offsetting trades.

“The zero per cent interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market,” said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.

I am not particularly confident the Federal Reserve will have much success in its experiment with ZIRP or with quantitative easing for that matter. The idea that the Fed should buy up financial assets also leaves me cold. They risk distorting the price signals that free markets give to investors and businesses with all of this market interference.

The Bank of England is correct in not having followed the Fed to zero. Maybe British savers will take some cheer from that decision.

Sources
BOE Voted 9-0 for Interest-Rate Cut to 2% in December – Bloomberg
Unemployment increases by 137,000 – BBC News
Ultra-low US rates undermine repo market – Financial Times

Related posts:

• The Fed leads a global rate cut by central banks
• When will Sterling hit Euro parity?
• What’s a central bank to do?
• Are central banks independent actors?
• Interest rates, the pound and good news for Brits

Zero percent interest rates are pretty Dollar-bearish.  So, the U.S. Dollar is getting hammered.  See these charts from the last day and a half of trading.  Even the British Pound is cleaning up!

Dollars per Euro

Dollars per British Pound

Swiss Francs per Dollar

Japanese Yen per Dollar

Related posts:

• U.S. Dollar: Cliff Diving Again
• Chart of the day: US Dollar
• US Dollar rising dramatically
• Chart of the day: Japanese Yen
• The U.S. dollar plunges due to quantitative easing

I recently wrote a post about U.S. Treasury securities which have been rising in price as interest rates have come down. In the post, I called the Treasury rise a bubble and I stick by that moniker despite protests from some astute readers.

However, I do want to point out one reason why Treasurys are rising. Inflation.

Non-Seasonally Adjusted CPI

Inflation is plummeting and that means inflation will soon become deflation. The U.S. Consumer Price Index (CPI) was released today, showing that inflation fell 1.9% in the last month alone. Prices are only 1.1% higher than last year at this time. In July that figure was 5.6%.

To be sure, much of that decline comes from the drop in oil prices – the energy index fell 17% in November. Nevertheless, this inflation report is a clear signal that prices are plummeting and that the Federal Reserve has been powerless to stop the fall.

Certainly, this is a very good reason why Treasury prices are rising.

Source
Consumer Price Index Summary – Bureau of Labor Statistics

Related posts:

• U.S. CPI: Lowest since 1954 – deflation here we come
• Chart of the day: Inflation
• Chart of the day: UK CPI inflation
• U.S. Consumer Prices Climb by the Most Since 2005
• US consumer prices down 1%, core prices also down

This is a thought experiment.

Imagine it’s the year 2003 and I am a senior credit card company executive. I have grown bored with my job and want to venture out on my own and start up a new company. With my industry connections, I am able to raise 400 million in capital. I soon start ABCD Card Financial and we are ready to start issuing cards.

Now, it just so happens, I am a fairly prudent fellow and I lend cautiously to creditworthy borrowers. But, unbeknownst to me, ABCD’s CFO invests our hard earned capital in Credit Card Asset-Backed Securities. Mind you, this is AAA-rated stuff, so to most observers, this looks like a prudent use of money.

Anyway, business goes well and we take the company public in 2006, raising $1.4 billion for 65% of the company. That’s a nice return for three years work. We are now flush with capital, $2 billion worth including retained earnings. We leverage this up 20 times committing to $40 billion in loans. Much of the capital is invested in more Asset Backed Securities.

Fast forward to 2009. We are now experiencing a deep recession and people are defaulting left and right on their credit cards. Suddenly, those AAA Asset-Backed Securities aren’t looking like a good call after all. ABCD is forced to announce credit writedowns of $300 million. But, luckily for us, our overall lending has been prudent and while charge-offs are high we will survive.

Now, think about it for a second. We just wrote off $300 million of capital. That means we have $6 billion less to lend. So everything else being equal, this credit writedown just vaporized $6 billion. Poof, gone.

What’s my point? Well, globally, financial institutions have written down almost $1 trillion. That is an enormous amount of credit that vanished in the stroke of a pen. Do you think that lowering interest rates 75 basis points more to 0.25% as the Federal Reserve did today is going to get ABCD to lend as much as it did before the writedowns? Maybe, if only we can leverage to 30 times capital and lend to riskier borrowers and that is not in our best interest.

When the Fed lowered interest rates to 0.25% today, the lowest since record keeping began in 1954, it influenced the price of credit lower, but not necessarily the quantity of credit. Low interest rates — what I call easy money — are not going to get the job done. What financial institutions need is more reserves and more capital.

So, what if the Fed came to my CFO and said we’ll trade you some of the Treasurys you own in your short-term investments for dollars? For the right price, we would say yes. Where do the dollars come from? Out of thin air of course. The Fed creates them in order to buy my assets. This is called quantitative easing. It’s basically inflating the money supply plain and simple. The difference between quantitative easing and low interest rates is that easing actually increases my reserves, giving me more money to lend. Whether I choose to lend is another question.

To my mind, lowering interest rates in the aftermath of an enormous credit bubble where institutions have just destroyed $1 trillion in capital is wrong. It distorts lending decisions such that yet more money will eventually be lent out imprudently. The only way to increase credit availability is by getting reserves into the system. And normally you do that by making a profit. However, profits are hard to come by for financial institutions right now. So the Fed can step into the breach adding reserves by purchasing assets with money that the central banks creates. Mind you, this is inflation. Even so, this money inflation won’t necessarily get financial institutions to increase lending.

On the other hand, lowering interest rates just won’t work.

Related posts:

• Is quantitative easing really inflationary?
• Quantitative easing: printing money like mad to ward off deflation
• Quantitative easing everywhere?
• What’s different about 2008?
• Chart of the day: Excess Reserves

Recently I wrote a post which claimed that Keynesian stimulus is what we need in the global economy right now. These ideas are considered heresy in Austrian School circles because trying to stimulate the economy out of recession only puts off the day of reckoning and often worsens that day of reckoning. This is exactly what we saw when Alan Greenspan lowered interest rates to 1% after the last recession.

So what exactly does Ludwig von Mises, the most revered Austrian School economist, say about this? The short answer is that he would say stimulus is only going to make matters worse.  He has written on this very subject in his essay “The ‘Austrian’ Theory of the Trade Cycle.” Let me provide you with some of the text from that essay and an explanation of why I believe stimulus is necessary despite what he warns. And remember, his essay was written in 1936, the same year Keynes released his seminal work so that everyone forgot about the Austrians.

In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as “suppliers” of additional created, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom wold rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise.

This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money. Such is the phenomenon that occurred in Germany and in other countries that followed a policy of prolonged inflation and that was known as the “flight into real values.” Commodity prices rise enormously as do foreign exchange rates, while the price of the domestic money falls almost to zero. The value of the currency collapses, as was the case in Germany in 1923.

Basically Mises has laid out very concisely the fact that the business cycle is due to the extension and over-extension of credit. Trying to continue to expand credit eventually ends in a hyper-inflationary scenario as it did in Weimar Germany in 1923. As a result, most countries are forced to stop.

If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of “profitability” created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to artificial lowering of the interest rate, and which had been sustained thanks to the equaly artificial increase in prices, no longer appear profitable.

If you read this and think about the Technology Bubble or the Housing Bubble, these are textbook cases. Investment money was diverted from other more useful sectors to fund over-investment in technology and telecom in the 1990s and to fund overbuilding in residential property this last decade. Both of these episodes were a direct result of low interest rates. And when Mises speaks of an “artificial increase of prices”, he means asset prices.

Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared “profitable” in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be “profitable.” The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants a not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of “profitability” based on the extension of credit.

Later, in the same essay Mises gets to the point about stimulus:

It has often been suggested to “stimulate” economic activity and to “prime the pump” by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.

Essentially, over-extension of credit is the problem. It is not the solution. One could say credit is a drug to which we have become addicted. So, how can giving more of that drug help us kick the habit? Why am I proposing more stimulus?

Using the drug analogy, I would say I am proposing “government stimulus” as methadone for addiction treatment to help with the heroin-like credit addiction. It is only a stop-gap. Going cold turkey is likely to lead to unpredictable — or even dangerous — results.

I do like to use the Weimar example to make this point. I lived and worked in Germany for quite a while and am very familiar with German history as a result. The Weimar Republic was Germany’s first attempt at democracy from 1919-1933. It was widely considered a failure and led to fascism and the Nazis as a result.

In assessing Weimar’s failures, most focus on the war reparations from the Treaty of Versailles that ended World War I as a principle reason for hyperinflation in 1923 and Weimar’s ultimate failure. In fact, the hyperinflation episode of 1923 is one reason the ECB and the Bundesbank before it had been noted for having a tight money policy.  Germans fear 1923 the way Americans fear 1929.

However, the severity of Depression of 1921 was a significant contributing factor to both Mussolini’s political success and Hitler’s initial political success in the early 1920s and the rise of fascism. Ultimately, economic depression again in the early 1930s created the pre-conditions for World War II and the breeding ground for despots.

So, my thinking is fairly simple: cushioning the fall with government stimulus will prevent worst-case outcomes — nothing more. It will not prevent depression.

Update: I have added an addendum to this article in my post “A brief philosophical argument about the role of government, stimulus and recession.” I wrote the second post to talk more about the efficacy of stimulus in hastening recovery. Please read that post in conjunction with this one.

Source
The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich Hayek

Related posts:

• A brief philosophical argument about the role of government, stimulus and recession
• Liquidity trap of a different sort
• Why should central banks cut interest rates?
• Peter Schiff: “Government is a burden on the economy”
• Confessions of an Austrian economist

The yield on the three-month U.S. treasury bill went below zero for the first time ever.  This seems to be an unprecedented move where investors are actually paying the U.S. Government to borrow money.  In my estimation, this is not just a flight to a safe haven in turbulent times.  Negative interest rates in U.S. treasurys reveal a bubble that will pop and end badly for all concerned.

Unfortunately, this is the end effect of easy money: the liquidity needs to go somewhere and it usually leads to a destabilizing bubble somewhere in the global financial system.  While I am comfortable with quantitative easing as a policy response to the credit crisis, low interest rates are having the usual unintended consequences.

Treasuries rose, pushing rates on the three-month bill negative for the first time, as investors gravitate toward the safety of U.S. government debt amid the worse financial crisis since the Great Depression.

The Treasury sold $27 billion of three-month bills yesterday at a discount rate of 0.005 percent, the lowest since it starting auctioning the securities in 1929. The U.S. also sold $30 billion of four-week bills today at zero percent for the first time since it began selling the debt in 2001.

“It’s the year-end factor,” said Chris Ahrens, an interest-rate strategist in Greenwich, Connecticut, at UBS Securities LLC, one of the 17 primary dealers that trade directly with the Federal Reserve. “Everyone wants to be in bills going into year-end. Buy now while the opportunity is still there.”

The benchmark 10-year note’s yield dropped seven basis points, or 0.07 percentage point, to 2.67 percent at 3:10 p.m. in New York, according to BGCantor Market Data. The 3.75 percent security due in November 2018 gained 21/32, or $6.56 per $1,000 face amount, to 109 12/32. The yield touched 2.505 percent on Dec. 5, the lowest level since at least 1962, when the Fed’s daily records began.

The two-year note’s yield fell nine basis points to 0.85 percent. It dropped to a record low of 0.77 percent on Dec. 5.

If you invested $1,000 in three-month bills today at a negative discount rate of 0.01 percent, for a price of 100.002556. At maturity you would receive the par value for a loss of $25.56.

Expect me to go into greater detail on this subject in upcoming posts.

Source
Treasury Bills Trade at Negative Rates as Haven Demand Surges – Bloomberg

Related posts:

• Treasurys are in a bubble
• Reserve Bank of Australia lifts rates again
• UK inflation exceeds Bank interest rate for first time since 1981
• Another take on the treasuries bubble
• U.K. central bank does not follow Fed to ZIRP