Nouriel Roubini, writing in the New York Daily News , said on Sunday that “unemployed Americans should hunker down for more job losses” given the likelihood of a job less recovery. This was as gloomy a piece as I have seen from Roubini in the past few months. He has clearly become more downbeat about the long-term picture for the U.S. economy.

The article begins:

Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%…

…we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back.

This sounds dire. As a result, Roubini goes on to call on the Obama Administration to take direct action on jobs. Extending unemployment benefits is not going to cut it.  Roubini says we need:

a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

With statistics showing that the rate of long-term joblessness is at the highest since the Great Depression, Roubini joins an increasing number of economists who are calling on the Obama Administration to take the employment situation more seriously.

Paul Krugman has said that we are now in a liquidity trap. Therefore, we need to subsidize jobs and promote work sharing as Germany is doing.

I have made similar arguments about quantitative easing for the past year. Monetary policy is effectively useless – and is merely creating bubbles.

The Obama Administration is moving into deficit hawk mode at the wrong time as this will only worsen the jobs situation and lead to a double dip recession. Instead, I have called for a payroll tax cut or a job subsidy.

Randall Wray, a professor at the University of Missouri-Kansas City, has also offered a unique job solution.

All of this is urgent, as Roubini indicates:

Based on my best judgment, it is most likely that the unemployment rate will peak close to 11% and will remain at a very high level for two years or more.

The weakness in labor markets and the sharp fall in labor income ensure a weak recovery of private consumption and an anemic recovery of the economy, and increases the risk of a double dip recession…

The damage will be extensive and severe unless bold policy action is undertaken now.

The Obama Administration is taking an ‘indirect’ approach. They do so for three reasons. First, they are afraid of being boxed in politically by taking more direct measures. They also see a need to defend their previous policy decisions.  But, Mark Thoma thinks part of the resistance to more direct measures is ideological.  In a post earlier today, he says:

Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers’ remarks reflect this type of thinking.

The Obama Administration’s approach of focusing on deficit reduction without enough direct job measures is sure to keep unemployment elevated. In looking at the politics of economics I said recently:

I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

The Obama Administration is doing the opposite. They seem to have received the ‘deficit reduction comes first takeaway’ from recent state elections in Virginia, New Jersey, and New York instead of the ‘jobs come first takeaway.’ That is bad news for Democrats and it is also bad news for the hopes of a sustained recovery.

Source

The worst is yet to come: Unemployed Americans should hunker down for more job losses – Nouriel Roubini, NY Daily News
Job Losses Mount, Enduring and Deep – Floyd Norris, NY Times (the long-term unemployment image is also from this story)

Related posts:

• Comprehensive unemployment rate is 17.5%
• 467,000 jobs lost in the U.S. in June 2009
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• 10.2% unemployment, 190,000 jobs lost
• Unemployment rate to 9.7%, 216,000 jobs lost

A friend sent me the following presentation earlier in the week when I was feeling a bit ill. So I neglected to post it.  But, I want to return to it because it is in keeping with my recovery/depression theme. These are the issues that were complicit in the latest financial crisis and almost none of them have disappeared.  They will most certainly rear their heads again precipitating or worsening the next downturn.

We’re talking about:

1. Duration mismatches (borrowing short and lending long)
2. Accounting (Mark-to-market, deferred tax assets and a lot more)
3. Conflicts of interest (no Chinese walls, ratings agencies)
4. Regulation (especially given poor risk controls)
5. Risk management (is Meriwether a leading indicator?)
6. Investment Banking vs. Utility Banking
7. Too big to fail (they must be downsized)
8. Heads I win, tails you lose (socialization of losses is crony capitalism)
9. Quantitative easing (QE has costs)
10. Hedges instead of capital

My baseline thinking at the moment is that we are seeing the beginnings of a cyclical recovery built on the back of asset relation more than anything else. The underpinnings of this uptrend are tenuous. So, when this latest burst of reflation hits the wall, all of the aforementioned issues will re-appear and policy makers will again do the who-could-have-known routine we saw in 2001 and again in 2008/ But the broader public is increasingly wise to this song and dance. Hat tip Scott.

Jim Chanos Presentation at Darden, 22 Oct 2009

Related posts:

• Chinese officials warn banks about reckless lending
• European banks: still undercapitalised
• The U.S. financial system is effectively insolvent
• Lessons from Japan’s Bank Crisis
• Bank of Canada blames Geithner for financial mess

Marshall Auerback here with a few thoughts on money, the Federal Reserve’s balance sheet, and the alphabet soup of emergency liquidity facilities.

The expansion of the Fed’s balance sheet has been widely misunderstood within the economics profession, because it has been viewed through the lens of a pre-existing debate about the monetary transmission mechanism. Those who emphasized the importance of the money supply (on nominal spending) saw the expansion as quantitative easing, and warned about eventual inflationary consequences. Those who emphasized the credit channel (as Bernanke) saw the expansion as providing credit that was temporarily unavailable in the private market. The fact that the balance sheet expanded on both sides, and in both cases with the private sector as counterparty, tells us that something else was going on.

I would argue that the Fed’s actions after Lehman should be understood as moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. Deleveraging provides one answer why the expansion was not even larger. But the deeper answer, I think, comes from an appreciation that the Fed was acting as lender of last resort, and in doing so supporting continued lending in the private money market that would otherwise have frozen. In effect the Fed was offering a standing facility at prices away from market prices, so only those who most needed it took advantage. Simply knowing it was there made others willing to deal privately at more reasonable prices.

Thus, the commercial paper lending facility expanded and then contracted as private lending recovered. The central bank liquidity facility has followed a similar course. The important thing to realize is that, as these temporary liquidity facilities have wound down, the Fed has ramped up additional facilities, now aimed at restarting the securitized lending system more generally.

Related posts:

• Chart of the day: Fed Balance Sheet
• Fed is buying money market fund assets
• Will banks exiting TARP take back their toxic waste now?
• Flooding the system with money?
• Why is Zero Hedge claiming the Fed is intervening in equities markets?

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback.

Update: This phrase, "PDCF usage declined, reaching zero in mid-May 2009," suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: "The Federal Reserve’s Primary Dealer Credit Facility."

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• TALF: A bailout if one reads the fine print
• A few words from a reader on TALF mechanics
• Understand the Fed’s balance sheet
• Bloomberg News sues the Fed under Freedom of Information Act

Morgan Stanley has an interesting piece out this morning called Debtflation. In the past, they have raised alarm bells over what they see as embedded inflation in the loose monetary policy presently being followed by most central banks.  This particular piece focuses not on a general potential for inflation, but the possibility that central banks will explicitly target higher inflation in order to reduce high debt burdens – a policy advocated by Kenneth Rogoff.

The recent downturn has called many of the old certainties into question. In the world of central banking, a prominent victim of the downturn is the – previously orthodox – view that central banks should neglect asset prices when conducting monetary policy. Yet more recently, another major tenet of central bank doctrine is being challenged – the view that monetary policy should not be used to help out governments under debt pressure. We think that the risk of independent central banks creating some amount of (controlled) inflation going forward cannot quite be dismissed out of hand.

We have flagged inflation as a major long-term risk going forward: if the recovery is as tepid as we expect, central banks will be inclined to err on the side of caution when it comes to withdrawing the unprecedented conventional and unconventional monetary stimulus. But we believe that there will be a familiar additional source of inflation risk – the mounting public debt burden.  There is no doubt that, last winter, with the global economy slumping, central bankers welcomed the help they got from hugely expansionary fiscal policy. However, the result has been a massive increase in developed countries’ public indebtedness – the extent of the debt build-up in some countries resembles the consequences of wars. Historically, developed economies have escaped high debt by growing out of it rather than inflating it away or defaulting (with the notable exception of Germany and Japan). Growth after World War II for example was fast, not least because war-ravaged economies were rebuilding their capital stocks.

This time around, however, eroding the debt through faster growth may not be an option. Instead, growth in many developed countries is likely to slow significantly going forward as labour forces shrink due to the demographic transition. Worse, population ageing will impose added pressure on public expenditure through higher pensions and healthcare costs. If outgrowing the debt is unlikely, and if governments lack the resolve to cut spending and/or raise taxes sufficiently, the remaining options are default and inflation. No policymaker in the developed world – and, by now, few in the developing world – would want to countenance default as an option. This leaves inflation. The question is familiar: could central bankers be forced to engineer inflation – ‘monetise the debt’? Almost all developing world central banks are independent from an institutional point of view. Indeed, one of the main reasons for setting up independent monetary authorities is precisely to avoid pressure from governments to inflate away the debt. So, central banks cannot be forced by their governments to generate inflation (unless governments were prepared to change the statutes of their monetary authorities; this would in most cases require going to the legislature).

With governmental coercion being unfeasible, is there a possibility that independent central bankers might generate inflation out of their own volition? If nothing else, they would take a big gamble with their hard-won credibility. And history teaches us that the reason behind most, if not all, episodes of very high inflation has been monetary expansion to finance government expenditure or reduce debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009).

Morgan Stanley is saying in effect that it fears central banks inflating away private and public debt burdens by printing more money. It is not clear that quantitative easing really is inflationary (at least in the short-term). For this policy to actually produce inflation in an environment that is geared more toward deleveraging, we will need serious asset price inflation to spill over into the real economy – and this would require increases in asset prices that would be extremely destabilizing when the inevitable bust occurs. Most likely an asset bubble bursting would tip the global economy back into deflation. This is the Scylla and Charybdis problem I outlined in June. So, I am not sure central banks could pull this off even if they wanted to.

More from Morgan Stanley at the link below.

Source

Debtflation – Morgan Stanley

Related posts:

• Quote of the day: William White and inflation
• Are central banks independent actors?
• Stephen Roach: Downturn in Asia less severe, but recovery later
• The inflation – deflation debate redux
• Emerging Markets will be tested by 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?

On numerous occasions you will have heard me use the term ‘monetizing debt’ to describe what happens when the central bank creates money out of thin air in order to increase reserves in the banking system. The central bank is certainly increasing the monetary base in this regard, but are they really monetizing the debt being issued by the federal government?  Let’s examine the issue to find out.

Fiscal and Monetary Authority

The crux of the issue here is whether the US or the UK central governments can deficit spend to their hearts’ content in order to prop up their respective domestic economies and whether this spending will be financed by printing money at the central bank.

In both cases, a small budget deficit in good times has turned into monstrous deficit reaching double digits in percentage terms. Moreover, the two countries have a monetary authority (the central bank) and a fiscal authority/backer of legal tender (central government) which is at the same level.  This is not true in, say, Spain, where the ECB and the Spanish central government are at different levels.

So what happens then?

Printing money

Let’s first turn to the central bank.  The central bank, looking to increase bank reserves in the system, buys assets (usually federal government debt) with previously non-existent money that it electronically prints out of thin air. This money printing is known as quantitative easing or QE. QE increases bank reserves in the system when the seller of the assets deposits the new funds at her bank and the bank then holds some of these funds in reserve at the central bank as it is mandated to do.

The hope is that the seller’s bank will then go out and lend the non-mandated funds, thus increasing credit in the system.  However, what has generally happened is that the bank has deposited these funds at the central bank as excess reserves without lending it out, receiving only the base rate of interest for doing so – almost zero.

The reason excess reserves are piling up in the UK and the US has as much to do with the demand for credit as it does with the impairment of banks’ balance sheets.  Banks are under-capitalized on a mark-to-market basis, and are, therefore fearful of making new loans when they need to increase their capital base.  But, companies and individual, fearful of their enormous debt burdens in a world of asset price deflation, show no demand for credit.  The lack of credit and the build-up of excess reserves is, therefore, due to constraints on both the supply and demand sides of the credit process.

But, this is a situation which cannot continue ad infinitum because those reserves are assets on the bank’s balance sheet earning near zero interest.  That means the bank’s profitability is lower than it would be had it lent out those funds or purchased assets with those reserves.  Right now, that is acceptable because banks are earning a lot of cash due to high interest spreads, but eventually, these excess reserves are going to become painfully unprofitable.

So, eventually, the bank will be forced to buy some treasuries in order to increase profitability. Obviously, treasuries would be the asset class of choice for financial institutions fearful of making loans while their capital base is impaired. This makes those lenders wiling buyers of federal government debt and financiers of the burgeoning supply of the government’s spending spree.  In essence, the central bank has caused the private sector to prefer bonds over reserves by pushing the overnight rate to zero. That is what is meant by monetizing debt.

Whether the seller is domestic or foreign, the net effect is the same in increasing reserves unless a foreign seller converts the money into a foreign currency without eventual re-conversion back into the domestic currency.  In this case, QE has actually increased reserves in the foreign baking system instead.

By the way, monetizing debt is a central issue in the debate over Federal Reserve independence.  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.

Is this inflationary?

It all depends on net private savings as to whether this stokes inflation in the short-term. The reason that the Federal Government is deficit spending to begin with has to do with the loss of consumption in the private sector due to increased deleveraging and savings.  In the U.S., we have seen the savings rate rise from negative territory (i.e. saving nothing and spending even more by drawing down accumulated wealth) to almost 7% in a few years’ time.  This behavorial change is a positive for America as it is a recognition of the excess consumption that an asset-based economy created. It puts America in a much better position on its current account and helps to reduce debt from unsustainable levels.

But, it is also responsible for much of the decline in the US economy.  So, to prevent a deflationary spiral, the federal government has stepped in to fill the void.  But, if the increase in net government spending (with the improvement in the current account balance) is less than the increase in net private consumption (both via individuals through lower consumption and companies through reduced capital spending), then the net effect of the spending will not be inflationary.  In that case, the net consumption of individuals, businesses and government (C + I + G +(EX-IM) for you economics fans) is lower than it was before the negative consumption shock.

Over the longer-term, the money printing is problematic.  When demand for borrowing is restored, the extra reserves in the system will be lent out. Moreover, the excess reserves can always be invested in higher yielding assets by the banks in order to increase profitability. Therefore, this sequence will engender rises in either asset or consumer prices, depending on how much excess capacity is in the system.  This is why it is imperative that the Fed outline how it plans to withdraw all of the excess liquidity it created when it expanded its balance sheet by twofold.

And since capacity utilization is incredibly low right now, my bet is on asset price inflation rather than consumer price inflation. So when Marc Faber says don’t underestimate the power of printing money, this is what he means.  That is how and why an asset bubble can inflate even in the face of poor fundamentals and why the present bear market rally can sustain itself longer than one might think.  Eventually, all of this comes to an end and the fundamentals re-assert themselves. When that is, is the $23.7 trillion question.

Related posts:

• Connecting Fed cuts with credit writedowns and quantitative easing
• Quantitative easing: printing money like mad to ward off deflation
• Chart of the day: Excess Reserves
• China warns that the west’s quantitative easing is inflationary
• Don’t underestimate the power of printing money, part 2

In the clearest signal yet that we are still in a potentially devastating global deflationary spiral, The Riksbank, Sweden’s central bank and the world’s oldest central bank, has effectively cut interest rates to minus 0.25% and has started a program of quantitative easing a.k.a printing money. These are the most dramatic moves yet by a major central bank and will be watched the world over for signs of success or failure.  Let me explain what the Swedes are doing and why.

On the 2 July 2009, the Riksbank unexpectedly lowered rates across the board.  Economists had expected the Riksbank to keep the repo rate at the low 0.5% level. The repo rate is the official bank rate at which banks can borrow from the central bank against government bond collateral. It is the floor rate, the lowest rate in the banking system.  But, the Swedes lowered the rate to 0.25%, a record low.

The interesting bits were buried deep in the accompanying press release, namely that the Riksbank was to engage in quantitative easing and to penalize banks for holding reserve deposits. The full press release is below with the important parts highlighted in bold.  I will translate this econ-o-speak into plain English after the Riksbank statement.

The weak development of the economy requires a somewhat more expansionary monetary policy. The Executive Board of the Riksbank has therefore decided to cut the repo rate by 0.25 of a percentage point to 0.25 per cent. The repo rate is expected to remain at this low level over the coming year. At the same time there are several signs that economic activity will improve.

Deep economic downturn

Economic activity abroad is very weak and this hits Sweden hard. Exports have fallen substantially and the situation on the labour market is continuing to deteriorate rapidly. The information received in recent months points to the economic downturn in 2009 being somewhat deeper than the Riksbank forecast in April.

Low repo rate over a long period of time

A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. The Executive Board of the Riksbank has therefore decided to cut the repo rate to 0.25 per cent. The repo rate is expected to remain at this low level until autumn 2010. The Riksbank’s assessment is that cutting the rate to 0.25 per cent will not threaten the functioning of the financial markets.

The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Supplementary measures are necessary to ensure that monetary policy has the intended effect. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. This should contribute to lower interest rates on loans to companies and households.

Stable underlying inflation

Despite the expansionary monetary policy, production and employment will be lower than normal over the next few years. Inflation will be kept up by weak productivity and a weak krona. However, there will be large fluctuations in CPI inflation during the coming period. This is primarily due to the fact that changes in the repo rate affect mortgage rates, which are included in the CPI. The CPIF underlying inflation rate (the CPI with a fixed mortgage rate) will on the other hand remain stable close to 2 per cent during the forecast period.

Signs of a turnaround

In recent months there have been several signs that economic activity will improve. At the same time, the financial markets in Sweden and abroad have begun to function more effectively, which creates the potential for an acceleration in international and domestic demand. The low repo rate and current fiscal policy will also contribute to the recovery. GDP growth is expected to be positive in 2010, but the labour market will lag behind and employment will not begin to rise until 2011.

Considerable uncertainty

The economic outlook is still uncertain. When the turnaround comes, the upturn may be stronger than in the main scenario. However, it could also be the case that the recovery will take longer than expected. The future direction for monetary policy will therefore depend on how new information on economic developments abroad and in Sweden will affect the prospects for inflation and economic activity in Sweden.

Forecast for inflation and GDP Annual percentage change

	2008	2009	2010	2011
CPI	3.4	-0.2 (-0.3)	1.4 (1.3)	3.2 (3.2)
CPIF	2.7	1.9 (1.9)	1.9 (1.8)	2.0 (2.0)
GDP	-0.2	-5.4 (-4.5)	1.4 (1.3)	3.1 (3.1)

Inflation forecast, 12-month figures Annual percentage change

	Sept. 09	Sept. 10	Sept. 11	Sept. 12
CPI	-1.2 (-1.4)	1.5 (1.4)	3.7 (3.7)	3.7
CPIF	1.5 (1.4)	1.7 (1.6)	2.0 (2.1)	2.2

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Sources: Statistics Sweden and the Riksbank

Forecast for the repo rate Per cent, quarterly averages

	Q2 2009	Q3 2009	Q4 2009	Q3 2010	Q3 2011	Q3 2012
Repo rate	0.6	0.3 (0.5)	0.3 (0.5)	0.3 (0.5)	1.8 (1.8)	4.0

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Source: The Riksbank

Deputy Governor Lars E.O. Svensson entered a reservation against the decision and advocated cutting the repo rate to 0 per cent and a repo rate path in line with the scenario for a lower repo rate in the Monetary Policy Report, so that the repo rate would be kept at this level for one year. He considered that such a repo rate path entails a better balanced monetary policy, with lower unemployment and higher resource utilisation without inflation deviating too far from the target.
Deputy Governor Barbro Wickman-Parak supported the decision to cut the repo rate to 0.25 percentage points, but entered a reservation against the growth forecasts, and thereby the repo rate path these entailed, in the Monetary Policy Report. Ms Wickman-Parak said her stance was due to a more positive view of economic activity both abroad and in Sweden further ahead, which would mean that the repo rate would need to be raised earlier than is forecast in the main scenario of the Monetary Policy Report.

The minutes from the Executive Board’s monetary policy discussion will be published on 16 July. The decision on the repo rate will apply with effect from Wednesday, 8 July. The deposit rate is at the same time cut to -0.25 per cent and the lending rate to 0.75 per cent. A press conference with Deputy Governor Barbro Wickman-Parak and Anders Vredin, Head of the Monetary Policy Department, will be held today at 11 a.m. in the Riksbank. Entry via the bank’s main entrance, Brunkebergstorg 11. Press cards must be shown. The press conference will be broadcast live on the Riksbank’s website, www.riksbank.se/.

So, here’s what the Swedes are saying:

1. Economic activity abroad is very weak and this hits Sweden hard. That means the Swedes can’t export their way to prosperity because no one is buying.  Everyone is in a synchronized global downturn.  One subtext I should mention is that Sweden is greatly affected by the collapse in the Baltics because there was a huge trade flow and banking relationship between Sweden and the Baltics.  Therefore, the economic depression there is not good for the Swedes or their banking system.
2. A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. Output and employment in Sweden is so weak now that it is creating deflation.  We have to lower interest rates in an effort to stimulate borrowing, which we hope increases credit and ultimately production and employment.
3. The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Look, we are cutting rates as low as they can go, effectively zero.  And financial markets are still not normal. Banks just are not lending enough to create the credit in the system necessary to increase production and employment.
4. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. Because cutting rates, the policy tool we prefer, is not getting the job done, we are going to effectively print money out of thin air. We will start making loans to banks with fictitious money that we create solely to increase the amount of money in circulation in a desperate attempt to increase consumer and business credit, consumer price inflation, and output.
5. The deposit rate is at the same time cut to -0.25 per cent. And as an extra measure, we will start penalizing banks for not lending by charging them 0.25% for holding deposits at the Riksbank.  Now, they will have every incentive to start lending…we hope.

Pretty aggressive plan, if you ask me. Will it work, though?

Well, first of all, most every major central bank in the world, certainly the biggest: the Americans, the Eurozone, the British, the Swiss, and the Japanese, have rates near zero and are printing money.  The world is awash in money and the incentive to borrow is huge.  So, is the Swedish announcement qualitatively different?  On some level, it is not.  Nevertheless, it is the most aggressive policy and the fact that they are charging negative interest rates for deposits is unprecedented.  This does make events in Sweden something to watch.

Moreover, the situation in Sweden is bleak.  GDP is expected to contract 5.4% this year and inflation is expected to be negative. Clearly, the Swedes are in a deflationary spiral.  It doesn’t help that its banks lent recklessly to the Baltics and that those countries are imploding.  The Swedish banking system is at present severely undercapitalized – this is why lending is not taking place.  The chart to the right of key figures from the Riksbank website sums it up.

So, the Swedes are lending and printing money. What’s more is they are taking economists up on their suggestions regarding negative interest rates. Back in April and May, Greg Mankiw and Willem Buiter suggested that negative interest rates were the way to go in order to deal with these problems.  Basically, you are giving people money to borrow.  There cannot be much more incentive than that.

The thing is you can lead a borrower to the bank, but you can’t make him borrow.  Do you even want him to borrow?  The last time I checked, it was savings and investment which created long-term growth.  In my view, people are terrified of over-borrowing now and no amount of easy money is going to change that overnight.

Here’s the problem.  I take a fairly Austrian School tack here.  Punishing savers by lowering interest rates to zero and printing money is not going to solve the problem.  The problem was low interest rate and easy money to begin with (and a lack of regulatory oversight never hurts too). This created a binge of reckless lending.  We are now seeing the result of that lending worldwide, Sweden included.

What Sweden needs is more capital in its banking system. Remember the whole song and dance about the Swedish solution? Supposedly, the Swedes were brave enough in the early 1990s to bite the bullet and nationalize insolvent banks in order to re-capitalise the banking system and get lending going again.  Everyone and his sister was saying this is what America needed to do (including me).  I still say this is what needs to be done: punish reckless lenders by liquidating zombie undercapitalized banks but provide enough liquidity at normal interest rates to keep the system intact.  And, I am sure taxpayers would be a lot more willing to pony up under these circumstances than under the present policy of giving the reckless lenders free handouts. If you want to prevent systemic collapse, it is the banking system, not the banks, which is important.

But, apparently, everyone just wants easy money and no one wants the Swedish solution – not the Americans and certainly not the Swedes.

Update 1300ET: Note – so as not to play too fast and lose with my terminology, I should clarify that the Riksbank is charging banks for holding deposits at the Riksbank.  They are not lending at negative interest rates as the statement “Basically, you are giving people money to borrow” suggests.  Also, regarding the lending by the Riksbank, they are not technically engaging in quantitative easing (buying government paper with new money). However, the net effect of the lending is to increase credit flow.

Related posts:

• Why should central banks cut interest rates?
• Interest rates, the pound and good news for Brits
• U.K. central bank does not follow Fed to ZIRP
• Norway makes three
• Connecting Fed cuts with credit writedowns and quantitative easing

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.

Related posts:

• Bernanke outlines Fed’s easy money exit strategy
• More signs of liquidity withdrawal, now from the U.S. Treasury
• Liquidity trap of a different sort
• U.S. has begun to drain liquidity
• Plosser: The Fed must stop qualitative easing

You have to hand it to Marc Faber; he knows how to grab your attention. Earlier this year, I posted a video of him saying “don’t underestimate the power of printing money“, a quote that has become mantra for me.  Basically, he believes a rising tide of quantitative easing is going to buoy stock markets globally and the global economy (at least for the medium-term). This is a view I agree with and one reason I have taken a more bullish tack at Credit Writedowns.

Earlier today, I also posted a video of Faber talking about Nouriel Roubini and the pressure not to overstay a bearish call and miss the turn which I found rather interesting (Here’s a video of Roubini sounding rather bullish – for him).  However, later in that same interview, Faber makes his most quotable statement yet: “I am 100% sure that the U.S. will go into hyperinflation.”  That is a very bold claim.

Just last week, I made similar comments in my post, “More thoughts on the fake recovery.”

In my view, the Federal Reserve has effectively demonstrated it is willing to risk hyperinflation in order to beat back the deflationary forces.

But I was using hyperbole.  Faber, however, is dead serious.  It is the secret desire of the Fed to want inflation that has U.S. government bond yields going bezerk.  But, most people are not expecting hyperinflation in the United States ever.

The video of Faber is below.  Is this headline-seeking exaggeration or serious punditry?

Source

U.S. Inflation to Approach Zimbabwe Level, Faber Says – Bloomberg.com

Related posts:

• Marc Faber: “it’s very tough for a forecaster who was ultra-bearish to stay bearish”
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber: China’s numbers are fake
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"

I received a high-quality note from Marc Chandler, Chief Currency Strategist at Brown Brothers Harriman, which I think worthy of posting.  He makes several points which are game changers regarding fiscal and monetary policy.  They are:

1. Don Kohn, an influential Fed official, thinks that the Fed has kept long-term interest rates down in the United States, despite the recent explosion in long-term rates. This has added $1 trillion to GDP in his view.
2. Kohn also thinks that a zero nominal rate makes fiscal stimulus doubly impactful.  Translation: all of the fiscal stimulus which is in the pipeline will have a meaningful impact in buoying growth in 2009 and 2010.
3. Sweden and Norway have gone QE.  This means that pretty much every major Western central bank and the Japanese are taking unconventional measures.  The list includes Japan, the U.S., the U.K., Switzerland, and the Eurozone.  I think this argues for global reflation.  Obviously, if we do not see recovery, it will not because monetary policy was restrictive.

I see that commodities are generally trading down today.  However, I see these reflation points as supportive of commodities and particularly gold and silver. Below are Chandler’s comments.

This past Saturday the Fed’s Vice Chairman Donald Kohn spoke on a panel at Princeton University. Kohn is also the most experienced person on the FOMC and he also headed up the working committee to help improve the FOMC communication. What he says is particularly important.

He claimed that the Fed’s purchases of Treasury and GSE securities may have helped hold down long term rates as much as 100 bp and could boost nominal GDP by $1 trillion. Given that the FOMC minutes of the April meeting indicated that the door to increased purchases was open, depending on financial and economic conditions. Because Kohn’s evaluation of the purchases was favorable, this would seem to underscore possibility that the Fed increases the purchases of long-term assets–and this is particularly relevant for Treasuries as the Fed’s purchase program was to expire Aug/Sept while purchases of GSE assets run until the end of the year.

The other note of interest from Kohn involved the multiplier of fiscal stimulus. Kohn suggested that the multiplier impact could be higher with Fed funds near zero than in more normal times. Kohn suggested the multiplier could be as a high as 2x rather than 1x assuming that the stimulus is perceived to be temporary.

Lastly note that it is not just the Fed that may have to step up what Kohn called LSAP (large scale asset purchase program). We suspect that by the end of the summer the BOE may request authority to buy more gilts.

In the last 48 hours, officials in Sweden and Norway have opened the door to unconventional measures as well if the economic situation worsens. Norway in particular noted that inflation may undershoot its target and the Norwegian banks need to boost capital. We wonder if Norway would not find itself in a similar position as Switzerland, with too small of a domestic bond market to pursue the king of quantitative easing (buying government bonds) that the US, UK and Japan are engaged in and be forced to buy foreign bonds.

Related posts:

• The ECB cuts rates 50 basis points to 2 percent
• RBA hikes rates 25 basis points in Australia
• Don’t underestimate the power of printing money, part 2
• The ECB gets aggressive and goes all-in for QE
• Chart of the day: interest rates

The ECB went aggressive today and a big way.  They were the last holdout in the move to quantitative easing (a.ka. printing money).  They have lowered rates to a record low 1.00% and issued a statement that the European Central Bank will begin purchasing covered bonds (a.k.a propping up the market artificially).  If you don’t think the reflation play is going to gain traction, you’re not in touch with present central banking and government fiscal policy.

Edward Hugh (the other Edward over at Global Economy Matters) told he me he thought this move significant. He said, “Just to bring to your attention that today’s covered bonds ECB decision, as well as being good for German banks who issue Pfandebriefe, is also aimed at Spain’s banks, enabling them to refinance.”

Later in the day, Marc Chandler, the Chief Currency Strategist at Brown Brothers Harriman sent out an investor notice that has the right tone to it about this move.

The ECB has taken a more aggressive than expected stance.  Trichet announced that the ECB will purchase covered bonds (see below).  The ECB had been expected to limit its non-traditional measures to the extension of the maturity of existing lending from 6 to 12 month maturities (which it did).  In addition to extending the maturity of existing lending from 6 to 12 months (which was widely expected), the ECB took a more aggressive than expected step in announcing it would purchase EUR 60 bln of covered bonds.

The questions now are why the ECB chose to target this sector and whether the size of the EUR 60 bln of purchases will help meet the ECB’s agenda.  The policy announcement does not appear to be aimed at reflating the economy.  Trichet’s statement indicates the ECB is very committed to making sure inflation expectations are well anchored and the ECB President said he was encouraged by the recent improvement in inflation.  The President also said the ECB would ensure that the policy measures would be unwound when needed.  The new ECB policy does not appear to be designed to lower interest rates either (as is the case with the Fed where asset purchases help to lower mortgage and borrowing rates).

The fact that the ECB has targeted the covered bond market shows commitment to easing conditions in a segment of the market that has been severely hit by the financial market turmoil of the past year. European banks are heavy issuers in covered bonds (especially in France, Germany and Spain) and a crucial intermediate for European corporate access to credit. The fact that Germany is the main issuer (roughly EUR900m in 2007) should also facilitate implementation of the ECB purchase program. The covered bonds do have an advantage in that the assets backing the bond issues remain on the issuer’s consolidated balance sheet and the pool of assets must consistently back the covered bond.  The ECB has chosen to announce that it may purchase, at some point, EUR 60 bln of the EUR1.5 tln covered bond market in the euro zone (2007 figure, European Covered Bond Council). 

While the size is small – as the Fed’s purchase of $300 bln of Treasuries is a small fraction of the overall Treasury market – the ECB’s announcement, while symbolic in nature, is a step in the right direction and could lead to some small improvement in the covered bond market as did news the Fed was considering purchasing mortgage backed securities.  The Fed then went on to implement the program.  It is unclear if and when the ECB does implement the program.  The statement still leaves our long term view of the euro unchanged.  We still expect the early steps by US officials to address the crisis will see the US macroeconomic picture improve relative to the euro zone.  At the moment, positive news out of the US is helping to ease global tensions and support foreign currencies.  Over the longer term, this will fade and strong US macroeconomics will help the dollar gain traction against the euro.

While Marc does not see this as a reflation trade or a play to target interest rates, it should be clear the ECB are propping up the Spanish and German property markets in particular.  My understanding is that Bank of Ireland, AIB, Anglo Irish, and Depfa, the subsidiary of the soon-to-be-nationalized HRE, all have significant Irish covered bond exposure as well.  So, this may be a way of getting at the Irish and Spanish markets, which are the two Euro land markets with the most significant property crashes. Pimco has a good primer on covered bonds on their site (click here) and I have written on this topic twice last summer (here and here).

However you look at it, the ECB has moved fully into ease mode along with the BoJ, the Fed, the SNB, and the BoE.  This will be very supportive to the economy and the market.  As always, don’t underestimate the power of printing money.

Below is a CNBC video detailing the interest rates and the covered bond move with a quote from ECB President Trichet himself.

Related posts:

• Is the ECB all-in on printing money?
• Irish sovereign debt interest rate spreads
• ECB hikes key rate to 4.25%
• Are covered bonds really the solution?
• The ECB cuts rates 50 basis points to 2 percent

Martin Hennecke, a frequent guest on CNBC, is recommending that investors who have fled to cash and government bonds need to rethink that strategy.  He sees inflation on the horizon and warns that western sovereign bonds will suffer as a result and sitting on cash will be throwing money away. 

The crux of his thesis rests on the huge budget deficits now being run by western countries to reflate their economies. These deficits must be funded and the fear is they will simply be monetized through printing money a.k.a quantitative easing by western central banks. This policy used to ward of the potential of deflation gives the potential for lots of inflation down the line if the excess liquidity is not retracted.

While I agree that the renewed risk of inflation exists (the Q1 U.S. GDP report demonstrating this), I am skeptical whether inflation will be a  problem for the immediate future.  Nevertheless, his view that vigilance against getting trapped in depreciating assets once inflation reappears is well in-line with how I see things.

He recommends commodities and precious metals as a hedge. He also recommends staying away from export-dependent Asian shares. But, he does see “some good picks” in domestic Chinese shares and elsewhere in Asia.

Hennecke makes some interesting comments about the Dollar and the Yuan as reserve currencies. Have a look at the video below.

Related posts:

• Japanese opposition would avoid U.S. dollar bonds if elected
• Faber: Gloom, Boom or Doom?
• How will the Fed withdraw all that liquidity?
• China issues bonds to “promote the RMB in neighbouring countries”
• Bill Gross: Sell equities and buy Treasuries

When the United States closed the gold window in 1971, the world entered a new era in which nearly all money was supported by nothing more than the full faith and credit of the governments issuing it.  If one looks back to the history of paper money, no government has had the discipline to maintain its currency without resorting to the printing presses.

All of these paper money experiments have ended in disaster.  This is one reason ‘gold bugs’ are so keen on the Gold Standard – because a currency tied to a real asset is better than a currency backed only by the promise of its government not to inflate (a return to Gold is nearly impossible, for reasons I outlined in my post “A New World Order“).

But, the era since 1971 is unique in history in that ALL major currencies are fiat currencies.  This is truly the Age of the Fiat Currency – unprecedented in human history.

As for how this will all pan out for the United States and elsewhere, Hayman Advisors of Dallas, has a few choice words to say:

As a nation and a world, we are coming to an important crossroad with the belief (whether it be forced or simply accepted) in “fiat” currency. The Old English Dictionary defines “fiat” as:

fiat. [a. Latin 'let it be done'; 'let there be made']

In short, fiat currency is money that exists because an authority, government or custom simply declares or forces it to be as such. The American Heritage dictionary defines fiat currency as “paper money declared legal tender, not backed by gold or silver.” I think of fiat currency as being paper money with no intrinsic value which has been simply declared to be legal tender. Up to this point, it has been widely
accepted that currency or money is worth the goods and services for which it is routinely exchanged. I hope this remains the case, but think that the odds are against it. In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years. This could not be truer than it is today. While I do not have a solution (and maybe it does not exist) to the problems facing us today, what I do know is that attempting to re-lever a massively over-leveraged system is clearly NOT the answer. The disintermediation of risk is one of the primary causes of the current problem and it is NOT the solution.

Alan Greenspan said it best when he wrote Gold and Economic Freedom in 1966 (before he entered the Federal Reserve System; since then, he has been silent on the subject):

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which – through a complex series of steps – the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy’s books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.
- Alan Greenspan, Gold and Economic Freedom, 1966

Edward here. But, that was the Alan Greenspan of the mid-1960s.  The Alan Greenspan of the mid-1990s was the “Bubble Blower-in-Chief” as Federal Reserve Chairman.  He was a man who believed in the necessity of printing money to avoid the necessary the pain of recession, a economic re-balancing process that is a necessary part of capitalism and a crucial feature of the business cycle.  It is like trying to stay  awake at the expense of any sleep.

The problem with this is that the world is awash in fiat money.  Hayman Advisors continues (emphasis added).

To the best of our knowledge, there has only been 160,000 metric tons of gold EVER mined in the world. At $950 per ounce, all of the gold in the world would be worth $4.887 trillion dollars. On the other hand, we estimate that there is roughly $60 trillion of fiat money (including currencies, deposits, savings, money markets and CDs) in the world. Given the fact that world governments are caught with so much credit market leverage and losses, we believe that they will – in true Keynesian color – attempt to print their way out of this mess. If this occurs, you have to ask yourself: How many of people do you think it will take to begin to question the value of paper currency when it is being debased in an attempt to save world governments? If a small fraction of them stop believing, where will they go to preserve their wealth? My guess is the U.S. dollar and precious metals.

Edward again. Wait a minute, U.S. Dollars? Yes, the Greenback. Why? Because as bad as things in the U.S. are, things outside of the U.S. are as bad or worse. Think about some of the countries outside the U.S. like Japan, with their exports imploding. Germany is looking at -6% GDP this year. Hungary, Latvia, and Ukraine are in depression. Spain and Ireland are in Depression. Singapore and Taiwan have entered depression as well. It is not a pretty picture. So, the U.S. Dollar will serve as a safe haven as this deleveraging takes hold.

Here’s how Hayman sees it:

If the Federal Reserve begins to purchase large quantities of newly-issued Treasury bonds – the electronic equivalent of the printing press – we better hold on to our wallets! The good news for the United States is the fact that, as a percent of GDP, it will not have to print nearly as much as many parts of the rest of the world.

What worries me the most about our analysis is the fact that the U.S. will have to issue $2.35 trillion new Treasuries this year, and collectively, Europe will have to issue even more. Today, China and Japan own 65% of the foreign ownership of U.S. Treasuries. Have you seen what is happening to China and Japan lately? It does not seem possible that there is anywhere near enough money in the world to buy that many Treasuries.

To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?

Given all of the above, we are very confident in two predictions:

1. The U.S. is in relatively better shape than the rest of the world, and the dollar will be a safer currency than virtually any other (and yes, that includes the Yen).
2. Uncertainty and fear are rampant. Confidence in governmental and central bank leadership (are the two really that separate?) is plummeting worldwide. As a result, we believe people will look to “old-fashioned” stores of value – those which represented money long before green pieces of paper backed by a promise existed. Indeed, investors have already begun moving into precious metals. We expect this will continue.

Basically, these guys are more bearish than Nouriel Roubini, Peter Schiff and Michael Panzner combined.

As a result they say:

1. It’s way too early to take a flyer in bank debt.
2. It’s not even time to take a flyer in mortgage debt.
3. Suspending mark-to-market in favour of mark-to-model is a sham. Writedowns will continue
4. Interestingly, they do not think Credit Default Swaps are that evil at all.

My thoughts here:  Their analysis is directionally right if extremely bearish.  I happen to think we could see a cyclical rebound as early as Q4 or Q1 of next year.

Nevertheless, we are witnessing the implosion of the Age of the Fiat Currency and its attendant deleveraging.  This is a major event – the most significant economic event n three-quarters of a century.  It would be naive to think it could end in two years as a result of central banks printing money. And then we’d be back to business as normal.  There are many more changes to come.

Source
March 2009 Hayman Advisors Newsletter

Related posts:

• Russia, sovereign debt defaults, and fiat currency
• Marc Faber: “U.S. dollar weakness is a symptom of inflation in the system”
• What is Inflation?
• Fleckenstein: Protect yourself from Financial Armageddon with gold
• A New World Order

Two weeks ago, the Fed roiled bond markets by signalling it would start to purchase Treasury bonds with printed money – the very definition of inflation.  

Now, its the ECB’s turn to show it can inflate with the best of them.  They have adopted extraordinary measures despite the view of many that they have not inflated. But, the ECB has certainly not been nearly as aggressive as the Fed. Are they all-in now too?

Marc Chandler from Brown Brothers Harriman gives his view.

After the March 18th decision by the Federal Reserve to increase its purchases of we argued that contrary to what many pundits were saying, the Fed was not “all in” and there were and continue to be a number of additional steps the Fed could take.

The focus this week is on the ECB meeting. What can it do ? We highlight a number of things in today’s North American daily, pull them together for convenience here. The first thing to note, however, is that through its unlimited supply of liquidity and liberal collateral rules, the ECB has already engaged in what ECB President Trichet calls “non-standard” operations. Second, the previous policy maker and market focus on the refi rate is not longer applicable. The 150 bp policy rate is not the key operational rate. The market rate is closer to 100 bp and the deposit rate, which is what the ECB pays on reserves, is at 50 bp. Moreover, there is not much difference between libor rates. Consider June 09 Euribor implies a yield of 1.3%, while June 09 Eurodollar implies a yield of 1.14%. Dec Euribor 09 implies a yield of 1.46%, while Dec 09 Eurodollar implies a yield of 1.29%.

There are a range of options that the ECB can still chose from:

1. Extend existing efforts
   • lengthen duration of unlimited liquidity provisions
   • reduce “haircuts”, allowing greater loans for same collateral
   • accept lower quality collateral
2. New Efforts
   • purchase commercial paper
   • purchase long term corporate bonds
   • purchase long-term sovereign bonds

Our contacts and public commentary makes it appear that a majority of the ECB may not yet be ready to initiate new efforts. Expanding existing programs seems to be the more likely scenario, coupled with a modest rate adjustment. The ECB may also narrow the gap between the refi rate and the deposit rate which is now 100 bp wide. The deposit rate acts as the floor for short-term rates. The ECB could cut this to zero, but that also seems unlikely at this juncture. A 50 bp cut in the refi rate, and 25 off the deposit rate coupled with some tweaking of its current liquidity provisions seems more likely.

The euro’s response is not immediately evident. As pressure on the ECB has increased in recent days, the euro has weakened. It is possible that a “sell the rumor, buy the fact” type of trading materialize, keeping the euro weak ahead of Thurs ECB meeting. The following day is the US jobs data and another dismal report is expected. However, the weak jobs data has not meant a stronger euro (only 2 of the past six months has the euro finished higher on non-farm payrolls release days).

A break of $1.2950-80 support area for the euro would have ominous signs and point to a retest on the year’s low set on March 4 near $1.2460.

Related posts:

• Don’t underestimate the power of printing money
• Quantitative easing: printing money like mad to ward off deflation
• Private citizens now printing money too
• Are European banks sitting on 16.3 trillion in toxic assets?
• U.S. Dollar: Cliff Diving

The following post is up on Morgan Stanley’s website and highlights the degree to which money printing has become the policy tool of choice used by central bankers with which to fight this deflationary threat.  I have highlighted the whole paragraph on the inflationary risk of all of this.

Central banks that have adopted QE have used very different strategies, except for one which they have all shared – they have managed to surprise markets with almost every announcement. Since our last write-up (see “QE2”, The Global Monetary Analyst, March 4, 2009), monetary authorities in the UK, Switzerland and the US have delivered hefty surprises to the market by introducing larger-than-expected or significantly enhanced programmes. The Bank of England put £75 billion of the £150 billion tranche approved by the Treasury to use on March 5, most of it to be used to purchase gilts. The Swiss National Bank announced on March 12 that it would buy corporate bonds as well as foreign currency – specifically the euro. Finally, at its meeting on March 18, the FOMC delivered a hefty increase in its MBS purchase programmes (from US$500 billion to US$1.25 trillion) and introduced a US$300 billion programme to buy Treasury securities.

We are optimistic about the traction from QE… QE is not a panacea for economic ills, but we believe that it can work in conjunction with the many other programmes that are attacking the problem from various angles. These actions from major central banks are a continuation of their earlier aggressive easing of policy rates and their willingness to use any and all available means to pull economic growth up by its bootstraps. The size of these programmes to purchase assets outright as well as the demonstrated commitment of central banks to persevere with unconventional measures are integral parts of the policy package.

…but we also see higher risks now. The increase in the size of the active QE programme directly increases the potential policy traction in much the same sense that pushing policy rates lower increases the monetary stimulus. However, the size of these programmes also raises risks in two ways. First, it increases the potential size of losses that the central bank and its guarantor (the government) may have to bear. Second, unwinding such massive purchases of assets will act like a sizeable contractionary monetary policy shock. While the chances of QE making a significant impact on the economy have increased, so have the risks associated with managing and correctly unwinding these programmes…

QE in the G10. The G10 aggregate policy rate is already close to zero. It is therefore not surprising that QE is being either considered or implemented here, depending on the need for further policy action. The Swiss National Bank announced its active QE package (purchases of corporate bonds and FX) only on March 12, but it has been using passive QE since November 2008. Both Norway and Sweden have allowed their monetary base to grow since September and October 2008, respectively, in sync with increases of the monetary bases of the G4 central banks. The Bank of Canada, having cut its policy rate to 0.5%, seems to be readying itself to use “credit and quantitative easing”. Our strategists believe that QE could be in action there sooner than markets expect.

Perhaps the most crucial decision on the adoption of QE clearly lies with the ECB. The ECB, like the other major central banks, has instituted a passive QE regime since September 2008. Our ECB watcher, Elga Bartsch, believes that the ECB is unlikely to go down the path of active QE, but would be quite willing to extend the term on repo operations. These facilities were put in place at an early stage in the crisis, have worked well and have been copied by other central banks around the world. Also, the ECB may widen the pool of eligible collateral yet again by lowering further the required minimum rating for eligible assets. There is still room to cut rates, and our forecasts project the refi rate at 0.5% in 2Q09. However, given the downside risks to growth, the adoption of active QE can clearly not be ruled out. If the ECB does decide to purchase assets on an outright basis, it is likely to prefer corporate securities to government bonds in order to ease credit conditions (for more details, see QE or Not QE? by Laurence Mutkin, March 20, 2009).

Now, I am going to stop there because I want to introduce a few words by Ambrose Evans-Pritchard of the Telegraph regarding the ECB’s quantitative easing strategy. Do read the rest of Morgan Stanley’s research at the link in sources.

ECB is clearly alarmed by the outright contraction of credit. Loans to non-financial corporations fell in February (minus €4bn).

Yes, the M3 money supply is still up 5.9pc year-on-year, but that is backward-looking. M3 growth has collapsed. The credit crunch that was not supposed to exist in the eurozone is already well advanced.

The bank’s vice-president Lucas Papademos (ex-MIT, a heavy-weight) said: “It may be warranted that the central bank purchases private sector bonds to enhance liquidity. No decision has been taken, but it is a possibility that could improve the markets”.

“Potential measures could include an extension of the maturity of the central bank liquidity provided to banks and purchases of private debt securities in the secondary market”.

Hallelujah.

Nout Wellink, governor of the Dutch central bank, in turn said there is now “an increasing risk of deflation”.

Thank you Mr Wellink.

ECB president Jean-Claude Trichet has been insisting for month after month that there is no risk whatsover of deflation. At least a million workers are going to lose their jobs over coming months unneccesarily because of this blind refusal to face the reality of what is happening in the world.

(Or perhaps that is unfair to Mr Trichet’s boss – Bundesbank chief Axel Weber. One suspects that Mr Weber does indeed understand what is happening but knows that once the ECB starts buying bonds, it is on the slippery slope to an EU debt union – at German expense. The pressure to bail out Club Med governments may become unstoppable. He is right about that.)

Mr Wellink went on to admit that the ECB had screwed up royally by raising rates last July in response to a phoney inflation scare (oil futures speculation) at a time when much of the eurozone was already in recession.

“In hindsight, this measure was based on a faulty estimate of inflationary risks and real growth prospects.”

Bravo, Mr Wellink. This is the first time – to my knowledge – that any ECB governor has admitted any fault in what must be described as the most remarkable act of monetary primitivism in modern times, or indeed admitted any error on anything. One was beginning to think they were incapable of self-criticism.

Thank goodness for Dutch honesty. The ECB will be much stronger for it. Chippy central banks do not command respect.

It has taken a long time to get here: a lot of damage has been done. A German contraction of 6pc to 7pc (Commerzbank forecast) is already baked into the pie this year. German unemployment may reach 5m in 2010 (RWI Institute).

Ireland’s GDP has already dropped 7.5pc (year-on-year to Q4). Eurozone Industrial output fell 17.3pc in January (y/y). It was down 31pc in Spain. This is a greater fall than anything suffered in Spain over a 12-month period during the 1930s.

Now, I am not going to take a view here, but I think you know my unease with printing money. And I do think the excess liquidity in the system will not be mopped up in due course when the global economy recovers.

What I want to focus on is the importance of the ECB’s move to a more explicit QE policy. In my view, this puts every major central bank into the same category i.e. printing money to ward off deflation. Irrespective of one’s ideological bent, one must this should mean recovery sooner rather than later. Whether this anticipated recovery is inflationary or ephemeral remains to be seen.

As for Evans-Pritchard’s piece, he does go on to say:

Sadly I have little confidence that the ECB will undertake QE with adequate dispatch, but at least they seem willing to swallow their pride and start to do their part to mitigate the global depression that we are already in.

If they move fast enough they may even prevent the eurozone breaking. Big if.

We all know he has an anti-Euro bias (one I often share), so you have to take his comments with a pinch of salt.

My conclusion is that we mustn’t discount the very real possibility of a cyclical upturn in 2009. While my base case view sees weakness through the end of the year, signs of reflation in asset prices, commodity prices, plateauing claims numbers, and consumer spending are certainly already evident.

Certainly, I still foresee some major writedowns and heavy challenges in stoking credit growth in North America and Europe. But, I will keep an open mind and look for evidence on both sides of this argument.

Sources
QE2 – Size Matters – Morgan Stanley
Europe fetches the monetary helicopters, at long last – Ambrose Evans-Pritchard, Telegraph

Related posts:

• Quantitative easing in the U.K.
• Nouriel Roubini: Will massive stimulus ward off stag-deflation?
• Is Japan next on the road to quantitative easing?
• Plosser: The Fed must stop qualitative easing
• Is quantitative easing really inflationary?

You probably saw this one already, but a pair of suspected narcotics traffickers threw gads of money from their car window while being pursued by the Drug Enforcement Agency (DEA) in a car chase in San Diego. Basically, it was free money for any other drivers willing to risk death picking up the money on the highway. Many people, including pedestrians did just that.

Kind of fitting given the move to printing money, wouldn’t you say? Chairman Bernanke should take note — it’s all in the wrist, as the video shows.

Two narcotics suspects have been arrested after leading police on a wild chase, tossing out more than $17,000 in cash out of their truck’s windows as motorists stopped freeway traffic to grab the bills.

The pursuit began Thursday afternoon when police and federal drug agents followed two men who drove off in a pickup truck, Drug Enforcement Administration spokeswoman Eileen Zeidler said.

The driver took officers on a circuitous route over several streets and freeways, eventually getting onto Interstate 5 at the height of rush hour. On the busy freeway, the suspects flung mostly $20 and $100 bills out of the truck’s windows before surrendering to authorities.

As the cash blew across lanes, motorists slammed their brakes in the middle of the road and scrambled to pick up the bills, police Sgt. Kevin Rausis said.

Source
Cash thrown from truck during chase – WoodTV.com (Grand Rapids, MI)

Related posts:

• Bernanke outlines Fed’s easy money exit strategy
• Don’t underestimate the power of printing money
• Blame Bernanke, the dollar and oil
• Paulson and Bernanke got it wrong on Lehman
• Bernanke expects recovery later this year

This comes via the Financial Times.

The Swiss National Bank’s decision to intervene to weaken the franc has left currency investors with one less haven from the financial crisis.

Its move comes at a time when there are also questions surrounding the future haven status of two other leading currencies: the dollar and the yen.

While the dollar has enjoyed a liquidity premium amid the current financial turmoil, many investors expect it to lose its allure as the full impact of large-scale US fiscal and monetary loosening filters through.

Simon Derrick at Bank of New York Mellon says: “The dollar has clearly been supported by haven flows during the current crisis.

“But, in the longer-term, the sheer scale of US fiscal spending and the lack of international capital available to support it represents a direct threat to the dollar’s strength.”

The other main beneficiaries during the current crisis, the Swiss franc and the yen, have both lost their haven status in recent weeks.

The Swiss franc has been driven lower by the SNB, which last week intervened to sell the currency, saying its recent appreciation represented an unwelcome tightening in monetary conditions.

Meanwhile, the yen has been undermined by a series of data showing a steep downturn in Japan’s export-driven economy.

This has helped stoke expectations that the Bank of Japan will follow the SNB and intervene to weaken its currency.

So where do currency investors turn now? One answer could be Norway.

David Bloom at HSBC says “The ultimate haven currency in our view is the Norwegian krone. “It’s probably the best currency in the world.”

Given quantitative easing in the U.S., Switzerland, the U.K. and Japan, there are not many options left for holding fiat money. Other currencies that might provide protection? The Aussie dollar, the Kiwi dollar and the Loonie.

Related posts:

• The Swiss get on the QE2
• Dollar falls to lowest on year
• U.S. Dollar: Cliff Diving Again
• Swiss Franc at Dollar parity?
• The latest dollar rout revealed

Quantitative easing is now the main policy course for the U.S. Federal Reserve.  The U.S. Federal reserve is buying $300 billion in long-term U.S. government debt in order to keep interest rates low.  As a result, the rally in Treasuries that I have long anticipated is upon us – it is the most powerful rally I have ever witnessed.

As Marc Faber has said, “don’t underestimate the power of printing money.”

The Federal Reserve plans to buy $300 billion in Treasury securities and acquire more mortgage and agency debt in an effort to bolster housing and hasten the end of the recession.

“To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage- backed securities,” the Federal Open Market Committee said after a unanimous vote in Washington today. “Moreover, to help improve conditions in private credit markets, the committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”

Chairman Ben S. Bernanke is opening a new front in monetary policy after unemployment climbed to 8.1 percent and economists forecast the economy will shrink through the middle of the year. Fed officials also kept the benchmark interest rate at between zero and 0.25 percent and said it will consider expanding the Term Asset-Backed Securities Loan Facility to include “other financial assets,” the statement said.

“We are not even close to the bottom and therefore the Fed is engaging in a massive quantitative easing,” William Poole, former president of the St. Louis Fed, said in an interview today with Bloomberg News. “We still have a very serious recession in front of us,” said Poole, now a senior economic adviser to Merk Investments LLC in Palo Alto, California, and contributor to Bloomberg News.

Historic Rally

Treasuries surged, sending benchmark 10-year note yields down to 2.50 percent from 3.01 percent late yesterday, the biggest decline since 1962. The Standard & Poor’s 500 Stock Index jumped 2.9 percent to 800.66 at 2:54 p.m. in New York.

I seriously doubted Federal Reserve Chairman Ben Bernanke’s helicopter piloting skills, but he is now showing he can fly with the best of them. See reactions on Bloomberg Television below.

Sources
U.S. Treasuries – Bloomberg.com
Fed to Buy $300 Billion of Longer-Term Treasuries – Bloomberg.com

Related articles
FRB: Press Release – FOMC Statement — March 18, 2009

Related posts:

• Don’t underestimate the power of printing money, part 2
• Mea Culpa: The Fed is not going to buy treasuries
• Treasury yields go below zero
• Quote of the day: Stephen Roach
• Bernanke outlines Fed’s easy money exit strategy

The U.S. dollar is getting hammered today. It is now trading near 1.34 to the euro, 1.42 to Sterling, 96 to the Yen and 1.14 to the Swiss franc. These are huge hockey stick style moves from 1.30 to the euro, 1.39 to the pound, 98 to the yen and 1.18 to the Swiss franc just this morning. The dollar is getting killed here.

What gives? Well, basically, the market has lost confidence in the dollar. Brown Brothers Harriman thinks its quantitative easing at fault (hat tip Marc).

The FOMC took major steps on the quantitative easing path and this sent the dollar sharply lower. The Fed will buy $750 bln more of MBS and $100 bln of GSE debt, but the big surprise is that it will buy $300 bln of long term Treasuries. The economic assessment is little changed as was the inflation asessment. The real take away is the actions the Fed is taking and is much more aggressive than observers, including ourselves expected. The US dollar has been crushed, even the emerging market currencies hhave rallied. The key consideration might be that quantititative ease is currency negative–as it was for sterling, yen and Swiss franc. However, an alternative explanation is that with today’s move the Fed has finally gotten ahead of the curve and this will boost confidence of a recovery later this year.

US bonds have rallied strongly. In answer to the ubiquitous question of who is going to buy the flood of Treasuries that are being brought to the market, the Fed says they will. The 10-year note yield has fallen more than 35 bp and the 30 year yield has dropped 30 bp. The stock market has rallied strongly. The magnitude of the move likely means positive follow through tomorrow in Asia and Europe.

Related posts:

• Swiss Franc at Dollar parity?
• The Swiss get on the QE2
• The dollar collapses
• The Norwegian krone: the new safe haven currency
• Quantitative easing in the U.K.

Apparently, the Swiss franc is too high — or so says the Swiss central bank.  As a result, they are selling francs in the foreign exchange market to get the franc to come down.  There has been a lot of speculation about the Swiss and their plans to devalue the Swiss franc, including on this site.  It now seems clear that devaluation is where things are headed. Quantitative easing (QE) may be next.   On Feb 19th, I said as much:

The Swiss are not a member of the Eurozone. They are not even a member of the EU. Like Norway (and Iceland, for that matter), the Swiss are on their own. This has benefits. The Impossible Trinity is a non-sequitur. One can print money and devalue at the heart’s content. The Brits have shown us the power of devaluing a currency from 2.11 per U.S. Dollar to 1.43 per U.S. Dollar. Surely, the Swiss can do the same. In fact, in the case of the Swiss, devaluation would mean that their debtors will be able to repay their loans more easily. I fully expect the Swiss National Bank understands this and is prepared to crank up the presses if they have not begun to do so already.

Just the other day, the Brits started quantitative easing a.k.a. printing money — joining the Americans and the Japanese in plucking bills off the money tree at the central bank.  

Who’s next to get on the QE2 – its a lovely ship?  Why, Switzerland, of course.

The Swiss franc plunged to its lowest level so far this year on Thursday after the Swiss National Bank said it was set to make purchases in the foreign exchange market to halt the currency’s rise against the euro.

The Swiss franc’s haven status has been heightened by the recent market turmoil and seen it rise 9 per cent on a trade-weighted basis since July and come close to its record high around SFr1.43 against the euro in recent weeks.

The SNB said the Swiss franc’s strength represented an “inappropriate tightening of monetary conditions” as it battled against a sharp deterioration in the Swiss economy.

“In view of this development, the SNB has decided to purchase foreign currency on the foreign exchange market to prevent any further appreciation of the Swiss franc against the euro,” the central bank said.

The central bank said it had implemented its decision, with traders confirming that the SNB had been active in the market.

This represented the first time a major central bank has intervened in the foreign exchange markets since 2004 when the Bank of Japan sought to weaken the yen.

The Swiss franc dropped 3.2 per cent to SFr1.5290 against the euro and dropped 3.7 per cent to $1.1952 against the dollar.

Marc Chandler at Brown Brothers Harriman said even though the SNB’s intervention to weaken the franc was enjoying immediate success, the policy’s longer term prospects were more questionable.

But do the Swiss have any choice? The Swiss are going to do QE too.

“The SNB is certainly next in line for such moves,” said Jan Amrit Poser, chief economist at Bank Sarasin in Zurich. “The SNB probably needs to do more. It’s game over for conventional monetary policy.”

Source
Swiss central bank sells own currency – FT.com
SNB May Cut Rates, Opening Door for Other Tools – Bloomberg.com

Related posts:

• Swiss Franc at Dollar parity?
• Why are the Swiss now issuing debt in U.S. Dollars?
• The dollar collapses
• Chart of the day: US Dollar
• The U.S. dollar plunges due to quantitative easing

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

Judging from recent events, the bond vigilantes are right to suspect that Ben Bernanke is all talk and no action when it comes to keeping long-term rates low. If you recall, I had actually believed the Fed would support bonds because it was concerned about long-term interest rates. This is part of the reason I believed that Treasuries would rise despite being in bubble territory but it looks unlikely.

The Federal Reserve is looking increasingly unlikely to purchase long-term U.S. Treasury securities any time soon, as the central bank gears up to launch a different program aimed at jumpstarting the market for consumer loans.

Federal Reserve Chairman Ben Bernanke raised the idea of purchasing Treasury bonds in November and the Fed has tipped its hand to the possibility of such purchases in its last two policy statements.

Such a move could help to bring down long-term interest rates, something that could indirectly help consumers and businesses since many loans are benchmarked to Treasury yields.

But Mr. Bernanke notably left the idea out of his testimony to the House Banking Committee Tuesday.

Fed officials could be preoccupied by a new program aimed at jumpstarting consumer loan markets, an effort being coordinated with the Treasury Department. That program represents an enormous commitment by the Fed. The Term Asset-backed Securities Loan Facility, which will help finance asset backed securities tied to consumer loans, could result in as much as $1 trillion in new Fed loans, a huge expansion in its balance sheet.

Now, if the U.S. federal government massively increases spending and the Feral Reserve does not buy long-dated treasuries, that is bearish for bonds. Buying junk assets like asset backed-securities will artificially prop up their prices by lowering their spread to treasuries but will have zero impact on the steepness of the yield curve.

Bernanke had warned that he was NOT repeating the Japanese experiment of quantitative easing when he spoke at the LSE (London School of Economics) in January. He said the Fed was focusing on the asset side of the balance sheet – what I would call qualitative easing (see my post from Jan. 13th on this).

The evidence is piling up that Bernanke is not going to buy Treasuries. I’ll leave it to Ambrose Evans-Pritchard to tell us what this means:

The yield on 10-year US Treasury bonds – the world’s benchmark cost of capital – has jumped from 2pc to 3pc since Christmas despite efforts to talk the rate down.

This level will asphyxiate the US economy if allowed to persist, as Fed chair Ben Bernanke must know. The US is already in deflation. Core prices – stripping out energy – fell at an annual rate of 2pc in the fourth quarter. Wages are following. IBM, Chrysler, General Motors, and YRC, have all begun to cut pay.

The “real” cost of capital is rising as the slump deepens. This is textbook debt deflation. It was not supposed to happen. The Bernanke doctrine assumes that the Fed can bring down the whole structure of interest costs, first by slashing the Fed Funds rate to zero, and then by making a “credible threat” to buy Treasuries outright with printed money.

Mr Bernanke has been repeating this threat since early December. But talk is cheap. As the Fed hesitates, real yields climb ever higher. Plainly, the markets do not regard Fed rhetoric as “credible” at all.

Shorting Treasuries was a lot better bet than I had anticipated.

PS. – Bill Gross is all over this one.

Source
Fed Looking Unlikely to Buy Treasurys – Real-Time Economics, WSJ
Bond market calls Fed’s bluff as global economy falls apart – Ambrose Evans-Pritchard, Telegraph
Gross Bought Mortgages, Sold U.S. Debt Last Month – Bloomberg.com
Real Treasury Yields Moving Lower – EconomPic Data

Related posts:

• Another take on the treasuries bubble
• Don’t underestimate the power of printing money
• TALF’s first recipient will be Nissan Motors of Japan
• Quote of the day: Stephen Roach
• Video: Andrew Barry says stay away from treasuries

News in Japan has been particularly grim. Industrial production has plummeted, exports are in free fall and banks are simply not lending as excess reserves pile up. As a result, Japanese share prices threaten to revisit lows that bring the country back to 1981 prices. Japan is in Depression. The question is what to do about it. Rates are already near zero. The answer that I believe will be found by Japanese policy makers is what is known in economic policy circles as quantitative easing, a hifalutin way of saying printing money.

One can see the implications of all this in a recent missive from the well-regarded Japan Economic Pulse where they say the BoJ will go unorthodox like the Fed has done and start funding companies directly instead of waiting for banks to supply the liquidity. That means buying up commercial paper and corporate bonds. Moreover, Japan Economic Pulse suggests that the government may want to buy shares in the market to prop up prices — and to eliminate writedowns by financial institutions which own those shares. (Japan’s fiscal year end is March and banks want to present a good face to the market when it comes time to show their numbers).

Now, I should add that the Federal Reserve and the Bank of England are both turning to the printing presses – although the Fed says it is focusing on the asset side of its balance sheet. And the ECB is now expected to follow suite – dragged kicking and screaming to this policy choice.

What are the likely implications? Here is my list:

1. The Japanese Yen, which I saw going to 85 to the U.s. Dollar, may end up being a lot weaker than anticipated.
2. We are seeing the makings of a competitive currency devaluation here.  China is also a major player in this, being the Alpha producer of choice in Asia.  I warned that I see the potential for unilateral protectionist actions if these types of activities continued.
3. Underlying inflationary pressures are building worldwide.  If you look at M2 in the U.S., it is exploding.  The only reason we are not seeing inflation in the U.S.  right now is deleveraging in the financial sector.  The same is true in the U.K. and the Eurozone to differing degrees.
4. This is a very bullish scenario for gold and commodities when reflation takes hold.  As I have mentioned in the past, I expect deflation followed by high inflation when the economy turns.
5. This is NOT a bullish scenario for government bonds.  This is the major reason you won’t see me advocating buying treasuries here despite my belief they will go higher.  Ultimately, treasuries are a bubble that will burst and there is a lot of downside risk in that trade given the factors enumerated above.

Those are my views here.  Feel free to add your two cents.

Related articles
Tokyo shares end 2008 42% lower – BBC News
Toyota closes domestic factories for 11 days – Guardian
Japan: New auto sales plunge 23.3% in December, 6.5% for 2008 – Japan Economy News & Blog
China cuts rates for fifth time as Japan suffers record exports drop – Independent.ie
Mitsubishi UFJ to Book 288 Billion Yen Loss on Stocks – Bloomberg.com

Related posts:

• A note on Japan’s experiment with quantitative easing
• China to diversify out of U.S. dollars
• Sweden: negative interest rates and quantitative easing
• Japan does not demonstrate the failure of stimulus
• Quantitative easing: printing money like mad to ward off deflation

Federal Reserve Chairman Ben Bernanke gave a speech at the London School of Economics today in which he outlined the measures the Federal Reserve was prepared to take in order to deal with the financial crisis.  Of particular note, Bernanke indicated that the U.S. central bank would keep interest rates low and that it would buy mortgage-backed assets in order to increase its direct control over the interest rates borrowers actually see.

Bernanke also clarified his position on quantitative easing (QE), explaining that the Fed is more concerned about the asset side of the balance sheet than the BOJ (Bank of Japan) was when Japan engaged in quantitative easing.  One could take this to mean that the Fed is engaging in both qualitative easing as well as quantitative easing. The Fed means to supply liquidity to the financial system and to buy poorer quality assets (i.e. Mortgage-Backed Securities instead of Treasury bonds), whereas the BOJ was merely supplying liquidity.  Bernanke was careful to note that the Fed was taking a ‘haircut’ and receiving enhancements in its experiment with QE so as to prevent any impairment in the Fed’s balance sheet.  However, I did not find this part of Bernanke’s talk particularly convincing.

Another interesting tidbit from the speech was Bernanke’s defense of Fannie Mae and Freddie Mac and their business conduct during the housing bubble.  Bernanke does not feel their actions were reckless, nor does he believed they contributed negatively to the situation.

On the whole, Bernanke was refreshingly clear regarding both his intentions and his reasoning. Below are three videos of Bernanke’s speech on CNBC.

Related posts:

• Plosser: The Fed must stop qualitative easing
• Don’t underestimate the power of printing money
• Pushing on a string and similar notions on monetary policy ineffectiveness
• Connecting Fed cuts with credit writedowns and quantitative easing
• Mea Culpa: The Fed is not going to buy treasuries