Sunday, 31 October 2010
Sunday, 13 July 2008
The Weekly Report 13 July 2008 (continued)
13 July 2008
Welcome to the Weekly Report. Normally at An Occasional Letter From The Collection Agency we try to focus attention on the macro-economic near term effects using the Weekly Report, allowing the Occasional Letter to look further into the future by about 18-24 months. We have reached a stage now where it is becoming difficult to keep the various strands of my convoluted thoughts distinct and clear for the readers so, in keeping with one or two other writers it is time for a re-cap.
My first public post on a financial site was 21 months ago so the timing is right. Unfortunately for the readers of my eco-babble I cannot do a 6 month resume, so here it is, a 21 month review of my work. We start off with a quick update to last week and a quirky question and then into the meat of the review.
Last week I opened by saying even I was worried about my own bearishness, using my own thoughts to make me think about possible supports (highlighting LTCM levels as possibly the area to watch for banks and financials). I am still watching this level. If support doesn't hold we are on our way down to the 9300 area on the Dow, eventually.
I have very little to sell, my little website was set up using the Austrian School of Economics as a guideline, it ticks along at a minimal cost to members because I didn't incur any debt or debt servicing costs to set it up. The capital I use is from savings and is repaid by the small subscription I charge, it even makes a small profit which when saved over a period of time may allow me expand the facility. If all my subscribers left tomorrow I could close the site down and walk away without having incurred any loss and move on to something new.
Now apply that line of thought to every single company in the S&P500. Can you find a single company that would be able to follow the same path? If you can, let me know because it would be nice to find a well run, properly capitalised Large Cap to put on the "long" watch-list. Remember, no debt. That includes bond issuance. If you wanted to be really at the cutting edge of investment in the new era of capitalism that will rise from the ashes of this Monetarist / Keynesian credi t/ debt orientated fiasco, check out the Funds in your portfolio, any leverage being used? The expression that "cash is king" is going to become the"new" catchphrase in the near future.
It is here that I have to do a recap of my previous remarks and comments about the economy. Unlike many bloggers and writers who are looking at the next Quarter or the second half of '08 and recounting what they said in March, my view has to go back much further than that to see if what I wrote about last year or earlier is coming to fruition. It is the only way I can help readers understand how my poor befuddled brain works. Now I cannot re-create each article here but what I can do is give you a link and a couple of key words or a phrase with the date of the article.
Is this an ego trip, a boost to my already self enhanced view of my abilities? Not really, it's just a way of showing you my timespan, how my thought processes work, you will find the odd wrong call too. So here we go:
A First Sighting originally written in November 2006:
- "A lack of cash, driven down by tighter, more expensive credit, a lack of liquidity that starts at the bottom and works its way higher up the food chain, until even those, referred to in whispered tones as daz boyz, see that the health of the US economy is going to require a donation of wealth from everyone. Even them.
Can you see what I have caught a first sighting of?
And out there, somewhere in Hedgeland, someone is finding it more and more difficult to sleep at night, thinking about all those CDO's sitting on the books. No one to lay it off to, a one way bet on liquidity."
Gone in Sixty Seconds originally written in June 2007:
- "If you have debt you are bending over and picking up the soap.
Straightforward, no nonsense, in the prison block showers, soap collecting. Hopefully coffee has been spat at screens, wives/delicate husbands have been offended and stopped reading within 60 seconds. Because what I'm about to impart to you should make you feel this way. You, Joe Public, are about to be ridden into the oblivion. No one can save you, no one really cares. Big boyz, from companies like mine are going to take your possessions away. Faceless corporations are going to take your home away. All because you have debt."
The Second Sighting originally written in September 2007:
- "This leads us back to a rather large problem. In fact its huge problem and its not being talked about out there in Media land. What happens to a tapped out consumer, loaded with debt, trying to roll a teaser/innovative (thanks AliG) mortgage if rates are going up? It's not going to happen, it's a train crash. Borrowers are already operating under tighter credit controls so the ability to re-fi is curtailed for many. Add in much higher rates and the situation becomes impossible. Banks are going to suffer from a curtailed income stream, as debt default rises, just as the teaser rates for the Banks' borrowings come to an end and reset much higher. Can you see the irony?
Banks are no better off than over stretched sub-prime mortgage borrowers. They need an income stream from lending to ensure they can pay the liabilities they owe to savers, savers that will demand higher yields. It's unsustainable and it's going to stop, soon.
Banks are hit with a double blow, as a lack of income leaves them either unable to service their own debt and default or forces them into repaying the debt using capital holdings or returns from assets sold in the markets. Either way, credit for business and consumers becomes impossible to provide. A massive contraction of activity is a given.
It's been noticeable of late to see the recession word crop up, even in the mainstream media. I think they are wrong. I think the future contains a scenario much worse than a recession.
So, my forewarned reader, will you be leaving your money in a "sub-prime" bank?"
I want to walk you through why I see deflation in the future.At this point I have to make something clear, whilst the traditional view of deflation is less money in the economy, I do not see cash as the current driver of inflation/deflation. The mover is credit. Allowing an unfettered increase of credit to replace the traditional over printing of notes to sustain a bubble(s) or ponzi scheme (if banks have, as a % of loans, effectively no reserves, what else can the system be based on?) then a reduction in credit must be deflationary.
The importance of this cannot be under-estimated. Credit itself has/is being used as an asset to beget more credit. This explains the exponential rise in credit; it feeds on itself as credit notes become the asset to allow further credit to be lent out. By allowing credit to underwrite itself to form other types of credit the whole system becomes reliant on the confidence of lenders and borrowers having the means to eventually repay. If that confidence is put under pressure, the system stops. If confidence cannot be restored in a very short timescale (Central Bank / Tsy intervention) then the system begins to reverse, as credit is redeemed. The reversal will be at the same pace as the initial rise in credit growth. Although painful, the reversal would be orderly, as long as all the borrowers have the ability to repay. If that ability to repay is impaired then the redemption becomes disorderly.
- "So is Mr Bernanke getting undeserved criticism? I think he is and I think I know why. There is a war on Wall St right now and it's viscous. There are interests that need protecting, accounts that need to be kept hidden and rescues that have to be carried out. All of this has to happen in conjunction with falling rates. If it doesn't happen quickly, with the full cooperation of the Regulators, Fed and USTsy, then whole ponzi scheme comes crashing down. Someone though isn't giving out enough covering fire. Mr Bernanke is keeping some of his powder dry by not telegraphing further rate cuts, in fact you could easily see a case for rate rises if some of the downside risks become too big to ignore.
Wall St doesn't like it. The last thing the Cabal expected was that they would have to use their own money to sort out their own mess.
Is Mr Bernanke getting bad press at the behest of Wall St?"
The Event Horizon For Credit originally written in November 2007:
- "You can now see why, as a result of a flat to falling monetary base coupled with a contraction of credit, I see the risks of a deflationary recession as a very high probability. A depression is not as remote as many think.
Is this just a US-centric problem? Not according to Esteban Duarte and Steve Rothwell at Bloomberg, who unearthed this:"
- Europe Suspends Mortgage Bond Trading Between Banks
Nov. 21 (Bloomberg) -- European banks agreed to suspend trading in the $2.8 trillion market for mortgage debt known as covered bonds to halt a slump that has closed the region's main source of financing for home lenders.
The European Covered Bond Council, an industry group that represents securities firms and borrowers, recommended banks withdraw from trades for the first time in its three-year history until Nov. 26. Banks are still obliged to provide prices to investors, according to the statement today.
Banks including Barclays Capital, HSBC Holdings Plc and UniCredit SpA took the step as investors shun bank debt on concern lenders face more mortgage-related losses than the $50 billion disclosed. Abbey National Plc, the U.K. lender owned by Banco Santander SA, became the third financial company to cancel a sale of covered bonds in a week as investors demanded banks pay the highest interest premiums on covered bonds in five years.
``We are in a deteriorating situation,'' Patrick Amat, chairman of the Brussels-based ECBC and chief financial officer of mortgage lender Credit Immobilier de France, said in a telephone interview. ``A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.''
"You can find more about Covered Bonds at: http://ecbc.hypo.org/Content/Default.asp - if you can spot the difference between a CB and the MBS, ABCP or ABX derivatives then you have a keen eye.Oh, and yes, you read that correctly - that is a $2.8 Trillion lending market that has been closed. No wonder LIBOR has been climbing to new 2 month highs and above and reaching new all time high in spreads from the Fed Funds Rate.
You are probably realising that this weekends events are not a surprise to me. As you can see my eco-babble ratcheted up as my first blog came into existence, prior to the blog I published my thoughts on financial bulletin boards, I moved on as the spammers began to disrupt any possible conversation and a core demand grew for my thoughts. Now I know you want more, especially as it is free, so refresh that beverage and we will move forward into 2008. First though was my long term warning about the state of the Stock market, given to readers as a Christmas present in December 2007:
Edwin Coppock, Fed Fund Rates and The Dow
- The next chart shows 2 things. The first is my dire attempt to display what I consider to be the best chart of the year. If only I was better at this graphics stuff eh? Ah well readers, you can't have everything..... The second is the chart itself. I have overlaid a chart of the Fed Fund Rates from 1986 to present with a monthly chart of the Dow from 1986 with its Coppock Indicator. It's clear to see the CI before 1996 did indeed lag and post '96 it's a much better tool. Although the CI is used to indicate a bull market on a rise through zero it can be seen that in either half of the chart CI did give a lower high before stocks broke lower (marked by faint red lines). What's more those lower highs were divergent when compared to the Dow which made higher highs:
- So, what are the Coppock, Fed Fund Rates and the Dow trying to tell us now? Firstly a rider. Although Fed Fund Rates are falling, other rates, especially LIBOR are not. We should keep this in mind. Firstly, we have a falling CI, with a divergent lower high when compared to the Dow. The Dow itself is beginning to resemble the 1999/2000 top, without a lower low as yet. Fed Funds are dropping and if consensus (a warning in itself) is correct, FFR will be much lower next year.
With the CI acting in a much more timely fashion, the minimum we can expect is for a flat return on stocks whilst FFR has ongoing cuts and the downward direction of the CI is maintained. A lower low on the Dow would make the flat return scenario seem less likely and open up expectations of a larger fall in 2008.
Are you thinking I may not be specific enough? Well I don't like to mention specific calls on individual shares, that's not really what I am about but this one had reached an important level:
Citigroup - Opportunity or Death Rattle? Originally published in January 2008:
- "The current low is different, a sustained period of selling continues whilst the oversold condition persists. It is the opposite condition of continued buying whilst in an overbought condition as seen in 1999/2000. Unless a financial miracle occurs Citigroup is going lower, 1998 anyone? If my suspicions come to fruition then the price may well end up quoted in cents."
Automobile Wreckage. It Isn't just Ford and GM
"We see the same deterioration in price and the widening of spread that has become so familiar in the CDO/MBS indexes. As with housing, the inability to create further derivative structures due to rising spreads (risk premium) will curtail the lenders ability to clear the balance sheets and facilitate further lending.It isn't just the Markit.com index which is dropping. TRR (Total Rate of Return) CLOs are struggling too as Fitch Rating Agency has noted, downgrading 28 tranches and also placed an additional 37 tranches on Rating Watch Negative. Unsurprisingly TRR CLOs are a mixture of derivatives of loan portfolios that according to Fitch are now at risk for intensified spread/credit risks. Market values on the SMi U.S. 100 have fallen 6% since mid '07. Considering the type of asset and its potential lack of worth in a flooded market (unlike housing) I expect spreads to widen considerably.
It seems to me that a combination of tightening credit for the consumer, caused by the inability of lenders to clear balance sheets due to derivative markets pricing in higher risks which is stifling new issuance, will cause a real fall in spending on Autos. It should not be forgotten that other unsecured debt will have the same problems.
The possibility of widespread damage in the US domestic Auto industry beyond GM and Ford seems much greater today than at any other time."
AIG Get Caught By The Auditors originally written in February 2008:
"Support at the $50 seems bust and the threat is a monthly close below the '03 low. It's yet another chart that flags up the lows from 1998. I'm not saying it's a short (or a long) that's not my job. I just want you too see something that looks worse than me in the mornings.By the way, be careful of who you listen to. This was one of the comments I saw on Bloomberg about the AIG drop:
"Investors eventually will look back at yesterday's announcement and conclude they overreacted, said David Katz, chief investment officer for New York-based Matrix Asset Advisors, who supports Sullivan (the CEO)." Must be a coincidence......
Then again we are at point in the markets were hope is being ladled out to the hungry and despondent. As I write this little snippet appears:
"U.S. Industry: Uber-investor Warren Buffett on tv making remarks about the monoline insurance industry, apparently has offered a reinsurance plan to those firms. Talk has boosted the recently ailing monolines and is said to be behind the solid bounce in US stock futures in recent trading. Provided by: Market News International"I have some bad news for Mr. Buffett. This isn't the bottom even for the better quality debt. As I have maintained for some time contagion in the derivative bond market is deeper than anyone realises and it has spread beyond investment and traditional banks. AIG know that only too well.
By now I was producing the Weekly Report and this particular issue got a huge number of hits:
The Weekly Report 25 February 2008:
- "Now, I am not going to give you advice on what to do about your cash on deposit and I don't want you to think I am being overly bearish but…….I have called this whole fiat credit collapse correctly from the beginning. No, I don't want a pat on the back. I just want to read the next line carefully.
If I had money in a US bank today, I would be worried. So worried I would withdraw the cash before new regulations are passed restricting account activity. I know it sounds alarmist but then the first warnings always do."
This from CNN Money:
"Customers with uninsured deposits will get at least half that money back, and they could get more back, depending on what the FDIC gets when it sells the bank, said FDIC Chairman Sheila Bair. IndyMac customers will have their funds transferred to a new entity - IndyMac Federal FSB - controlled by the FDIC. They will have uninterrupted customer service and access to their funds by ATM, debit cards and checks.However, customers will have no access to online and phone banking services this weekend, according to the FDIC. Service will resume on Monday. Loan customers were advised to continue making loan payments as usual."
On the 3rd March in the Weekly Report I wrote this:
- For those who think a run on the $ would be inflationary, think again. The pressures placed upon the financial system would be overpowering. It would collapse, within hours. A fiat system without access to credit would result in instant depression. It doesn't matter how "expensive" assets are if you cannot buy them. For instance, taking account of Fed Pres Poole remarks, the opportunity has arisen were speculators can start to look at shorting GSE's and the $.
The Fed is playing an incredibly dangerous game and I suspect it is about to be called after going "all in".
But what of the future you say? Get another coffee and we will look forward to what I think maybe in store for us all.
How close is the Federal Reserve to a margin call? Well, anecdotal evidence is pointing to a need for the Fed to open the discount window to bailout Fannie and Freddie. In an article published on the 12th March, Pre-emptive Warning of a Major Banking Crisis I highlighted this snippet:
- "Right now the Primary Dealers are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available."
- "Collateral for U.S. currency in circulation and other reserve factors that show up as liabilities on the Federal Reserve System's balance sheet "
Of course the real risk is to the Banks, Brokers and Insurers. All that GSE debt is AAA rated, as good as cash, and is classed as Tier 1 type assets - or it was until this week.
The problem? This:
- "GSE securities are booked as risk-free investments by banks owing to an "implicit guarantee" assumption attributed to the GSE's. This relief is theoretical and changes in regulation may affect this assumption."
If you think this is far-fetched then have a chat with Merv King over at the Bank of England who made sure the restrictions below were included in the terms and conditions of the Special Liquidity Scheme, as quoted in the Weekly Report for the 27th April 2008:
- "The main category of assets will be securities backed by residential mortgages. Securities backed by credit card debt will also be eligible. These assets will be high quality - rated as AAA. If the assets were to be down-rated, banks would need to replace them with AAA assets. The facility will not accept raw mortgages and none of the underlying assets can be derivative products. The Bank of England routinely accepts assets denominated in currencies other than sterling. It will not accept securities backed by US mortgages."
Either more reserves will have to raised to cover the loss of value to these Tier 1 assets or the banks may decide that marking to market is "difficult" and enact the recently passed legislation, moving the assets down to tier 2, or 3. Either way, the liability for banks will go up. Basel 2 once more comes to the fore.
Some are relying on the possibility that this:
- " The Senate measure would create a new $300 billion government-backed foreclosure prevention program and strengthen oversight of Fannie Mae and Freddie Mac."CNN Money.
- "Trone in a research note estimates that JPMorgan Chase's total exposure -- holdings of GSE debt, mortgage-backed securities and counterparty risk -- is $87 billion, or 69 percent of its equity.
Citigroup has exposure of $51 billion, or 40 percent, while Goldman Sachs has the largest total exposure among investment banks at $14.2 billion, or 32 percent of equity.
In addition, GSE bonds and mortgage securities generate underwriting and trading business that have fueled Wall Street profits for years."
- "As we work through this tough housing market, we are maintaining a strong capital base, building reserves for our credit losses,"
Freddie Mac on the other hand took a slightly different approach, after the usual bluster, easily summed up as everything is okay, Freddie then went on to say this:
"Beyond that, there are a number of options to manage our capital position. The average rate of run-off on our retained portfolio is currently about $10 billion per month, and not replacing that run-off would free up approximately $250 million of capital per month. Over the course of a year, this would free up approximately $2.5 to $3 billion of additional capital if this run-off rate remains constant. We also could consider reducing our common stock dividend. Our current annual common stock dividend is approximately $650 million.Currently, Freddie Mac's liquidity position remains strong. This is a result of the combination of two factors: access to the debt markets at attractive spreads and an unencumbered agency MBS portfolio of approximately $550 billion which could serve as collateral for short-term borrowings. "
Who is left to lend to the GSE's? I don't see the Banks rushing in - do you? The answer is the Lender of Last Resort, the tax payer. What of the moral hazard that grows daily as the US Fed and Gov't commit more and more dollars to this expanding mess? I wrote a warning in the 25th May 2008 Weekly Report of the need to keep tight control:
"To avoid moral hazard arising, strict controls have to be placed upon the facilities that are created and the use of the assets supplied from those facilities. A failure to control the results of centralist intervention will encourage the very behaviour that caused the original problem.Let me be blunt. There is no risk to the financial sector that is so great that could justify invoking a moral hazard. If a bunch of banks and investment houses collapsed under the strain of unserviceable debt or losses so great that creditors required compensation, so be it. The pain would be enormous and the recession deep but the US economy and importantly the US financial sector would re-emerge stronger, leaner and fitter than at any time since WW2.
As we know such an event will not be allowed to happen, the Fed and the US Gov't are working together to ensure that credit markets at least allow maturing debt to be rolled over, giving time to the banks and investment houses to rebuild their capital reserves. It is a 2 pronged attack, the Fed keeps the banks functioning and the US Gov't drops money directly onto consumers in an effort to encourage spending or re-finance mortgages that have become too burdensome. These measures have no time limit, they can be repeated and increased until the day occurs when banks tell the regulators "all is well".
The groundwork for an episode of moral hazard is laid out but not yet constructed as long as the facilities are controlled and the assets applied to the task at hand."
To give you some idea of the attempt to increase inflationary expectations, read this excerpt from someone we have already quoted today:
- "US HOUSING: Federal Deposit Insurance Corporation Chairman Sheila Bair outlined in an Op-Ed piece in today's Financial Times a proposal that would assist one million homeowners who are facing foreclosure. The plan proposes that Congress authorize the U.S. Treasury to use $50 billion to make loans to borrowers with unaffordable mortgages to pay down up to 20 percent of their principal. The repayment and financing costs for these Home Ownership Preservation (HOP) loans would be borne by mortgage investors and borrowers. This approach is scaleable, administratively simple, and will avoid unnecessary foreclosures to help stabilize mortgage and housing prices."
And what of the future, are we going to continue to stagger from one financial implosion to another, constantly increasing liabilities in an effort to keep the system going? Without a doubt the Governments and Central Banks will attempt to follow this path, sacrificing your future to preserve the present for a corrupt, failed and illegitimate financial system based on a branch of economics discredited not once, or twice ('30s and '70s) but now for a third time.
Yet I see a different outcome, one that is reaching towards its final conclusion:
- " A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."
After the deflationary experiences of the '20s and '30s the Fed embarked on a strategy to eradicate deflation and to control inflation using interest rates.
Yet today we see Fed Fund Rates at 2% whilst price inflation, caused by the pass though effect of the rising costs in the production of goods, remain stubbornly high. The Fed isn't fighting inflation, it is fighting deflation as it attempts to divert the effects of the great credit crash and de-leveraging of the financial system. The Fed understands that current price inflation is the legacy of loose credit availability, the feed though effects of the massive expansion of credit used to escape the deflation scare in 2002.
Yet despite the Feds every move, credit is being wiped out as losses and de-leveraging reduce cash reserves and banks tighten their lending standards to the extent that many are avoiding the market.
The situation is a copy of that in '29-'32 and similar to '37. Banks are unwilling to lend and are doing all they can to raise capital, cash is king. Prices of goods and commodities are reaching levels that are causing buyers to stop and think, not just consumers but Governments too:
- "BANGKOK (Thomson Financial) - Japan has turned down 60,000 tons of rice from Thailand after the asking price nearly doubled in the space of a month, the Thai Rice Exporters Association said Wednesday.
Chookiat Ophaswongse, president of the association, said Thailand on Tuesday offered the Japanese government 100 percent white rice at $1,300 per ton -- up from the $720 it paid in March.
"This time, Japan turned it down, saying that the price was too high for their budget," Chookiat said, adding that Japan did not want to be seen as a country pushing up global rice prices."
A consumer retrenchment of proportions never before seen approaches. The temporary relief of tax rebates for US consumers has passed; it was noticeable that the main beneficiary was Wal-Mart, not the specialist or high end part the retail sector. The rebate was spent on essential or near essential goods.
It will be the inability of consumers and business to buy assets or services that will force prices down as the suppliers seek to keep market share. Are there signs that the availability of credit is going negative coupled with a reluctance of banks to do business?
Credit is contracting along with borrowing. The banks are deleveraging and unwinding positions at an accelerating pace. Banks continue to keep credit standards high and discourage borrowing by charging higher rates, or in the UK by not passing on Central Bank base rate cuts.
When will we know the process is finished?
We have a way to go. At a rough guess, US Banks and Institutions need to unwind $200Bn of capital. At a leverage of say 10, that's $2Trillion of positions, minimum.
Is there any sign of relief for the stock markets in the near future? The following chart (Dow weekly) shows the Dow since 2004 along with an important moving average, traditional support and resistance and a proprietary indicator. The vertical red lines identify turn points as flagged by the indicator.
I have had to compress the chart but it does show the change from low to high volatility. The head and shoulders, with a downward sloping neckline is textbook. The yellow highlight shows the retest of the neckline that took place over the past 2 weeks. If that neckline holds then the target for the Dow is 9305 (the lower thick purple line) minimum. The neckline is my line in the sand, circa 11430.
The diagram below is the Armstrong Economic Confidence Model:
Is the attempt by Governments and Central Banks to avoid the fallout from the credit crash and the horrendous damage being caused to the global economy doomed to failure?
My thanks to you all if you managed to stay with me to the end of this article. I firmly believe that this is how eco-bloggers, writers, analysts and fund shills should recap their calls on the markets. I do not believe a 6 month timespan is an effective window for investors to base their investment decisions on. What happened in the past does influence the future, the present is just those events unfolding.
Choices made over 10 years ago have influenced current events, those that dismissed the writers back then who warned of the possible outcomes will never be called to account, the memory of the market participants is too short. Those who did warn of the eventual outcome will get no recognition, unless they are one of the handful who managed to survive the snide comments and muffled laughter sent their way over the past decade.
I have no doubt we are in a bear market, a bear that will devour ALL asset types and not be restricted to stocks. A 20% fall in stock markets does not signal the onset of a bear, that was just a figure used by fund managers et al to keep you long in the market so you could absorb 20% losses. If that Head and Shoulders plays out a 20% loss will seem like a lucky escape.
During the last bear in stocks the advice from the vast majority of "advisors" was to stay in the markets, for many that meant unrecoverable losses. The advice back in 1929-30 was the same, most people only sold after they had taken enormous losses on their portfolios. Has it changed with the advent of the internet, satellite TV and mobile phones? No, it hasn't. All that happens now is the bad advice is delivered quicker that previously.
Bear markets are viscous, dangerous periods designed to make everyone hurt, including bears. Some of the biggest rallies in stock markets happen in bear markets. I do not expect markets to go straight down, you only need to look at 1998-2003 to see why.
Protect yourself, use stops, use only spare capital, be able to carry on with life if you lose your pot and stand back from the market, take a wider, longer term view. Finally be very careful who you listen to and what you read. When the overall pot shrinks those who need your funds to survive will do and say almost anything to try and make your wallet lighter.
This will be the last full article to be freely available for some months. If you like the analysis then consider visiting www.caletters.com and sign up to the 14 day free trial.
Sunday, 22 June 2008
The Weekly Report -23 June 2008
This week I want to aim the article at those who normally do not frequent financial bulletin boards or sites. You, the reader, need to help me in this cause.
People who read financial BB's are already interested and to some extent (though not always) informed about how certain economic conditions occur and can hold a healthy debate about the cures for such ills.
However we are a small group of independent thinkers, we exist at the margins where we try and do our best to inform the public about the dangers and benefits of our financial system. How many of us have watched our family and friends adopt a fixed grin and a glazed expression as we try and explain the complicated world of money flows, interest rates, inflation, deflation etc? We all know the moment when they stopped listening; it was when they started looking over our shoulder to see if there is someone more interesting standing behind us to talk to.
This Weekly Report is for those who glaze over. The trouble is the target audience doesn't read my website or these financial boards. So this week I want you to do a little something for me, send this article to your friends, the ones that now know something is wrong but don't realise what the problem is. It will be available, in full, on my old blog here.
However, before I start the article proper I want to share a little something with you. In April I wrote a series of articles about G B Eggertsson and how his paper "An interpretation of The Deflation Bias and Committing to Being Irresponsible" was being used by the Federal Reserve as the plan to escape from the deflationary effects of the credit crash. Three of the articles were subscriber only but I have now enabled those articles to be read in full without subscription of any sort at An Occasional Letter From The Collection Agency.
That's it, the second to last mention of my site in this article, you have permission to cut and paste this article from here (see the acknowledgement at the end) if you wish to send on to your friends and relatives who you think need to know what is coming. Reproduction on other sites is allowed too. This article uses the US and to a greater extent the UK to describe the background. It is applicable to all countries that allow a fiat currency.
How did this happen?
You will have heard of the sub-prime defaults, that credit conditions have changed, that banks are struggling. All these things are the not the cause of the current problems but are the symptoms of a system that allowed itself to become a one way bet, a self reinforcing merry-go-round of increasing debt. Let me show you how it works and how it breaks.
Mankind has only ever truly created one thing, fiat currency. Fiat currency is cash, paper and coins that are only backed by confidence, for paper they are promises to pay the bearer, coins have an intrinsic worth depending on the metals used to make them.(Hence why coins have become smaller and lighter over the years, production costs need to be below the notional worth of the coin). Paper has practically no intrinsic worth, except to paper recyclers.
Mankind can produce as much paper and coins as it wishes and since it is all based on promises, these days you don't even need a note, you can electronically promise "cash" too. Think about a mortgage payment. It is paid by an electronic transfer of an amount out of your bank account to the mortgage lender. The "cash" was originally placed in your account to be able to make the mortgage payment by electronic transfer from the account of your employer or your interest bearing savings / investment account. No real paper was used, no bags of coin delivered. It all happened electronically.
You can see the temptation such a system offers. You can invent money, lend it to others who pay you interest and at the end of the term you get the principal back too. You do not need to have any collateral to make this happen, though we do have regulations for banks that say they must have a reserve amount that is a percentage of the amount of money they invent. As all money in a fiat system is invented and relies on confidence, it doesn't really matter if reserves really exist or not, except to fulfil regulatory requirements.
Let me show you the system in this simplified diagram:
At the basic level the system is that simple. As long as the costs and defaults are exceeded by the profit made from the interest received your reserves grow and enable higher levels of leverage. You can get very rich doing this.
However every so often in human history events make this simple idea break down. It doesn't matter what the event is but if it makes the costs higher that the interest received then the reserve shrinks. This stops the increasing levels of lending and in severe cases can cause lending levels to fall or even stop altogether.
This is what we call a credit crisis. They have happened before and caused the bankruptcy of many lenders. Those that survived such events usually did so because they refused to allow indiscriminate lending, they applied standards to borrowers, checking to see if they could repay loans and refused to leverage to the maximum potential.
If an economy is reliant on the ability to borrow to achieve purchasing power or increase productivity then a credit crisis has an enormous impact, stopping growth and commercial activity. This worries bankers who have no wish to join the list of "also ran" names of yesteryear. So they decided to try and protect their business model and move some, or all, of the risk to another sphere of the financial system. To do this they had to make such risk taking attractive to others by offering compensation.
Again, here is our simple model but with a basic level of protection added:
You can see what has happened; the original bank lending system now looks stronger as the risk is lowered at the expense of some of the interest income. But notice how the model now becomes acceptable to the Insurer who can use the new income to raise their own reserves. What was a very simple model has now, with one change, morphed into a multi-party system that can be continuously expanded as risk is offloaded to other parties.
So what can go wrong?
- 1. Interest income does not cover costs.
If the amount of interest charged is too low to cover costs, interest rates on variable products can be raised. If the product is fixed rate then either customers can be encouraged to take variable rates that can be reset higher (after a lower introductory offer) or the debt can be packaged together and sold on to another party at a discount.
2. The principal may not be repaid.
The bank will invoke its insurance policy to cover the losses if the principal worth is calculated to have dropped below a certain level previously agreed with the Insurer. The payout can then be added to the reserves to ensure the bank complies with regulations.
3. Regulations change.
If the governing body decides that banks need to hold a higher percentage of reserves compared to lending then capital must raised to boost the reserves (e.g. Basel 2). This can be achieved by borrowing, rights or bond issues or by reducing the amount of lending.
Any one of these circumstances alone would not cause bankruptcy. Even a half decent capitalised bank could survive 2 of these events running concurrently. However if banks (and the Insurers and other lenders) have stretched the leverage out to 20, 30 or 40 times reserve capital and all 3 of these circumstances arrive at the same time you then have a credit crisis.
Remember the financial system relies on confidence. If confidence in the survivability of the system or part of the system is impaired then the structure slows and stops. In an extreme crisis the system may well go into reverse. Sub-prime became the headline for the current crisis but it is just a manifestation of the events above all occurring at the same time:
In many ways the 3 events almost seem to have been perfectly timed to cause the maximum damage, with rates moving higher from 2004 to 2006, just as many sub prime, Alt A and jumbo mortgages began to reset from teaser rates to higher nominal rates. In 2007 and 2008 capital requirements and the accounting and pricing of assets changed as Basel 2, sponsored by the Bank of International Settlements (BIS) came into force.
Certainly anyone in an informed position could have seen that the situation was set to deteriorate rather than stabilise. Without doubt the effects of these events where under-estimated by those charged with ensuring the Financial and Monetary system remained fit for purpose.
How is the financial system made fit for purpose?
Let me say that the methods used to make the credit system work again will be the same as those employed previously. Right now the world worries about inflation. Inflation is simply too much cash and credit chasing too few goods. Any asset or commodity that is in short supply will attract funds, causing the price of that asset to go higher.
The traditional method to control inflation is to raise interest rates, causing cash to be saved as returns become attractive and restricting the use of credit as it becomes prohibitively expensive. However there is another method that can be used.
Think of cash/credit as an asset. If you want the price of an asset to rise you make it scarcer, you restrict the amount available. As cash becomes more valuable the amount needed to buy less scarce assets drops. A s we are talking about cash that means the price of commodities etc falls.
Are central banks restricting the flow of cash into the financial system? Here are the latest money supply M4 figures (£ billions) for the Bank of England (The Federal Reserve will follow the same path, in time):
Whilst the growth of M4 continues we can see a slowing in the growth rate. The amount of cash and credit available in sterling is slowing:
This slowing of issuance and availability makes sterling more valuable, especially if the interest rate is attractive (this is the overnight interbank rate for sterling from Jun 07):
Notice the falling interest rate coincides with the slowing of M4 growth? As sterling becomes "rarer" the rate of return required on investment falls. Sterling itself appreciates, requiring less compensation in the form of interest. If you look back at the M4 growth chart, you can see that the 3 month rate of growth has been lower than the 12 month rate for some time (the blip in March was the second round credit crunch effects liquidity "save"). If the 3 month ROG remains like this then growth of the amount of sterling will continue to contract over the medium (12-24 months) term.
This is an anti-inflationary move by the Bank of England, yet the rhetoric over recent days has been about inflation fears. The increased rhetoric is to counteract inflation expectations and the fear that a widespread demand for greater wage increases will take hold, as the Bank of England Governor, Mervyn King, alluded to in a speech last week:
- "The immediate cause of the current pickup in inflation is increases in food and energy prices relative to other prices. They are caused by the pressure of demand on the supply of food and energy in the world as a whole. Part of that pressure may well reflect expansionary monetary policy in the world as a whole. But the rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to. We will not. So although inflation in the UK will rise in the short term, inflation will then fall back.
That means that the rate of increase of other prices and domestic costs, notably pay, must remain low. The MPC does not take that for granted. Surveys - including our own -indicate that expectations of inflation have risen, meaning that inflation is likely to have some tendency to persist. That is why, as I explained in my letter to the Chancellor, we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures and ensure that we fulfill our remit by returning inflation to the target. And growth is now slowing quite sharply - broad money growth is falling, business surveys point to particularly weak output growth in the second quarter and growth is likely to remain subdued for the rest of the year."
Read that extract carefully, within it are terms couched for the ears of business and economists. The threat is that if inflation expectations lead to higher wage demands then interest rates will rise. However King then goes on to explain why he thinks the rising inflation expectations will be quashed:
- "we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures"
In other words the cutting of M4 growth rates is being carried out to deliberately slow economic growth. By restricting the availability of cash and credit the economy will slow to a recessionary level where business will create a "margin of spare capacity" also known as unemployment. As I mentioned earlier the methods used to make the credit system fit for purpose are and will continue to be the same as those used previously.
The result, for ordinary mortals, will be an increasing difficulty in finding work, a greater fear that current employment may be curtailed and a reluctance to ask for higher wages. Savings will grow as non-essential spending is curtailed during an uncertain period, further reducing the availability of sterling circulating in the economy. Interest rates will remain high relative to discretionary income until the Bank of England decides that the Financial and Credit systems are once again fit for purpose.
The recession that will occur over the next 12-18 months is being deliberately engineered. Any growth in M4 will be redirected from the public to the banks, allowing the banks to repair their depleted reserves. Once these reserves are rebuilt lending standards will be loosened, allowing credit expansion to begin again. By that time interest rates will have been lowered, making the use of credit attractive, encouraging consumption and investment and helping GDP to expand. Another cycle of boom will then be initiated.
Less than 12 months ago the phrase "financial innovation" was still given credence, the "end of boom and bust" was still uttered to justify an economic third way. Now both phrases are discredited (pun intended) and have turned to ashes in the mouths of those who uttered them.
I have outlined above the truth of the current situation, how the greed of lenders caused a fatal weakness in the financial system and how ordinary people will have to deal with the results. A recession will be deliberately engineered to slow growth and allow banks to recover. As throughout history those that suffer in economic hard times are not those who profited in the boom. The masses will bear the burden and wonder what they did wrong to be placed in such hard times.
This article is to inform the public that the only thing they did wrong was to believe the rhetoric, the jawboning that was fed to them during the boom. The current situation is about to get much worse, it will not be due to higher wage claims, lack of productivity or uncompetitive practices. It will be because the politicians and bankers follow an economic system that is inherently flawed.
Until the public become educated about the way in which they are used to allow banks and governments to recover from "busts" and change the way they are led, then the banks and governments will continue to operate in their own interest, regardless of what becomes of the people. That education will not occur at the behest of governments or through the increased transparency of banking procedures and methods. It is up to us to try and let the people know what is happening. So use this article, reproduce it on blogs and sites and send it to others. All I ask is the following line is included:
Copyright: M Phoenix 2008. An Occasional Letter From The Collection Agency. Use of this article is unrestricted other than the inclusion of this acknowledgement.
Tuesday, 8 April 2008
The Future Actions of The Federal Reserve And US Govt Are Known
Introduction.
This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.
I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.
I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.
Background.
Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.
The Federal Reserve Makes a Choice.
We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.
To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.
Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).
Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:
- "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."
Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:
As GB Eggertsson put it:
- "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."
If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.
Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.
However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.
Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:
- "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"
At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.
Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.
As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.
The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.
Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).
Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)
- The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.
Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).
However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:
- "Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."
Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:
- "The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."
As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.
It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.
Since 2000:
- The US Government has run an increasing deficit.
The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.
The loosening of regulatory oversight allowed a wider use of debt and increased consumption.
Since mid 2007:
- The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.
The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.
The US Treasury does not rule out making the new Fed facilities permanent.
I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).
The Future
We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:
- I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.
Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.
Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.
Again we rely on Eggertsson to lay out the groundwork:
- "deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."
It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.
Eggertsson continues:
- "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."
- "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).
- It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).
- Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.
If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.
Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.
The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.
Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.
A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.
Is the path hyperinflationary?
To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.
Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.
Conclusion. Is it working?
It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.
What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.
I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.
What should be remembered is the title of G B Eggertsson's paper:
The Deflation Bias and Committing to Being Irresponsible
(Edit: The above link to the NY Fed stopped working, I have found another on line version at the IMF and linked to it. I have also downloaded a copy, just in case)
In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.
Sunday, 6 April 2008
The Weekly Report - 6th April 2008
5th April 2008
Welcome to the Weekly Report. This week, I stick my nose in where it ain't wanted. (again)We get down in the dirt about deflation and we look at some stocks and wonder why and I show you my long term indicators.
Now, I'm not one to boast, really I'm not. No one enjoys the likes of me stuffing "I told you so" remarks down reader's throats. There comes a time when it does become slightly unavoidable. Is it ego, a demand of recognition? Is it a desire to be kingpin, the ultra guru? Frankly my dear, I don't give a damn, as long as my readers get something that helps make life as an investor /trader easier then my attitude is "so what?"
What a week that was, Dow up, then down, up again…..stop! Hindsight - blah! This is the Collection Agency, we pride ourselves on looking forward, not back. Where do I look, how far forward? The Occasional Letter looks 6-18 months ahead, soon it'll be looking for some buy opportunities. The Weekly Report is more short-termism, with the aim of looking for opportunities in the next few weeks.
Speaking of readers it is time for an update. Now most of you know I'm a blogger, no fund to sell, no angle to push, I really don't care what you buy and sell. I'm not bothered. I'm googlable but I don't really exist beyond those that read me at some rather classy sites. Yes that was me being a creep.
Here is my world coverage over the past 2 months, remember, I'm an unknown, a blogger:
If it's green, someone visited. I know, I'm amazed too, my grammar is awful! Around 16000 people have read my stuff in the past 2 months. Some may scoff at such figures, I don't. I would like to thank you all, I had no idea my "stuff" was that readable. As much as I can be, I feel slightly humbled.
"Enough" I here you cry and being one not to spit in the face of a crowd, lets get on with it.
There has been a war of words between Gary North and Steve Saville about whether the Fed is inflating or deflating. I have absolutely no connection with either writer and have no interest in badmouthing either of them. I am sure both have a loyal following and I do know both make interesting points.
Here is my roadmap, unchanged these past 5+ years:
- "A recap of the scenario:
bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."
If you read that 5 years ago, you would have pegged me as a survivalist or a gold-bug. Now you can pick your appropriate position. How did I know such tremors were coming? Simple, I studied the very same things Ben Bernanke studied, he became a bald academic, I became a bald blogger. I am better looking though.
Back to the GN/SS spat. I looked on, an interested observer in all matters inflationary and deflationary and decided to strip the argument back to its core. From what I could see this was a difference between M1 and MZM as to which held the key to inflation/deflation signals. So I went to the Fed.
St Louis to be exact, mainly because I like Poole, his St L Fed site is excellent; I do hope his successor keeps the access to facts as open as Poole did. Its worth reading up on William Poole, he may well surprise you. I digress, again:
Charts:
This is a chart of MZM (green), M1(orange) and CPI(blue), using the base of 1982, as CPI was rebased in 1982/84 according to St L Fed statistics. Everything is based on the left side, pure figures. You know what's coming next:
Same chart with CPI based on the left axis and M1 and MZM on the right axis with the same baseline of 1982. Astute readers can know see why I stick my nose into uninvited areas. Is any measure of "M" a worthwhile measure of inflation trends?
Inflation is not purely a monetary phenomenon. We all know if you over-print cash notes you encourage a debasement and a monetary inflation. What isn't so understood (except by some and believe it or not, the Fed) is that in a fiat monetary system, reliance on growth using leverage for the expansion of credit, is the true driver of inflation/deflation.
It's simple and easily understood if you think of greed. It is also why a fractional GOLD backed currency won't work.
I have $10, I lend it to my bank as a "savings" deposit. The Bank uses the deposit as an asset, lending on that asset by a factor of 10 (leverage). The bank lends out $100 backed by the original asset. The Hedge Fund borrows (credit) $100 from the Bank and utilising margin (further leverage), raises positions in markets notionally worth $1000.
The economy is booming, thanks to my $10. I am a capitalist hero. One day I decide to take my $10 out of the Bank to spend on a battery powered radio, to alleviate my boredom whist mowing the lawn.
Does the Bank have to unwind the leveraged lending based on my $10? No, it can count upon other deposits, savings, to replace the capital base.
This is all well and good during the good times. What happens when all my neighbours decide they would rather own assets than leave cash on deposit? We know already, thanks to the 3 day collapse of Bear Stearns. Banks fear above all else a run, where depositors decide they would rather have their cash in hand than in the Bank. You can see why they fear such a run, mass withdrawals would force the unwinding of leverage, a call on the loans made. That means the Hedge Funds would have to unwind their positions, to enable repayment to the banks. You get the picture. Another angle would be to look at productive workers, paid for their labour and depositing wages into the Bank. If the Banks had a shortfall of received wages the same problem would occur, Banks would no longer have the fractional base to enable their lending. Less workers, less deposits.
What we are witnessing is not a shortfall in the ability of innovative structures to enable credit. What we are seeing is the beginning of the destruction of the fractional base of Banks. I could go on, mentioning the shortfall in expected corporate profits over the next quarter or 2 as judged by the S&P500. My astute and clever readers have already jumped ahead to that conclusion.
Back to the central question, is the Fed inflating or deflating? Amazingly, it is doing both, thanks to the newly introduced "Facilities":
Above is something I rustled up earlier in the week. To my eye, the Fed is inflating the amount of Treasuries available to both Banks and Primary Dealers and debasing their worth by swapping them for cheaper assets. On the other hand the Fed has been extremely active with the Permanent Open Market Operations, selling treasuries and absorbing cash from the markets. The Fed is walking along a very loose tightrope, where each step is producing vibrations that affect all market participants.
It would seem the Fed is set on a course to provide solvency to Banks and Primary Dealers, by lending assets that can be used to raise/roll borrowing from Banks who are only willing to lend on AAA assets. This is far beyond the ability of MZM and M1 to measure. Such slow moving indicators are unable to capture the true intentions of the Fed as it provides the replacement for the Commercial Paper markets.
Let us gaze upon the graphs for M1, M2 and MZM:
Where M1 has remained in a tight range for the past 11 Quarters, the sudden acceleration in M2 and MZM points to a reflation BEYOND cash.
- M1 is defined as all coins and currency held by the public including travellers cheques, checking account balances, NOW accounts, ATS accounts and balances in credit unions.
M2 is defined as all of M1 plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts.
MZM is defined as all of M2 minus time deposits but including money market funds.
Yes, we are back to the Fed and its Facilities again. M2 and MZM include overnight repos at commercial banks. Since the credit crisis burst open in the summer of '07, the Fed has made ample use of repos. Indeed when the crisis intensified in October '07 and again in January '08 the Fed enlarged the amounts and frequency of repo arrangements.
It is quite clear that M2 and MZM are reflecting this. M1 does not include such actions as those carried out by the Fed. Repos can only be viewed as credit, newly created by the exchange of assets. Cash itself is not printed, there is no need. All that happens is a bank can swap assets to increase the notional amount it holds in its reserve and meet reserve requirements. Only if the repo was made permanent, with assets remaining at the Fed, could the Bank issue currency.
It is at this point I agree with Gary North, consumers are not seeing a reflation in wages or income, actual cash in the economy has been remarkably stable over the past 3 years. If one considers the loss of spending power of each dollar, then without an increase in the amount of physical cash, consumers are already in a deflationary cycle as the amount of cash after liabilities is falling. An inflation of prices must never be confused with an inflation of monetary supply, consumers are suffering a deflationary lack of cash when compared to the requirements demanded by an increase in the PRICE of goods.
For the consumer this is clearly unsustainable. Eventually the consumer will hoard resources and only use cash to pay for essentials. Regardless of the Fed pumping assets into Banks and Primary Brokers who use the largesse to fund their own borrowings, the consumer will find it extremely difficult to access credit. Without credit consumers will be unable to expand spending as reliance on increasing wages is obviously misplaced.
Here we have the roots (and they run deep) of a major deflationary period. I have opined before that I saw a two track America, one where consumers where crushed by deflationary forces whilst "International USA" continued to offer acceptable returns in exchange for it debt. That moment may well be playing out in front of us now.
Here is a chart of 2 inter-related phenomenon; Consumer Prices (blue) and Total Retail Sales (red):
Here is a classic example of prices rising when goods are in demand. If you look closely, you can see that retail sales lead CPI, dips in sales slows and at times reverses CPI.
An adage I have for this is it doesn't matter how high prices go if there is no demand for goods. The goods will either be re-priced lower to stimulate demand or the production of the goods is stopped if the venture becomes unprofitable. It is the lack of cash that causes (spending and therefore) sales to drop. How the amount of cash consumers own is decreased is important. If more cash is required to pay taxes or service debt then the expenditure is onerous on the consumer balance sheet, no asset is exchanged. If the consumer chooses to spend more money buying assets, then at least there is an asset owned. If however the asset is depreciating in value, including assets bought using debt then the net worth of the consumer suffers a double blow.
Housing is suffering from the same effect. Now we see it in retail sales. You can see why tax rebates have been lined up, it is an attempt to stave off a deflation in sales. If it works it will have a lagging inflationary affect on CPI.
The problem though is whether consumers will spend tax rebates or save them. If rebate cash is used to pay down debt or placed on deposit there will be no stimulation to sales. CPI will drop. Here is a close up of the same chart:
The tax rebate effect can only be temporary even if it does stimulate spending. Without an expansion of credit or an increase in wages sales will continue to drop. What are the chances of credit conditions changing in the medium term or wages increasing during a recession?
The interesting part of all this is if consumers do save the tax rebate then M1 will not increase as savings and small time deposits are calculated in M2/MZM. Thus savings could cause a display of supposedly inflationary tendencies in M2/MZM. M1 would only increase if the savings ( or the tax rebate itself) were used to buy goods or services.
The actions taken by the Fed and the US Treasury will either distort CPI or cause a misreading of inflation if M2/MZM are used. The latter would be a grave mistake as the consumer would not have increased their spending power. The increase in M2/MZM would be a combination of increased use of credit by banks and an increase in savings by consumers.
The following chart shows the relationship between Sales and Industrial Production for Durable Consumer Goods:
Sales and Production are linked, it shows that the compensation given to workers for their labour is used to buy products, amongst other uses. The correlation is particularly noticeable prior to 1991. However since 1991 an inequity between spending power and production has appeared. It is my contention that increased productivity was a function of the slowdown of compensation in real terms and spending was boosted by an increase in the use of credit allowing sales to continue to rise.
This is a form of mal-investment, were credit has replaced true efficiencies in production. Purchases were not made from savings (workers earnings) but from earnings of yet unrealised worker compensation with a forward CPI and risk premium added.
With the standards for credit now at much tighter levels seen since 1991 this mal-investment is beginning to bite. Although this has consequences for consumer spending power, the real problem will lie within Corporate balance sheets. Reduced income will make the servicing of corporate debt much more difficult as we have seen in the Financial Sector. "Liquidity injections" from overseas investors have high rates of interest and with income streams falling, increased productivity and the ability to service debt can only be achieved by lowering costs.
If a production system is reliant on the use of credit to expand and that facility is removed then the results of previous bouts of debt fuelled expansion cannot be carried forward and offset against expected future income. Either the debt is repaid or defaulted.
Can increased productivity re-light consumer spending? It would appear not:
And it's a tactic that's already been tried. Notice the increase in productivity in 2007 did not re-ignite sales. It's most likely that the 2007 increase was a function of cost savings, rather than expansion.
On a more practical front, how can an investor use such information to aid their strategy?
Avoid debt on company balance sheets. An investor should get into the habit of checking the ratio of company debt to income and reserves. If you can find a company selling essential products that carries no debt on its books you are on the right lines. If you can find a company that also has saved its profits and is only willing to expand using its savings you may have found a good opportunity.
We finish off with a look at some charts and wonder why investors are buying financial sector stock. Is the recent rebound in financials worth buying into or watching? I leave that decision up to you, I don't do recommendations but as you have read, my filter for acceptable buys would discount the sector. You may well have a different take on the situation, my only advice would be to do your research with extra diligence. I have no positions in shares in the following charts and will not take a position on them for some time.
Firstly my Dow Daily Chart, used for long medium length trends:
We are near the top of the sideways trading range(down arrow) that has been in force since January. For the first time in 4+ months we have a neutral reading, with 3 days of support at the pink, median line (up arrow). Whilst calling direction from here would be a bit silly, at least with a neutral scenario we can take cues from breaks of support/resistance from here.
Citi, I have removed the down channel as we have broken out. Citi is trying to break above the MA but might be forming a rising wedge:
Goldman is at the upper end of its down trend channel and finding resistance at the MA. Strong support at $163:
Gold, an update from last week. The down arrow shows the attempt last Monday to regain the MA which failed. Gold found support in the $885 area on a closing basis. This level now becomes important support for future moves. I would need to see a higher high and support from the MA before looking for upside:
That's it for this week.
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