Planet Yelnick

The Fed Has Started QE3 in Disguise By Backstopping Europe

The surprise the bears feel over the continued rise of this market may be due to QE3 in disguise. ContraryInvestor has a good analaysis of how the backstopping of the European bailout fund LTRO by the Fed is acting like a wnother wash of liquidity, this time trhough Europe. (See chart).  

Given how the market inexorably rose with minor pullbacks during the last two QE episodes, we should expect something similar now until the LTRO backstop runs its course.

The bears will expect it to crest before getting too out of control, but they may be misreading both the Fed's determination and thye wave count.  If we count this structure as wave C since 2009 in a large ABC made up of two doubke zigzags internally, it could continue up like the QE2 period (the A leg of the second double zigzag) towards 1500, giving a triple top since 2000. 

Not a prediction but food for thought for the  bears.

Broken Pattern, Token Risk

I appreciate all the concern in the comments on my transit back through Narita, but it came and went and I still have my hair. I spent about an hour in transit, and the food on the return was worse than normal, telling me that it was not sourced from Japan. 

The risk I took was very low. I wrote about it in my other travel blog: Bananas Are Radioactive Too. The risk I took was about the risk of a daily commute. You guys who commuted for the six working days I was gone were taking on much more risk.

Investing trades in risk and investors get it wrong all the time. Right now the bet is not to fade the Fed, to believe QE Infinity will continue to pump this market. The calls to end both QE and the zero interest rate policy (ZIRP) are increasing. Andy Kessler just explained in the WSJ how ZIRP crushes capital formation and stifles the recovery. Risk on.

The other bet is that the four-year re-election cycle will pump the market. This is the most predictable cycle, and its causation is clear. Yet Obama shot this bullet early, right away in fact, and the Stimulus is already fading to the point it is acting as a drag on GDP. He is facing political headwinds from the grumpy Republican House, and if he loses QE, he is left with only a war to pump the economy. Libya? Yet another Middle Eastern war threatens to keep oil prices high, acting as a bigger drag than war-spending. 

You can see the impact of this in this chart showing the current market vs. the normal re-election market. Now, "normal" here is an average of many years, so we should not expect any one market to actually match the curve; also, the curve is not combined with statistical variability (eg. Bollinger Bands), so cannot we easily assess if this one is still within the bands of "normal". The key, though, is the extent the recent dive has taken this market off the normal pattern. Broken pattern betokens bigger risk.

Chinese Curse Bewitches the Dollar

Be careful what you wish for; it may come true - Chinese curse

China made a bold currency move Wednesday, and it barely registered in the West: it is encouraging the Yuan to be a reserve currency, to be used to settle transactions in and out of China, instead of the Dollar. For all those pundits and politicians pressuring China to float their currency, they just got their wish. 

This marks a shift from an export-driven mercantilist economy, to a consumer-led capitalist economy. The internal pressures from mercantilism eventually create their own contradictions:

• inflation from laundering the currency conversions
• unrest by people who wish to cash in and enjoy the good life
• lost wealth from capital trapped in forced savings that act as a sinkhole of productive investment
• lost profits from excessive competition & multiple me-to factories

The curse is that it removes one of the largest borrowers of Dollars, and reduces demand for Dollars for international settlement. This has led the WSJ opine that the Dollar's role as the one reserve currency is coming to an end:

1. Technology is undermining the scale and depth of Dollar trading by allowing rapid cross-cirrency comparisons without translating in Dollar terms
2. Rivals of enough scale are emerging, especially the Euro and the Yuan
3. US fiscal policy (such as QE and huge deficits) are undermining confidence in the Dollar as a safe haven that is a stable store of value 

Asked rhetorically, can the Fed continue infinite QE (indefinite Dollar debasement) as the foundations for Dollar strength (oil trade, international settlement, safe haven) crumble?

The Fed has become the biggest buyer of Treasuries, which has worried Bill Gross to ask the question: who buys Treasuries when the Fed exits?

His answer: Treasury rates will have to go higher to attract investors. This could scuttle an incipient recovery, especially with higher oil prices. It would, however, be good for the Dollar - but it is months off until QE2 ends, and expectations of QE3 are increasing as fast as GDP fades. 

The Dollar, then, remains on edge. It has traded below the trendline of support that has held for the past three years. The longer down below, the more likely it begins to lose support and possibly crash. 

When measured in the Dollar Index, as shown in the chart (with the key trendline), the so-called crash would like more like slip-sliding away; but when measured against metals or commodities, it would look like gold and silver shooting north & commodities heading up parabolically - which is how they have begun to look recently. You can scan the blogosphere and pick up all sorts of predictions on silver ($130!) for example. It is pretty clear that Dollar weakness since last summer has led to commodities strength (Dollar in green, using the UUP instead of the DX; commodities in blue):

Another leading indicator of a Dollar collapse would come from the commodity currencies - the CAD, AUD and NZD, which indeed have been showing recent strength. You can scan the blogosphere and pick up all sorts of predictions on the CAD (Fifteen reasons to love the Loonie!) as well as the AUD. 

A further (but in this case misleading) indicator is oil, which is undergoing a dramatic spike - up 15% in five days. Such a spike is rare and almost always fades back quickly (the one recent exception being the invasion of Kuwait in 1990, which led to the first Gulf War). Such an event-driven spike gives little guidance on the direction of the Dollar since it is likely to be temporary; indeed it may be the primary explanation of why the Dollar Index has fallen below the support trendline and stayed below. When the immediate Libyan crisis abates, oil should fall, and the Dollar recover. 

Bullishness on the Buck is below 10%, according to the STU. This is what happens around a Dollar low, so they wait for it to bounce, but add that the wave structure is unsettling. The bounce that began at the QE2 announcement has now faded more than 78.6% off its peak in November, and the wave structure is ambiguous. Normally a fade beyond 78.6% means it is going beyond 100%, but they expect the opposite. Again, the explanation for the ambiguity may be the temporary oil spike. 

In the longer term, the Chinese move should be good both for China and the broader world, as China rebalances toward a more Western-style economy, which will come with opening it up more for imports. The move will put pressure on the US to get its economic house in order, also a good thing in the long term. Also, the multiplicity of reserve currencies may smooth a transition to a different form of reserve currency, one not tied to any domestic set of policies, what Keynes called the Bancor. This frees the reserve currency from the tyranny of domestic policies, and lets all currencies float against a standard. 

In the near-term, with turmoil in the oil-bearing countries and a painful adjustment domestically to get off the drug of stimulus and back into a sound economic foundation, the US may have to live through the other Chinese curse: "interesting times."

The Fed on Commodity Inflation: What, Me Worry?

Is it inflation or speculation? The Fed Chairman spoke very plainly today, but what he left out is important. Coincidently, he spoke right after the ISM Report on expectations. Good news: manufacturing expectations are booming. Bad news: inflationary expectations are also booming.

These CPI expectations (the blue line) do not predict inflation, but a lot of folk are worried. Not Ben. He said commodities price increases are NOT a concern. 

His comments have been picked up by the punditsphere, and you can get a quick read from Barry Ritzholz thinks ("I disagree") and Cullen Roche at PragCap ("totally oblivious"). Here is Ben's view of surging commodities:

[T]he increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases.

Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months. 

The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations.

I think all three assertions are true, but hide the truth: his QE2 policies have driven up speculation, and that has driven up commodities across the board. Let's look at his assertions:

• demand and shortages have driven up prices - ok, but why would all commodities be going up in lockstep due to weather here or there, or other local causes of shortages? And why up so much when the great demand generator, China, is slowing down? As Cullen Roche opines: "There is nothing normal about cotton prices rising 200% in six months."
• prices have risen across all currencies - ok, inflation is the result of weaker currencies, and normally the whole world does not weaken at the same time in much the same pace. Also, QE2 does not 'print money' in the way people casually toss out. Still, his core assertion is too loose: prices have gone up faster in Dollar terms than Euro or Yen, bespoking Dollar relative weakness since QE2. Still, the inflation argument would have more weight if the Dollar were falling faster than it is, given how much commodities have risen. 
• commodity price rises are not being passed through - ok, so far anyway. I see blogosphere comments about official stats hiding the real inflation going on, but it is pretty clear that other than food and energy, where costs have an easier time being passed through, most industries are having a terrible time passing on the rise of input costs. This is why corporate earnings are about to run into a margin squeeze. 

Under the New Austrian School of Economics, interest rates are mechanisms to adjust business investment behavior. Normally low rates speak to longer investment horizons, but in the deflationary depressive aftermath of a credit bubble, keeping rates artificially low as the Fed is doing has the opposite effect: it spurs short-term, speculative investments over the long term. You could think of low rates as destroying the returns on sunk capital, leading to low replacement of existing plant - pretty much what has been going on during the Great Recession. 

BTW Bernanke let out his own estimates of how much he has lowered longer term rates - 75 bp. ZeroHedge extrapolated his formula across all his various QE measures:

The sum of QE 1, QE lite (the top off of QE1) and QE2 is $2.35 trillion. Using Bernanke’s formula you get a range of 4% to 5% as the approximate interest rate consequence of QE. 

That is an extraordinary number. The Fed’ ZIRP policy set interest rates at zero. QE has brought that to -4.5% (average) based on Ben’s numbers.

I don’t think that this has ever happened before in the USA. The examples I can think of in history outside of the US all ended badly. Ben has set monetary policy so that interest rates are 5-6 % below inflation. There can be only one possible result. Inflation of everything we use is going to explode. 

Maybe. The ISM reports are clear in seeing price increases on inputs across the board, and maybe American industry will not accept the margin squeeze and will try to pass it on. If so, prices should begun to push up in the next six months, and while this might make GDP tick up (see chart), it could just as well depress consumer spending:

The other explanation than coming inflation is that the speculative fervor is about to cool. We will likely see this first with oil and the Dollar. A strong Dollar reversal will unwind the speculative positions (priced in Dollars), and a break in oil will remove the biggest driver of cost-push seen by the ISM managers. 

What the Big Mac Index Says About Inflation

I was shocked to hear from a friend that a Big Mac in Philly now costs $7. I haven't kept tabs, being long-past my kids' Happy Meals days. The Big Mac Index must not be very happy right now. And I hope he meant a Big Mac meal not a mere sandwich. 

The Big Mac Index was a cheeky concoction of The Economist as an exercise in figuring out purchasing power parity between currencies. In its early days, everyone would make a beeline for the China price, and cluck cluck about their cheap currency.

Today it has a much better use: testing the reliability of official inflation figures. I am of course shocked, shocked! to learn that governments fiddle with their figures. As you can see at a glance from their chart, Argentina is the biggest cheater, with the US and China not that far behind:

During the height of the Great Recession, McDonald's was one of the Four Food Groups of the Apocalypse, along with Campbell's Soup, Hershey's Chocolate and Hormel Spam. With food costs rising and difficulty pushing through price increases, how are they faring now? They should be a canary on the coal mine of the Great Margin Squeeze. 

McDonald's has made menu changes since 2008, rotating to higher margin food to keep ahead of rising food costs. So far analysts expect the change in product mix to allow McD to maintain flat margins, although just in the past week (after the Q4 earnings release) more analysts have begun lowering earnings than raising. While Mickey D's has been pushing healthier food, a lot is riding on their re-introduction of the ever-popular and calory-heavy McRibs. Yum!

Oh, and I did stop by a local McD's. Out here in the Left Coast, a Big Mac is only $2.99 and the meal $5.19. I don't suppose that is a dime or two more than it has been for a while. No rampant inflation here. 

QE2 Working the Wrong Way - Has the Fed Redefined the Mission?

 Monetary policy responsibility cannot substitute for government irresponsibility - Jean-Claude Trichet

A funny thing happened on the way to QE2: rates rose rather then fall. It appears The Ben Bernank has now redefined the mission from keeping long rates down to pushing stock prices up. He says he wants to create a "wealth effect" among investors that pulls the economy out of the slump. Never mind that rising commodities prices (especially oil) create a corresponding "poverty effect" for the middle class. How will this end?

John Mauldin's latest, Thinking the Unthinkable, is a must read. (Also available here.) He notes how Bernanke in 2002 believed that the Fed could target an inflation rate such as 2%, raising short rates to stifle inflation and lowering long rates to fight deflation by buying forward in the Treasury curve. This buying forward is what Ben means by Quantitative Easing (QE). John's comment on QE2:

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, "In theory, there is no difference between theory and practice. In practice, there is." It’s got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link here) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben’s answer (paraphrased):

“We have seen the stock market go up and the small-cap stock indexes go up even more.”

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed’s target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes? 

So isn't rising stocks goodness? What could go wrong? Richard Fisher of the Dallas Fed has been plainspoken about the risks:

The new Congress and the new staff in the White House have their work cut out for them. You cannot overstate the gravity of their duty on the economic front. Over the years, their predecessors — Republicans and Democrats together — have dug a fiscal sinkhole so deep and so wide that, left unrepaired, it will swallow up the economic future of our children, our grandchildren and their children. They must now engineer a way out of that frightful predicament without thwarting the nascent economic recovery.

So far the new Congress does not appear serious. Only three House members joined the Tea Party Caucus. The first major action is to try to repeal ObamaCare - a futile and symbolic effort at best. The stated goal is to reduce $100B from spending - a drop in the bucket. 

What has gone wrong for Bernanke is the rise in rates. The 10 yr is approaching a record spread with the 2 yr: 273 bp where the record is 283 reached in Feb 2010. Normally this spread is goodness for banks, as they can borrow short and lend long in the spread; but most of their mojo would come from mortgage lending, and new mortgage applications are "plumbing" 15 year lows. So instead of profiting, they are seeing the value of homes drop, pressuring the asset values for their carried mortgage base. At this point either he has to reconsider steps to reduce long rates, or hope Mother Market takes care of it for him.

What may go wrong next for Bernanke is a drop in stocks. A stock fall would show that the Fed Emperor has no clothes, that his justification for QE2 is baseless. A serious correction eradicates the wealth effect, and the continuing rise in commodities extenuates the poverty effect from high oil prices. In any event, the purported wealth effect has been studied and found wanting - not much there, and very little trickle down to the middle class. 

The biggest risk comes from theory hitting reality. Niall Ferguson (economic historian) decries the economic theorists for believing in some form of neo-classical equilibrium, that things tend to stay in balance. Neo-classicists, including Bernanke, completely missed the 2008 crisis because it was outside their view of how the world works. They thought markets were self-correcting and changes incremental. The history of booms & busts, however, says that change can be rapid and dramatic - crashes not slow slides.

In other words, QE could spiral out of control. Already it is not working as Bernanke expected. As Niall concludes:

Complex systems look like they are in equilibrium, but they are not: they are constantly adapting, highly decentralized, interdependent systems and this process of adaptation can continue for quite a long time. And you think to yourself when you look at it, that's in a wonderful equilibrium. That's how we think about the economy. That is how economists teach economics. They talk about it in terms of equilibrium.The bad news is that in fact we inhabit a complex system that has virtually nothing to do with the neoclassical model that you are taught in Econ 101. And that's why the economists failed to predict the financial crisis ...

For me American power if you generalize beyond the realm of finance through the geopolitical system is a perfect example of a highly complex system which looks like it is in equilibrium but like all the great empires of the past is quite close to the edge of chaos. And our nightmare scenario should be that something happens to us like happened to the Soviet Union... It suddenly just falls apart.

And I think the trigger, the catalyst if you want to switch to chaos theory the butterfly in the tropical rainforest that flaps its wings and posits the distant thunderstorm is going to be the credibility of fiscal policy. That just seems to me like the obvious place where things can turn nasty, and they turn nasty with amazing speed."

QE2 Explained - The Music Video

Putting The Bernank back in business! The original is here.

How's That Net Neutrality Thing Working Out?

The free-wheelin' days of the Internet are numbered. The Internet now becomes subject to Federal encroachment with the new net neutrality regs. It is not clear if the FCC has the authority to regulate the Internet, and that proposition might be tested in court, but they went ahead and grabbed the power anyway. 

The most immediate impact is on Internet stocks: cable is up, phone companies are down, and content companies have gone up a bit then plateaued. Google and Apple went down when the news broke.

It is perhaps no coincidence that this is breaking when WIkiLeaks is under assault. Julian Assange is in jail under a somewhat odd (if not trumped up) sex charge from Sweden, and he may fall into the clutches of the US government. 

Where are the civil liberty folks when we need them? Is it that hard to compare WikiLeaks to The New York Times, and the private who illegally leaked to Daniel Ellsberg of the Pentagon Papers? Or are web sites about to lose the protections of the First Amendment, including Freedom of the Press?  

Instead, it is left to the WSJ of all places to expose the forces behind net neutrality, which are probably not what you think they are. John Fund unveiled what led to this decision and the motivations behind it - which are to control content, not simply price the fast lanes of the info highway:

The net neutrality vision for government regulation of the Internet began with the work of Robert McChesney, a University of Illinois communications professor who founded the liberal lobby Free Press in 2002. Mr. McChesney's agenda? "At the moment, the battle over network neutrality is not to completely eliminate the telephone and cable companies," he told the website SocialistProject in 2009. "But the ultimate goal is to get rid of the media capitalists in the phone and cable companies and to divest them from control."

There is a lot of blather flying around the blogosphere over this, and over McChesney's background, and the story could easily blow this out of all proportion. The current administration did, however, try to shut Fox News out of the flow of press briefings by the While House, and have floated the idea of reinstating the Fairness Doctrine in order to shut down talk radio in general and critics like Rush Limbaugh and Glenn Beck in particular. Their record on a free press is already suspect.

The FCC decision today is much more limited, but might be the proverbial camel's nose under the tent. This is the angle taken by TechCrunch, which views the fight as just beginning. GigaOm focused on the disparate treatment of wireline and wireless networks, expecting wireless broadband prices to rise. VentureBeat found the exemption of wireless networks "a bit of a head scratcher." 

The capstone to this story might be the old adage to be careful what you wish for. Big Internet content companies like Google have been lobbying for some sort of net neutrality rules, and may someday wish they had left things alone. 

Bulls Take Note: Tax Deal Won't Stimulate Much

There is much less stimulus than touted in the press. Political posturing has resulted in poor policy. Funny to watch the erstwhile critics of the Bush tax cuts turn into Reaganesque supply-siders. They are besides themselves crowing about how a tax cut will stimulate the economy. Where were they when Chirstina Romer was still Obama's head of economic advisors? Her seminal studies showed properly-structured tax cuts had 3x the stimulative impact as increased spending. Instead, they pushed through the Stimulus which they now admit was poorly done.

The tax deal actually creates little incremental reduction in taxes, since it mostly continues what is already in place. Put simply, not letting the Bush tax cuts lapse is NOT stimulative; it just avoids a drag on the recovery. What is actually new is relatively modest in size. If you review this chart from Megan McArdle at The Atlantic, the first three items are continuations; the last four are incremental:

In addition, the highlight of the deal, the payroll tax cut, is poorly structured to have the right type of impact. What the economy needs is business investment that leads to new jobs; this just continues demand-side stimulus of the sort which has kicked the can down the road for the past two years rather than lead to a recovery. Worse, it is temporary, and going back to Milton Friedman, it is well known that temporary tax cuts have no lasting impact. 

The politicization extends to the CBO, which normally does sound work; their assessment of the tax deal is being criticized by center-left commentators like Megan, who notes this:

According to the CBO, the low estimate is that temporarily extending the Bush tax cuts for the middle class aren't very stimulative, while extending the tax cuts for those who make over $250,000 doesn't show up at all; in the high estimate, extending the tax cuts for incomes above $250,000 reduces employment by about a tenth of one percent, while extending the tax cuts for incomes below $250,000 lowers it by about half a percent.

It's true that there is some differential effect. But most of that figure is not driven by the fact that wealthy save their tax cuts, while the middle class spend them; it's driven by the fact that the tax cuts for incomes below $250,000 are much larger, in terms of the federal budget, than tax cuts for higher incomes.

According to CNN, the two-year cost of the tax cuts for high earners will be about $75 billion, while the estimated cost of the cuts for incomes below $250,000 is about $310 billion, or four times larger.

Consider this finalirony: as we head into the 2012 elections, the debate will be about supply-side tax cuts, not demand-side stimulus - the Republican playbook, not the stuff of the Democrats. Worse for the Demos, an Obamcare tax increase (the medicare 3.8% surcharge) will kick in in 2013 and have to be dealt with. 

QE and Stocks: The Japanese Experience

Since QE2 was pre-announced in late August, stocks have been on a tear. They pulled back a bit when QE2 was announced in early November, but have since continued to rise. Many people believe they will continue to rise as long as the Fed continues QE. The Japanese experience would agree. This chart (courtesy The Casey Report) shows how a massive dose of QE lifted stocks, which promptly fell back when QE was ended after a one-quarter lag: 

What seems different this time than with Japan is the meltdown in Treasuries. Could that scuttle the stock rally? Casey Research thinks not. Alex Daley, Casey’s Extraordinary Technology, comments:

[I] do see at least one compelling reason to stay net long in equities right now: The wheels are coming off the bond market.

And that means money is flowing into equities in a major way. Excess liquidity, especially in the sheer proportions now flowing into the stock markets, tends to drive up asset prices. And the stock markets are seeing liquidity at levels not seen in years. ...

[S]ince the beginning of 2009, the net inflows to bond funds have been more than 11x (!) the inflows into stock funds. But as you can see from this graph, that trend is deteriorating rapidly. It’s such an about face that, bond inflows have gone negative for the first time since the crash (and at that time they were only negative because every asset class saw massive withdrawals):

QE2 Report Card

A plethora of reports on QE2 are coming in with low grades. It launched to a bumpy start, and many observers thought it wouldn't have much of an impact in the real world (vs the worlds of speculation and expectations).

Global Bond Rout

Most noteworthy is that rates have gone up rather than down, and up quite a bit - 60 bp in the ten-year - enough so it has pummeled the bond market and led to descriptions of a Global Bond Rout. PragCap shows how dramatic the reversal has been, albeit we are still below yields earlier in the year:

 

Doug Short piles on, showing how since the actual QE2 announcement in November, the rate increases have been dramatic:

Econbrowser did a careful, somewhat scholarly review, and generally concluded that whatever impact it was supposed to have had is being swamped but other events. Their primary criticism is that the Fed has executed QE2 in the mid-range of Treasuries, rather than the ten-year (or longer) bonds. 

Banks Lending Again?

Another purpose of QE was to right the banks, encouraging them to lend again. Banks make money borrowing short and lending long, so a rise in long rates should encourage capital formaton.

John Mauldin adds a long, careful assessment of QE2 in his weekly newsletter, reprinted here. He sees unintended consequences to QE2: a global sell-off in sovereign debt. Why?

virtually every country in the world is grappling right now with how fast we get out of our fiscal stimulus and much do we worry about this longer term problem of debt

This may explain why rates spiked after the Obama tax deal was announced - it reflects more of the stimulus mentality, piling on more debt, than a change of approach to grapple with excess debt. The bond vigilantes disapprove. 

John went on to ask whether QE2 had begin to fix the core problem of capital formation - in other words, are the banks ending again? The answer is a resounding no. Credit continues to contract, and now with the long bond over 4%, mortgages have gone up, further hammering the housing recovery. Indeed, housing has started a double-dip. 

Inflation Increasing?

A third goal was to reflate the Dollar, with the view that rising prices would also encourage capital formation. I have always found this goal an odd one, perhaps a post hoc, ergo propter hoc fallacy looking back at the Great Depression. When FDR broke with gold, the USD fell and we had inflation. Did the recovery come for other reasons, brining inflation, or did inflation drive the recovery? In any event, in coming the financial blogs I have seen sophisticated arguments for increased inflation expectations, but no signs of inflation (other than asset speculation). Indeed, the inflation-adjusted Treasuries, TIPS, have not signaled higher inflation, rising with the ten-year not ahead of it. Instead, bonds are weak because of QE, not inflationary expectations:

The market sees the deflationary forces mixed with the inflationary signs and trades it to a draw. The market is shooting bonds because it is afraid and confused about the distortions that QE is causing. 

Gore Effect Strikes Cancun Climate Conference

As if ClimateGate wasn't bad enough, the climate politicos in Cancun are amidst record cold temperatures. The Gore Effect, of course, is the inconvenient coincidence that when Al Gore attends a conference to give a climate speech, cold spells and freak snow storms attend. He is not even there this time. 

Global temperatures seem to have flatlined over the past decade, despite increases in Co2. The Cancun conference has little hope of changing the political climate, which is decidedly chilling against the concept of hampering economic growth to limit Co2 emissions. Instead it seems to be devolving into demands by the third-world for "climate justice" - meaning transfer payments from the developed world. See picture below.

While the climate parade marches into irrelevance, we do see progress on solving real problems, particularly rotating the fleet from oil to electricity. The electric car momentum continues, with Tesla's stock remaining buoyant and expectations for the Chevy Volt still high. 

Political Compromise Is Not What You Think

The tax deal that is bumbling through our esteemed Congress shows how in the political realm a "compromise" is not what you think it is:

• In business, a compromise is when two parties give up something to come to agreement
• In politics, a compromise is when two parties each get something to come to an agreement

When a politician compromises, it means they get what they want and the begrudgingly let the other side get what it wants. And the voting public gives up something. Consider this deal, which is supposed to be tax cuts for all, but is actually something else:

• the "rich" get no cuts, but an increase in estate tax
• the working class gets a one-year social security tax break, increasing the deficit
• the 99ers get no new unemployment, but the current unemployed get 13 months more

QE For Kids

Hat tip to Mish for this. He says he especially likes the part about Bernanke being so dumb as to want to raise prices in a recession.

Update: an economist deconstructs the cartoon bunnies' arguments here.

QE Stumbles at the Starting Blocks

Global interest rates are rising, which is not what Bernanke had in mind with QE. The US 30-year auction went poorly yesterday, reflecting a change in psychology of the Treasury markets the opposite of what QE is supposed to engender: according to this morning's WSJ, fear of inflation is trumping the Fed's buying power, and rates are rising.

Bond buyers have bought ever-lower yields expecting they could bail out if rates began a persistent rise. The spread between the 30-year and the 10-yr has increased in one of those parabolic curves which tend to end badly:

PragCap observes that this means bond buyers are eschewing the long bond so as not to be locked into rates close to the 10-yr, which means the market is expecting rates to rise and the 30 Year Bond Bull to end. Since the QE pre-announcement at the end of August, the long bond has gone from below 3.6% to above 4.2%, a huge move. Can owners of large positions get out fast enough? This is PIMCO's nightmare come to life.

The Dollar continues to firm while the Euro seems in trouble. The sovereign debt problems of the PIIGS have returned. The Euro is close to $1.365, a level which could trigger a dump of the Euro. The AUD remains above parity after ticking below $1 yesterday, and it too might get a sell-off if it breaks 99.5c. 

To follow this more closely, note that EWI is offering their forex services for free this week. Click here if interested. 

Even stocks are not reacting as Ben expected. Recall that his stated reason for QE2 is to drive stocks up, creating a wealth effect that restores confidence to the economy and spurs more business activity. It is not just that stocks have flatlined since the QE announcement, but insider selling is way up:

• MIsh congratulated Cisco insiders for getting out ahead of the earnings debacle last night, which sent shares initially down 15%: over the past six months, the Cisco scorecard is 6.6M shares sold, 0 share bought
• ZH reports that insider selling hit an all-time record last week:

Contrarian footnote: while insiders are selling and global markets are reversing, bullish sentiment soars! Small investor bullishness is back to 2007 levels! This is what happens around a top. 

Big Reversals Prior to G20

The drumbeat of criticism of QE2 is getting louder as we approach the G20 meeting later this week in Seoul, and it have spilled over into big reversals in global markets:

• On QE2 Day last week, the Dollar bottomed (DX75.63) and the Euro peaked ($1.43)
• Since then the Dollar Index has been on a run, getting to 77.87 (so far)
• The Euro has plunged to $1.375
• Silver in this period shot up in a parabolic blowoff to over $29/oz.
• After the pits closed today, silver fell 10% and the CME raised margin requirements

Here is a chart of a silver ETF right BEFORE the 10% fall in the overnight market. You can see the QE2-inspired run up and then the classic parabolic blowoff:

Maybe that errant missile off LA was silver taking off (hat tip to EvilSpeculator for that)? Or some wit said it was Jerry "Moonbeam" Brown taking off. Zerohedge gave a handy chart by the Air Force on how to identify unkown flying objects:

Most likely it was a normal contrail misidentified. 

In the same sense, we should be cautious not to jump to a conclusion about these big moves. We are very close to the levels where a reversal is confirmed. The STU put out a special bulletin tonight to note the potential reversal. Still, these big moves may reflect interventions by central banks as they pre-position for what should be a pretty volatile set of meetings on the global currency imbalances. The next few days should prove interesting.

 

QE For Dummies

There is lots of confusion over quantative easing (QE), so much so the markets may have over-reacted. I have been following PragCap's analysis, which is very good, but dense and lengthy to read, so let me try to simplify:

The Treasury sells bonds to Primary Dealers (banks), who resell to the public.

• In QE, the Fed steps in and buys many of those bonds.

Where does it get the money from?

• It creates it out of thin air

Isn't this inflationary?

• No, since the new money goes into the reserve accounts of the banks. 

What are these "reserve accounts"?

• Deposits the banks keep at the Federal Reserve (see where the name came from?) 

Why isn't this inflationary?

• Because the money sits in the Fed rather than circulating in the wild

What a minute. Didn't the Treasury get new money, and won't they spend it?

• Of course, that is why they sold the bonds to the primary dealers

So why isn't that inflationary?

• This happens all the time when Treasuries get floated, but the buyers have to pull money out of someplace else to buy the bonds

Yes, but this time the Fed is creating money out of thin air, instead of the prmary dealers (banks) pulling it out of the economy

• Right, but again it ends up in reserves not in the economy

Here is a chart which shows the before and after picture. You can see the new bonds bought by the banks (primary dealers) are swapped for reserves.

Why don't the banks use those reserves to lend, putting the new money into the economy?

• THAT would be inflationary, but they are not doing that 

This is the crux of the confusion. Cause and effect are the other way around:

• Banks don't lend because they have more reserves; they lend when they can make money on the deal

For a long time banks have not been reserve-constrained. They can easily borrow from the Fed when they need liquidity. This is why the current crisis is NOT a liquidity crisis like the 1930s. History shows that bank reserves go up AFTER they increase lending, not before. 

Why won't QE make the climate for investment by banks better?

• Unlikely. QE is trying to reduce longer term rates, but banks make money by borrowing short term and lending long term at higher rates. When the spread is decreased, lending stops.

What is the Fed up to?

• Bernanke has stated that he hopes stocks go up, creating a wealth effect, and the extra wealth gets spent, propping up consumption

Does this make sense?

• No, since it does not create extra money - the stocks you sell are bought by someone else, so the net money is the same. At best you get a little boost due to margin accounts - the buyer could use debt to buy more and not use as much cash. The real hope is stock sellers spend more and invest less; but then stocks will stop going up

Here is CNBC on the QE2 wealth effect:

Then what is he really up to?

• Lots of speculation on this. Maybe he is worried that the amount of government debt that we need to finance - both new debt and old debt rolling over -  is about to overwhelm capital markets. We would either need to raise taxes or interest rates - both of which would short circuit the recoveryless recovery. 

What about all the signs of inflation?

• The market in its confusion expects inflation. Commodities are way up, and the inflation-adjusted bonds (TIPS) are showing higher signs of inflation

This chart from Calafia Beach Pundit shows how the long bonds are not behaving as Bernanke wants. Their yields are going up, not down, signaling inflationary expectations:

We could end up in a bad place: commodities go up, squeezing middle class families and compressing business margins, as their inputs get more expensive but they lack the ability to raise prices.

Well, aren't stocks a good place to be? 

• Japan's recent experience with QE says be careful. As PragCap concludes:

[I]n Japan ... QE caused a brief 17% rally in equities as speculators leveraged up, jammed prices and then later realized that the slightly lower yields hadn’t really changed anything.  What happened next?  Their equity market fell 40%+ over the next two years.  QE was a great big “non-event”.  All it did was manipulate markets temporarily and cause a huge amount of confusion.

History of the Tea Party

A quick and funny video from Slate (tricorn hat tip to Barry Ritzholtz).

QE2 Off to a Bumpy Start

QEII first looked like the Love Boat, but may turn out to be the Titanic - Art Cashin at UBS.

You would have thought that with three months warning and boatloads of commentary, the Fed's QE2 announcement would have settled in by now. The Dollar took a dive, not a surprise, but bonds fell too (rates rose), which was a surprise, as QE was supposed to lower rates on longer term bonds. The 30-year yields jumped 20 bp to go back over 4% as the market was surprised that the long bond was not targeted by QE this time around. Last time around, during QE1, rates also rose.

PIMCO, the big bond fund, is worried that QE2 will backfire.

"Doubts grow over wisdom of Bernanke's 'super-put' " intoned the headline by Ambrose Evans-Pritchard at the UK Telegraph:

It is the clearest warning shot to date that global investors will not tolerate Ben Bernanke's openly-declared policy of generating inflation for much longer.

Soaring bourses may have stolen the headlines, but equities are rising for an unhealthy reason: because they are a safer asset class than bonds at the start of an inflationary credit cycle.

Tinkering with markets risks losing control. Is Bernanke already in trouble? Markets are getting disorderly, worldwide. The impact of QE seems to be exporting US inflationary pressure to overseas markets. India hiked rates to quell inflation, as China also did recently. The chorus of criticism from around the world is increasing. China, Brazil and Germany in particular have complained that QE without other measures to turn the US economy will do no more good than literally throwing Dollars out of helicopters.

Global inflation is clearest in commodities. Besides all the metals, oil rose. The Saudi's expanded their budget, expecting to reap windfall profits. Many inputs in products besides petroleum have risen dramatically since August. Cotton is a striking example, showing the signature of a parabolic bubble that will end very badly:

Bernanke is trying to create a general monetary inflation in prices in the US. The inflation indicators (GDP Deflator and CPI) are showing only modest levels of 1-2%. His challenge is daunting in that banks create money in the US and they are not increasing lending in any serious way while the shadow banking system is still deleveraging. Another surprise today is that M2 actually dipped ahead of QE, not what should be happening for his inflation pump to work. Instead of inflation, Bernanke is risking margin compression: the inputs rise, but prices of end products remain about the same, squeezing margins. 

He is also trying to drive the Dollar down in an ill-guided attempt to increase US exports. Exports of commodities respond quickly to changes in relative currency rates, but end-products are much stickier. The impact of a lower Dollar will be higher inputs (imports) and less return on about the same exports until the expectations of cheaper end-products causes sales and pre-existing contracts to adjust. This means the "net export" component of GDP is likely to be hammered as imports rise (in price) and exports fall (in value). 

The Dollar Index broke a critical trendline today, plunging below a support level that had held for three years. As you can see from this chart, a day before the QE announcement the Dollar Index was sitting on the line:

Breaking it is bad news for the buck. What usually happens with a break is a retest from below. If the Dollar can recover back above, it was a False Break, largely driven by getting caught in the turbulence of the QE announcement as central banks adjust. If the retest fails, we may see the Dollar kiss that trendline goodbye for a while. You can read more analysis at Slope of Hope. 

The macro forex environment will now become even more turbulent. Many Asian countries rely on pegs to the Dollar to keep their currencies cheap, and they will now have to intervene. This puts them in an awful trap, as intervention risks importing inflation, but letting their currencies rise risks slowdown of their export-driven industries. 

In all of this, stocks rose today. Perhaps it was but a momentary spike, as Neely opined in a special bulletin. If so, we shall find out shortly, as stocks should reverse down. Yet it might instead be a Bernanke Put (see next chart). There has been some suggestion that he is purposely targeting stocks, perhaps in the hope of generating a wealth effect to pull more spending into the economy. This is quite a change for a one-time monetarist, watching stocks and not the money supply or surrounding indications of inflation, such as commodity bubbles. 

Market After the Mid-Term Election

Uncertainty is now behind the market. The R's accomplished the biggest wipeout of the party in power since 1938, a fitting year given all the macro similarities. The Fed's QE2 announcement at $600B was pretty much as expected. And Jerry Brown as the governator of California again somehow seems fitting.

You can understand California's economic dynamic as Era of Growth vs Era of Limits, or as Pre-Brown and Post-Brown. For those of you who are Back To The Future fans, it is his "density" to preside over the consequences of his decisions 30 years ago. Optimists in the once Golden State hope he takes on the unions. What does he have to lose? And only Nixon could go to China. Pessimists are preparing to leave. Will California be the next bailout? We'll probably get a read on this pretty quickly. 

We should get a pretty quick read on this market as well. The STU is hanging onto their ending diagonal, which would be in its final spike up. Recall that it should not get above Sp1208. Their alt count is the thrust out of a triangle, which could go higher, but should not breach the April high of 1219, or their whole model is wiped-out as much as the D's yesterday. Given that the Dow has already broken above, the Election QE Wave may roll over their wave count. For a clue, watch the Dollar Index. It was supposed to retest its recent low at 76.14, but held up last week. Today the QE2 moment got it back down near there at 76.22, hitting the trendline that has provided support for the past three years (70.70 in Mar08, 71.31 in Jul08, 74.19 in Dec09). The last time it bottomed (Dec 2009) it had a sharp thrust down, then a retest that fell short, then a huge up move in a short time. 

Question of the Day: Are Markets Waiting to Fade the Election Rally?

There is a general trader view to let the election come, then fade the market. This is no more profound than "buy the rumor, sell the news." More likely, the market stays a bit longer, waiting for the Fed's QE2 announcement the day after, since there is a well-known FOMC pattern: the market usually rises into a FOMC pronouncement, then falls. The question du jour is, does the market follow a simlar pattern during mid-term elections?

Bespoke provides a wealth of data for elections and markets, worthy of baseball-statistician-turned-political-poll-watcher Nate Silver and his 538.com. Stocks normally do well on election day and the days after: a gain of 53 bp (0.53%) since 1970. Before 1970 the market was closed on election day, and looking at the day after as a surrogate, markets have been up 28 bp since 1900, vs. the average of 3 bp for all trading days. Over election week the mid-term election gain has been almost 1%:

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The fundamentalist point of view is that QE2 will not do much to help the economy, especially when the expected Tea Party victory will turn fiscal policy towards austerity. Trader's Narrative reports that the word from the pits in Chicago is that the average response from the primary dealers is to expect $930B of QE, but very few expect anything beyond $500B to be announced, setting up the market for a missed expectation and a drop Wed.

The technical point of view is that the market is nearing a top of sorts, even from the bulls such as Carl Futia. The ever bearish STU sees the S&P in the final throes of an ending diagonal, which requires one more sharp move up - perhaps the election day rally. This structure limits the rally to below Sp1209 (or wave 3 would be shorter than wave 5). Their alt count is a running triangle (which has a large second leg) that also means a sharp rally to come. (The current waves do not meet Neely's definition of a running triangle, since leg D failed to finish above leg B.) Normally the thrust out of a running triangle goes at least the widest part of the triangle, which would target 1214.

Under Fractal Finance we have just had a double top at 1196, and a triple top would normally be expected before a change of trend. This would be consistent with an election rally that holds below 1200 and fades. If instead we break and hold above 1196, Fractal Finance would remain bullish, as it has been since mid-Sept.

Another technical issue is an increasing divergence among the leading sectors, typical of a top. Tech stocks have been leading, and quite strongly, having run from a one-year low in relative strength (not price) to a one-year high in just two months (chart courtesy Bespoke):

The fomer leading sector of the Hope Rally, however, financial stocks, have lagged badly in the same period, and are on the verge of breaking to a new one-year low as well as breaking below a support level at 42.5 (chart courtesy EWTrends):

The irony of this divergence is that QE2 is largely designed to shore up the banks, especially in the face of a pending foreclosure-gate disaster. The banks manage the primary dealers of Treasuries, and would be beneficiaries of a concerted program of QE. They could use it to continue to swap toxic stuff out and good stuff in. For some reason the expectations of QE are not rallying the prime beneficiaries. The risk of a second wave of bank issues is trumping the QE bailout. 

Dollar Firming After G20 Failure Signals Market Reversal

G20 was a dud. The US went to the G20 to try to avoid a competitive devaluation of currencies yet redress trade imbalances, and got pushback from the Germans, among about everyone else, for hypocrisy, given how QE2 will act as a large currency devaluation regardless of jawboning about trade imbalances. When we faced a mercantilist threat from Japan in the '80, the US was able to coordinate a halving of the Dollar's value with cooperation from Germany among other trading partners. Not this time. 

While the initial reaction was that this meant a continuation of the trend since late August - Dollar down, everything else priced in Dollars up - a series of reversals began late Monday. The Dollar appears to have caught a bottom. I posted on the same theme a week ago, but the break of the Dollar at that time looked like a short squeeze, and after a sharp spike, fell back into the trading range since late Sept. That marked it as a False Break, which under Fractal Finance puts us into a wait-and-see mode for the next move.

Some pundits such as the STU expected the Dollar Index to continue down, retesting and even breaking its recent low (76.14), but a funny thing happened on the way to the retest: the G20 failure. The Dollar Index bottomed above the recent low, and has now run fairly well up above 78, approaching the 78.36 level of that short squeeze false break. If it breaks above, the STU believes it pretty well confirms the Dollar has bottomed. 

It may be a bit premature to jump to that conclusion, given the uncertainty surrounding both the mid-terms and the Nov3 Fed QE2 pronouncement. David Petch does an in depth technical analysis of the USD, and in contrast with the STU thinks we have a fake out rally for several weeks and then continue down. His chart shows his wave count and the recent trading rnage of the Dollar Index around 77:

To add a third pundit, Neely expects a several-week Dollar rally and Euro weakness, but not a change in the Dismal Dollar trend. And to add a fourth, here is a longer-term Dollar chart as of last week, which this commentator took as bullish:

My take: along with the pundits, the forex market is now confused as to the Fed's intentions, following the failure to get any coordinated approach out of G20. Goldman first speculated that QE would be $2T, and more recently said $4T for the Fed to accomplish its purpose. They also say it is unlikely the Fed would announce even a $2T program. Instead, what has been pre-announced is $100B to start and then play it by ear. 

Besides the Dollar, however, we have other reversals, starting with a (momentary?) end of the slide in bond yields. This has impacted the possible Dollar bottom; or is correlated to it. A few weeks ago the differential between rates in Euroland and the US were favorable to the Euro, but the gap is closing. The market may be expecting the ECB to monetize in order to prevent a slowdown, or perhaps has priced in any expected ECB rate increase. In either case, the Euro rise against the Dollar has reversed for the moment. 

Perhaps US bond rates have bottomed. Bill Gross of PIMCO made a splash today repeating his theme that the 30 year bond market is over and trash-talking QE as a ponzi scheme that won't work. Bespoke notes how the Long Bond broke support in the last two days, contradicting the argument among bond traders that the bond trade can't lose! because either the economy strengthens, and the Fed keeps rates low; or the economy weakens, and the rates stay low. 

PIMCOs argument is based on QE causing inflation. Not clear it will, as I explored in my prior post; and as noted above, Goldman thinks at least $4T would be required to spur a 2% inflation. Yet an indicator of future inflation gave a stunning signal this week: the inflation-protected TIPS bonds went to a negative interest rate for the first time:

At first glance paying a negative rate may strike you as dumb, but TIPS are instruments which gain in principal depending on the CPI (see table). They can make up for a negative interest with an increase in principal. The spread between the TIPS and the Treasury of same length is the inflationary expectation. Currently the negative rate of -0.55% means the bond market is expecting 2% inflation - spot on the stated intent of the Fed. 

The five-year TIPS had briefly gone negative in August, and has been trending around zero since mid-September, but this dip to 55 bp under raises an interesting risk for investors: if the economy remains weak and inflation does not re-emerge, you will end up paying the government to hold its bond. Given how uncertain are both QE2 and its impact on inflation, this seems like a poor bet. 

PragCap makes an even bolder argument: that QE is DOA already, even before it has been launched. The 10-yr Treasury has only moved 34 bp since the QE2 was first rumored back in early August. Since Bernanke's Jackson Hole speech at the end of August, rates haven't moved! 

The implication is really nasty: QE2 would inflate commodities, meaning the inputs to production, but not cause inflation in prices, the output. Instead of restarting production, it will force it into margin compression. We also saw this in the Great Depression. Rather than helping get us out of the mess, it will push us in even deeper. 

If QE2 Flops, Will Stocks Dive?

There is a general belief that the pre-announcement of QE2 in late August drove the September-to-Remember rally. The market is in a sloppy, overlapping wave action seems to be somewhat headed higher pending the mid-terms on Nov2 and the expected QE2 announcement on Nov3. This indicates it is churning ahead of those events. It is beginning to take the shape of a converging wedge or ending diagonal, although it is not following the rules, according to the STU. Perhaps it gets to 1220 or thereabouts in a final thrust, but it is behaving as if it will hold up into those dates. If so, we may have a double setup for buy-on-rumor, sell-on-news.

I have already discussed how a Repub victory would likely lead to gridlock, and gridlock may not portend well for stocks. Mad Hedge Fund Trader goes further and characterizes gridlock as a market myth. When the Repubs embraced supply-side economics (aka voodoo economics) in 1980, gridlock with a Demo Congress/Repub President created a dynamic of increasing spending, eschewing the balanced budget, as shown in this chart. Milton Friedman had argued that large deficits would constrain spending increases, and Congress proved him wrong. Bush 42 began to reverse the deficits, and this continued under Clinton, especially after the Repubs took the House in 1994; deficits decreased and we got the fabled balanced budget. Possibly, then, gridlock with an austerity Congress will constrain spending, but after 1994 we had a President willing to triangulate to the center, whereas Obama seems determined to hang onto his reforms.  

Similarly, the Fed's actual QE2 announcement is fraught with risk for stocks. There still is a debate inside the Fed as to how large and committed QE2 should be. At one end Krugman urges as much as $10T; and the other is the feeble talk of a mere $100B. If a large slug of QE2 is priced in, the actual announcemnet may disappoint.

Let's go a step deeper. Krugman's call for $10T QE is not as dangerous as it sounds. The hyper-inflationists hyper-ventilate that this is simply printing money! Yikes!

They need to get a grip. It may very well be that even Krugman's QE would have little effect. John Hussman, coming from a very different perspective, essentially agrees. He starts with the impact of being in a liquidity trap, captured in this chart:

Cutting through the fairly dense econo-speak that surround the concept of a "liquidity trap", what this means is at zero interest rates, a short-term bond is the same as cash. Get a bond that pays no or little interest; why not just get a batch of currency? So when the Fed engages in QE by buying bonds, it is not so much printing money as simply swapping a bond that would have issued anyway for currency. 

Hussman's analysis is interesting in that it challenges the deeply held belief that increasing money is what causes inflation. He shows that as the currency base increases, velocity decreases, offsetting the inflationary impact of more money. Mish does a good summary of the analysis. The implication is that monetary manipulations have less impact than economists take for granted. This explains why QE had little effect to save Japan from its two lost decades. As Hussman summarizes:

Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity. ...

Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5-10 year total returns below 5% annually). The Fed is not helping the economy - it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

Hussman is now in agreement with Krugman on the impact of QE. Credit Writedowns does a good job of comparing the two arguments:

Krugman says that the result of this equivalence between short-rates and cash means that the Fed’s QE is really just a duration change by the Treasury.  In quantitative easing, as contemplated in this next round, the Fed will be buying long-dated Treasuries. Given the preceding analysis, it’s as if the Treasury started issuing a huge slug of short-term debt and retired a bunch of long-term debt, making short-duration bills relatively more plentiful than ten-year or five-year Treasury bonds. I really didn’t think about it this way until I put the Hussman piece together with my November article.  But Krugman’s characterization of this is true. 

Hussman goes one step further, however. He has a view of what would create inflation, or the dreaded hyperinflation:

One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data, and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970′s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers).

My take: the Fed has now created an Expectations Trap: if they fail to deliver the high expectations of QE2, stocks will fall. If they do deliver and it has little impact, stocks will fall. For traders the arbitrage is between the Nov3 announcement and the discounting of future ineffectiveness of QE. 

Dollar Reversal May Unwind The Presumptions Behind the September to Remember Rally

The Dollar has continued the break up since Friday. The reversal has been strong and has all the earmarks of a short squeeze. As I noted a few days ago, the net short position was quite large. This chart from Credit Suisse shows how deep the Dollar bearishness got:

The break up has formed a nice 1-2-3 pattern, which under ewave suggests it has more to run in wave 3 and beyond. It has also bifurcated out of the recent trading range, which under Fractal Finance means we have a trend change, unless it reverses quickly back down. The STU yesterday was written by Peter Kendall, who has a different style than Steve Hochberg who normally writes it, and as it has for several issues, it started with the Dollar. The bounce since Friday traced an initial five-wave pattern and corrected yesterday in three waves. The strong move today confirms the change of trend up. You can see the bifurcation above the recent trading range, and the turning up of key sentiment indicators, in this chart from EWTrends:

If this Dollar Reversal continues, the most immediate impact should be on commodities and gold. Oil and gold fell today. Treasury yields have reversed up in the last few days, despite the overhang of QE2.

The most interesting move today came from China, where the PBOC raised rates for the first time since 2007.  China continues to be concerned over inflation and other signs in internal overheating. Growth in Europe and Japan has been turning down, and China may follow. The global economic recovery may be topping.

Optimism still rules in stocks. Carl Futia sees a short-term consolidation before a continuation of the uptrend, targeting 1300 by April 2011. Goldman Sachs has provided their guidance, with targets of 1200 by YE and 1275 within a year:

What is noteworthy is Goldman sees continued earnings growth but fading PE, and hence less of a rise in the S&P even as earnings get back to 2007 levels. Carl's key chart also shows a triple top in the e-mini followed by a bifurcation below the recent trading range, which under Fractal Finance indicates a top, not a consolidation:

The case for bullishness rests largely in fundamentals: QE being good for stocks, and continued earnings growth. If the Dollar Reversal continues, score one for technical analysis, since the overhang of QE would not have caused fundamentalists to expect the bounce. So what about stocks?

One of the better technical indicators at a top is to watch the leaders fade against the trend. While Google popped well after their earnings, Apple, IBM and Amazon all showed weakness. Apple in particular may have been priced to perfection, and yet the reason for the drop after hours yesterday seems spurious: while revenues and earnings blew away expectations, iPad sales were lower. Being in the Silicon Valley community, it is clear that iPad missed due to supply not demand. Apple is selling every iPad they can build. Hardily the cause for pessimism. Perhaps Apple will be back on trend in a few days, but if it and the other tech leaders lag despite good fundamentals, it signals a reversal brewing.

Nowhere is this clearer than with bank stocks. They led the rise off March 2009, and were a huge percent of both earnings growth across the whole S&P and market volume. Facing all kinds of pressure due to foreclosuregate, including threats of buyers of their toxic junk wishing to put it back, financial stocks may be in for a tumble. And indeed, Shanky noted over the weekend (and I also received charts from readers via email) that the banking stocks were noticable laggards:

The bears are being cautious, but some are growling. PrincipalAnalysis thinks a big drop is next, and gives levels that would change his view: SP1177 and Dow 11068. The drop looks like a reverse of the Dollar break up, being a wave 1 down, a wave 2 correction,and now we appear to be in 3 down. The levels to watch are the wave 2 highs, which should not be broken if a big drop is right ahead:

Dollar Spike on Friday May Be the Bottom

Once a trend makes it to a major newsweekly, it is usually over. By the time the mainstream media spots a trend, it has already been fully baked into the market and is about to reverse. Historically the newsweekly is Time, although it is hardily the trendsetter it used to be. This week's issue of The Economist has Currency Wars on the cover. Does this signal the end of the free-fall in the Dollar?

I have been noting that 76 in the Dollar Index is a key level, representing the confluence of two trendlines: the down-sloping trendline of the dramatic fall this past two months, and the up-sloping trendline off the prior two bottoms. 

The Dollar Index (DX) fell to 76.14 on Friday, and then bounced to 77.13, a large move. This Sunday evening it has gone above 77.20, then stepped back a bit. When the machines come on in Europe, we may find out where the Dollar is really headed, but this sort of V-shaped bounce is what we should expect at the bottom after such a sharp fall. 

If the Dollar does bottom, it could be expected to run up towards DX100 by 2012, a strong move that would reflect expectations of deflation coming from debt destruction. Possibly the foreclosuregate scandal will lead to mortgage write-downs that spawn the debt-deflation spiral we have so far avoided. Consensus expectations remain that the Fed can prevent deflation, especially with the injection of QE. In the short run, expectations of QE may be so baked in that any slippage of resolve may by itself reverse the Buck. In the longer run, however, it cannot be presumed that QE will prevent deflation. Massive injections of liquidity since 2000 have failed to reflate, as measured by CPI or the GDP deflator. Velocity of money continues to decline. 

The argument that the Fed cannot prevent deflation is one of Prechter's core assertions going back over 10 years. I first blogged about it in 2003. You can read his argument in this excerpt from his book, Conquer the Crash. He has been way ahead of the curve on this issue. His short term update service (STU) has been focusing more on the Dollar lately than stocks, with this observation Friday:

The U.S. Dollar rally appears to be starting. The stock rally is overbought and overbelieved. The conditions are in place that makes a stock market decline a high probability. 

In the larger picture, however, the Dollar may still be doomed, which means it has farther to fall in the Dollar Index. Joe Russo provides a Big Picture view of the Dollar, using the next chart as a backdrop to several scenarios going forward. 

The chart shows the bottom (listed as green C) at the end of the Carter years, followed by the Volcker Rally into 1985 (green D), when the Plaza Accord coordinated a rapid 50% drop in the Dollar. Under Robert Rubin during the Clinton years (blue A), the Dollar strengthened until the dot-com bubble top (blue B). Since then the massive injection of liquidity by Greenspan and Bernanke has driven the Dollar down to historically low levels (red A). 

Russo views this falling wedge pattern as "no better pattern from which our financial masters of illusion could better engineer the most orderly and flexible destruction of currency." He proposes three scenarios:

1. bounce off 76, continuing a cyclical bull into 2012 (red B in the chart)
2. continued slide to 70.70, testing the recent low (red A), before the rally
3. "total destruction" of the Dollar by 2017 if we break 70.70

Whew! We found a technician more bearish than Prechter! I think what Russo is overlooking is that the US is not acting in a vacuum, and has much less leverage now then it had in 1986 (Plaza Accord) or 1971 (going off gold), let alone after the wreckage of WWII (Bretton Woods). Already economic indications are showing an effect of the possibility of QE2 driving the rapid drop in the Dollar: the Eurozone is slowing, and Japan is on the verge of recession. The developed countries therefore have an incentive to stop the Dollar slide. In effect, the US needs to coordinate debasing the buck along with the Euro, the Pound and the Yen; by debasing them together the emerging market currencies (particularly the Chinese) will be forced to rise. 

We shall see how this plays out in fairly short order, as G20 is soon to meet. My bet is the Dollar rises into those meetings and continues up into the next election. 

Dollar is Finding a Bottom

In the last two days the Dollar appears to be forming a bottom. You can see in the attached chart how its rapid decline has paused, and it even spiked above the upper trendline of its descent. Overnight it has fallen back inside, and it still may get to DX76 before bouncing. Currently it is right above DX77.

EWTrends adds to this a discussion of the circled technical indicators, which appear to have reversed. 

Sentiment is more bearish than at any time in history (at least since the Dollar was finally severed from gold in 1971).

The downward momentum stalled late last week when the Euro hit $1.40. The AUD is hovering around 98c and flirting with parity, hitting 99.2c so far.  

The most crisp analysis comes from Credit Suisse, which predicts a 100% chance of a rally from here based on net speculative positions. They believe QE2 has been fully priced into the USD "and then some." 

The Dollar Runs Into the Triffin Dilemma

Ever since the Fed pre-announced QE2 (and QE Lite) at the end of August, the Dollar has fallen sharply, and other asset classes (stocks, bonds, commodities) have risen in Dollar terms. There is nothing in the economic fundamentals that should drive those assets to rise, as economic news in the US is ambiguous at best if not worsening. Indeed, the continuing 'recoveryless recovery' is the prime reason for the Fed to consider QE2. 

The Fed is running into the endgame of the Triffin Dilemma, an eventual day of reckoning of the reserve currency that was noted in 1960 and reiterated in 2008: the nation that runs the reserve currency gets a seemingly free benefit of being able to consume more than it produces since it gets to (indeed has to) run budget deficits along with trade deficits to create enough global currency liquidity; but inevitably the value of the reserve currency falls as foreign accounts hold more Dollar claims than the US GDP can support. 

The good news for the Fed is that a near-term bottom for the Dollar may be in reach. The Dollar is rapidly approaching a support level in the Dollar Index represnted by the lower trendline off the two recent bottoms (chart from PragCap):

The Dollar Dive is also running in a channel, which is expected with a zigzag style correction, and the lower trendline of that channel hits the rising trendline of the first chart at the same area, DX76:

You might wonder how the Dollar could bottom when QE2 has not even been launched. Why wouldn't it continue to dive as the Fed proceeds to execute on QE2? Markets may have already anticipated the impact of QE2 and reacted. Goldman Sachs believes QE2 is largely priced in, estimating that $1T of QE is priced into bonds (see chart) and stock traders have taken positions expecting $500B of QE:

Goldman may be too conservative with respect to stocks - the Wilshire5000 has already gained $1.3T of market value since QE2 was announced. This continues a trend since 2000, where the drop in the Dollar (from 120 to under 80 in the Dollar Index) has kept stocks afloat in nominal terms even as they have plummeted in real terms.  This chart from The Big Picture shows the S&P in gold (blue line) vs the S&P in Dollars (red line). One looks good, the other is bad.

Econbrowser agrees with Goldman with respect to bonds, then raises the question of why commodities have risen when inflation expectations (as reflected by lower long term bond rates) are absent? This may be one of those cases where economists are still fighting the last war (the '70s) and not looking at the current fight (the credit bubble), where commodities are up in Dollar terms because the Dollar is down, not because of a rise in inflationary expectations. We saw this in 2008, with oil running parabolic well after stocks had turned down and deflationary fears ran rampant. 

Bullish optimists point out that if the market has already priced in QE, maybe the Fed can skip it altogether? The mere "Bernanke Put" to prevent deflation at all costs may be enough.

This brings us back to the Triffin Dilemma. I have discussed previously how the apparent free lunch of endless budget & trade deficits, which enable the welfare state as well as cheap goods from China, has a terrible cost, but one that only becomes apparent after years of living high. That cost is the eventual erosion of the currency. 

The Triffin Dilemma can be managed by increasing interest rates at about the same rate of foreign clams, which should maintain the foreign exchange value of the Dollar, but that option seems unavailable to the Fed which is trying to restart commercial lending against deflationary headwinds with ZIRP (the Zero Interest Rate Policy). Or, the Fed can try to manage the decline of the currency via inflation at a pace somewhat in balance with the increase in foreign claims (in effect debasing the currency as fast as foreign claims increase, keeping real debt even), but it is having a devil of time trying to reflate. 

In 1933 the US could reflate by going off gold, and had the benefit of doing so after a huge debt-deflation spiral that rid the wold of excessive Dollar indebtedness. This time we went off gold 39 years ago, and cannot pull that trick again; and have kicked the can down the road on deleveraging at scale, and thus have been unable to restart lending, which is how money is "printed" in the fiat currency regime. 

I see bloggers opining that since QE1 failed, so will QE2. The comparison is inapt as QE1 sprung from a different purpose, to essentially back the failing interbank lending markets, as I describe in the post Peak Debt. The Fed has been calmly trying to explain this and apparently falling on the deaf ears of noisy bloggers. Still, there is a big lesson to be learned. During QE1, commercial credit fell, which in effect sterilized the impact of higher reserves. 

John Mauldin has a good discussion of why QE2 may fail. One issue is that the banking system has not been fixed, and so QE2 may not spur any increase in lending; if anything, with the foreclosure mess brewing, more rapid debt deleveraging seems to be ahead. That is deflationary, and the size of potential debt destruction dwarfs the scale of QE2. Also, QE2 has already spurred competitive devaluations from countries such as Japan, and if a general Currency War erupts, as predicted by the head of Brazil, we might see most major currencies race for the bottom, and ironically the Dollar might rise based on falling less fast! At the moment, however, there is no general debasement of currencies. 

Intrade Markets Make the Mid-Term Anything But Dull For Investors

One of the most interesting phenoms of the Internet Era is the remarkable predictive value of synthetic trading markets like Intrade. My son did a study of the predictors of a movie's success used by Hollywood, and found the synthetic trading market among Hollywood insiders was more predictive than the studio heads and all their models. These markets are of course widely used for predicting elections, and you can scan Intrade to see how your favorite candidates are doing.

Yesterday Joe Biden at a fundraiser quipped "You're the dullest audience I have ever spoken to." Normally a midterm election is fairly dull. A study shows that of the 27 midterms since 1900, the party in power only changed 7 times, and the change occurred in both houses of Congress only 4 times. The stock market appeared to be a non-factor.  War is a bigger factor, with the change occurring only once in wartime (2006). 

This one is anything but dull, and raises the core question for investors: does the switch in power have any predictive value for stocks in the next two years?  Normally the two years into re-election are good for stocks:

Most investors remember how after the switch in 1994, the market took off in one of the greatest bulls runs in history. Based on the seven change midterms, one can say the market should be up: in the four where both houses switched, the market was up 3 times; and in the three when one house switched, the market was up one year later in two of those years, and up two years later in another two (but not the same two). Now, the market tends to be up; it is flat or up 80% of the time. When no change occurred in the midterms, the market was normative, up 80% of the time. Hence, these historical comparisons have too little statistical predictive value.  

More important is the reason for the likely switch: a strong desire to cut spending and end the bailout culture. This suggests the new Congress will change course from the past decade of easy credit and large deficits. The more dramatic the change of economic policy, the more unpredictable the markets will be. And it seems increasingly likely that a major change will occur. For a while the Intrade markets have shown the House likely to switch:

Today the Intrade prediction of Biden's party holding onto the Senate went below 50%: 

Is QE2 About to Launch?

ZH ran a scare piece of the Fed announcing a $3T QE2 on Nov3, election day, which they argue would send the USD to the floor, gold to the roof and spawn a huge speculative fever in about everything (stocks, bonds, commodities) until it brings down the global financial system. Whoa, baby! Rein in those bearish emotions. 

Even Prechter is not this bearish. Prechter's view is the opposite, that the Fed is powerless to stop deflation, and such a dramatic move is not to be expected, or won't be tried until the very end, sparking a bout of hyperinflation .. but not now. He comments on QE here. (You may need to join Club EWI to read it, but to join is free.) He provides a longer transcript of a discussion about deflation and the Fed here. His core point: there is more debt out there that is worthless (but not yet written off) than the Fed can monetize, even with $5T of QE.

Not to be deterred, ZH ran a follow-on piece which still sees at least $1T of QE2, which would make a mockery of statements by Geithner.

Something has changed, however, ever since expectations of QE2 became consensus. The two-year bond is at record low yields, and the Dollar Index just broke below 79, falling very fast over the past week. Only 4% Dollar Bulls left, so some sort of low seems imminent. Chart courtesy ContrarianAdvisor:

Ed Harrison puts some welcome perspective on QE2 (and provides the fine picture of the boat above) when he notes that QE doesn't really affect the economy since the new money just sits in a bank vault (or reserve account) rather than be lent out. John Mauldin in Pushing on a String explains that QE has had little effect so far as the excess simply went into reserves, not new lending. He notes an analysis from a former Fed governor that says even $2T of QE2 would have a modest affect:

• lower Treasury yields by 50 bp
• increase GDP growth by 0.3% in 2011 and 0.4% in 2012
• lower unemployment rate by 0.3% at YE11 and 0.5% at YE12, still over 9%

Morgan Stanley believes much of these effects have already been priced into markets, based on recent comments by Bernanke. In any event, Mauldin does not expect the Fed to drop the QE nuclear option unless GDP comes in weaker than last quarter, currently at 1.6%. We shall learn more Thursday this week with the final Q2 revision. The Q3 estimate comes out Oct29, right before the election. Since QE2 will be good for stocks, at least at first, paradoxically a poor set of GDP reports may be bullish! Probably some speculation of how this will turn out is already baked into this rally - after all, the September-to-Remember Rally started right after the Fed's big policy offsite at the end of August.

What this sanguine analysis of QE2 leaves out is the effect on the Dollar. Ambrose Evans-Pritchard believes the Fed's real goal is to weaken the Dollar.

The US may be acting in a coordinated way all of a sudden. Besides a weaker Dollar, why not a stronger Yuan? Pressure is back on China to revalue the Yuan upwards in what some are calling Currency Wars.

A trade war is brewing; China, Japan and the US are all at odds.

Our esteemed Congress is debating a punitive tariff again, this time on a case by case basis by affected industries. Our inestimable President issued an ultimatum to the Chinese premier in the Security Council chamber at the UN on the autumnal equinox last week (Sep23), surely a poor use of the place dedicated to preventing conflict.

The last time we did something like it was against the Japanese, in 1986, who meekly complied, leading to the '87 crash, the Japanese bubble and the Japanese crash of '89. We did it then to make the US more competitive, but instead it made the Japanese companies strive to get even more efficient, and made raw materials cheaper to them than to us. We got less competitive until we finally got serious about our own corporate restructuring in the '90s. The Japanese took a 75% bath on their US debt holdings by the 4x relative rise of the Yen (from 0.25c in the '70s to 1c in the late '80s) - and a 50% loss in in one year after the US pressured them when the Yen rose from 240 to the Dollar to 120 - an absolutely huge loss of national wealth. 

This time around the Chinese hold all the cards, and are not about to let the value of all the US debt they hold be thrown away by a cheaper Dollar. The QE2 ship may be launched, but not leave any benefit in its wake, just a larger deficit and a weaker Dollar. No wonder Bernanke has been imploring Obama to fix our profligate fiscal policy to right the Ship of State. 

Beware the Elephant!

"Gridlock is good" - apologies to Gordon Gecko, Wall Street

This is curiously interesting: The Curious Capitalist (part of Time) reports that the Dem's do more for stocks than Repub's when the opposition party wins back Congress in a mid-term, creating gridlock. Idle chatter on top of that is that 2010 is shaping up like 1994, which helped launch the dot-com bubble. So the expectations of a change of Congress is driving stocks up.

While this chart is more intriguing than statistically meaningful, it does challenge that view. Maybe in general gridlock is good for stocks, but in a poor economy, Time argues it may be more bullish for Dem pump-priming to drive stocks up into the 2012 election. 

Does the 1938 Analogy Indicate Bonds Are Topping?

I have posted a series of analogies in stocks to 1937-8 and more recently to 2008. These analogies are interesting although not predictive unless the underlying conditions are creating a similar investor psychology. The 1937 analogy seems particularly apt because a change in fiscal policy - a withdrawal of stimulus - seems to have caused a double-dip. (It certainly caused a roller-coaster of endless academic debate.) The greatest Keynesian Cheerleader of them all, Paul Krugman, is now analogizing our policy environment to 1938. 

We still seem inside those analogies in stocks. The 1937 picture would have predicted a drop off the August high (we got it) followed by a rebound that stalls below the August high (we are in the rebound, do not know where it will go). The 2008 analogy says after the August drop we come back to retest the August highs, then fall off a cliff. Both have a few weeks to go before they really get tested.

I am now seeing a similar analogy game applied to bonds, specifically Treasuries. PragCap compares our current rates to those in the 1930s, and speculates that we are coming soon to the end of rate drops:

 

The question is why will the Fed raise rates, especially after the recent public comments about QE2?  EWI continues to argue (convincingly) that the Fed responds to changes in market rates, rather than drives them. 

 

PragCap goes on to answer the question they raised, and the answer is consistent with the EWI perspective: rates will flatline when the recovery commences, since demand for borrowing will cause market rates to turn back up. The analysis is also why low rates are not inflationary, since they have not led to increased lending (or borrowing); only a recovery will do that. 

Yet how close are we too a recovery and thereby a top in bonds (and a bottom in rates)? You can read my countdown to the double dip in prior posts, in which I conclude that we are unlikely to dip until 2011. Even now the signals are still ambiguous. 

Instead of an imminent top, bonds have more to rise. R&B Capital put out a report on a massive decline in yields that got a lot of play. Barry Ritzholtz picks up this theme, and provides this chart showing that 20-yr government bonds are high compared with benchmark interbank rates in both the US and UK:  

 

The implication is that the mid- to long- end of the yield curve has room to keep dropping. 

Yet we have had a really strong rise in bonds over the past few months, the type of race to a category that ends badly, or least is likely to correct rather than continue. When you compare stocks to bonds over the past decade, bonds can be argued to be approaching a blow-of top of the sort stocks hit in 2000:

  

That correction may have started. 
 

The Market is Looking Like 2008 All Over Again

After a crash as we saw in 2008, the punditry launched rationales for various crash analogies - 1929, 1987, Japan, etc. A veritable fleet of analogies was floated into the blogosphere. By themselves these comparisons are intellectually interesting and little more - it is not sound to extrapolate from a one-time sort of event. Market patterns reflect underlying psychology, so when a pattern is correlated to similar exogenous conditions, the odds of some level of predictability rise. This is why the 1937 comparison appeals to me, given the high-level similarities:

• crash in 2000, crash in 2009
• strong rebound off the bottom in 2003, rebound off 1932
• lots of stimulus and govt interventions in '04-08, similar in '33-'37
• recovery turns south in 2010, recovery faltered in 1938
• sovereign debt problems in Europe 2009, similar but not as severe as in 1931

This time around we avoided some crucial errors, especially the Fed intervention in 2008, which prevented the sort of freezing-up of the banking sector that we saw in 1931 after the Bank of the United States failed in Dec 1930; this may be a primary reason why the 1929 analogy failed to fit. There are also significant differences in the 1937 analogy, which is why it has been a bit remarkable that Summer 2010 is tracking closely to 1937 (with update posts here and here). 

In terms of timing, starting with 2000=1929, the tighter comparison would have been 2008=1937, not 2010=1937. Remarkably, the pattern we saw in the summer of 2008 seems also to match very closely as well to the market in the past few months. The exogenous events are also, oddly enough, lining up, especially the upcoming election: 

• back then we had a choice of a remarkable emergent force for change & historic figure (Obama) vs what looked like continuity with failing policies
• this time we have the a remarkable emergent force for change (the Tea Party) vs what has turned out to be less of change than a doubling-down of prior bailout/stimulus policies

The STU provided this 2008 chart on Friday, which I am reprinting with permission, and accompanied it with some interesting analysis:

 

In 2008 the peak of the summer rally happened on Aug11 with a subsequent bottom on Aug20 and a secondary top on Sep2. The "bifurcation" out of the August trading range didn't happen until Sep19, when we fell off a cliff. This time the summer peak has been Aug9, and the recent bottom on Aug25, both fairly close to the 2008 dates

You can see in the STU chart how they draw a 'plateau' around the period of Aug11-Sep19, showing the trading range. The bifurcation occurred on a second drop below the range; the first was a false break that was rapidly retraced into the range. 

The wave pattern has been an ABC flat, which has subdivided enough to have ended, or might have a small subdivision left. While the wave structure points to a drop Monday or at least early this week - and that remains the STU's primary wave count and prediction - the 2008 pattern suggests instead we meander upwards through the upcoming week (Sep3) and perhaps even a few weeks beyond. 

We just had a fifth Hindenburg Omen. A flurry of Omens does not increase the odds of crash after the second, but does strengthen the Fractal Finance case that market entropy (disorder) is increasing. (An Omen, if you recall, is when both new highs and new lows are high on the same day, plus other criteria). Entropy increases as a trading range extends, and leads to a sharper thrust out of the trading range. This means a sharp bifurcation is coming once the divergence in positions is worked out. That working-out shows up as a continued trading range. 

In the Fractal Finance view, we have been in a trading range (a "plateau") since May25 which has ranged from 1040 to 1130, with the momentary break of July 2 a False Break that was quickly corrected. The mid-point of the range is 1075. Plateaus are sideways moves like flats and triangles. and like triangles, often end near the mid-point. The recent drop off the Aug9 high also ran into a small plateau from 1074-1087. Thus a suitable end point of this whole trading range is 1074, the bottom of the recent plateau and the midpoint of the whole move. Neely as well often sees a retrace in a corrective move to the mid-point of a "box" built around the trading range. The 2008 experience, however, says the small degree plateaus are but a part of a large pattern, from Aug9 to sometime in Sep. While the 2008 pattern suggests we go higher than the mid-point, even retest the 1130 range at the top of the box, note that the bifurcation happened off the mid-point of the range (see chart and look at Sep19). 

We can now try our fourth test of Fractal Finance vs Wave Theory. So far Fractal Finance has succeeded in each test. 

• Wave Theory says the market will drop either Monday or early this week
• Fractal Finance says a trading range this week and likely longer, with at least getting back to 1075 range if not running back up towards the Aug9 high to retest the top of the larger plateau 

That 1937 Analogy Fits the Bigger Picture

Doug Short does a nice set of analyses and charts, and does a take on how well the current market is tracking 1929-1945. His key chart shows the constant-dollar S&P, overlaying 2000-present (blue) on 1929-1945 (red). It is striking how closely the key turn dates seem to line up, especiaslly with the drop in the past few days matching the red drop on this chart:

 

We avoided the big drop that they got in 1932, and have now settled into a pattern that would suggest a further drop ahead, and even a lower low than last march 2009, but not the deep collapse touted by the über-bearish commentators. His chart even suggests timing for the low: Fall 2012. 

The charts look different in nominal terms, but over longer periods the inflation-adjusted constant-dollar index is a better comparison. There are several deflators to use; Doug chose the CPI, which has issues due to changes made to 'save' social security in the 1980s. Using the CPI prior to those changes would have shown a deeper drop in 2007-9. It is striking that even with the unadjusted CPI, we fell deeper in 2009 in percent terms that at the comparable time in 1938.

A lot of these comparisons are done with the Dow, but the S&P is a broader index which should paint a more accurate comparison. It also gives a different and more troubling picture. It is well known that the peak in 1929 was not breached again in the Dow until the 1950s, and in the inflation-adjusted Dow, not until the 1960s. The constant-dollar S&P skimmed slightly higher than 1929 in the '60s, but did not get back above permanently until 1985:

Market Still Following 1937 Pattern

 In 1937 All Over Again I laid out the case that we are following the pattern of the original double-dip, the reversal in 1937 that broke the hope of coming out of the Great Depression. 

James Shaw at SeekingAlpha had first suggested this pattern back in 2008, and updates his analysis today. The chart is a bit busy, but you can see he overlays a simplified pattern of our market on top of the 1937-42 market. If the pattern continues, here is the roadmap:

• flat for the rest of August
• bounce in Sept/Oct
• sharp drop in Nov/Dec
• sickening slide for two more years
• new low in 2012

Implications of the Market Wedge Formation

Today was the lowest volume of the year. The Summer Rally usually comes on light summer volume, especially around this time which is the peak vacation period. The market is also treading water ahead of tomorrow's Fed pronouncements. The recent "leaks" over "dissent" inside the Fed & the trial balloon over a mortgage relief program have gotten the market to expect some sort of new direction. Perhaps as a consequence, the market has formed a bearish ending diagonal (ED) wedge pattern which reflects a psychology of compression pending some expected event. 

Chart from AllAboutTrends

The psychology of an ED is worth noting. We saw similar ED wedges right before the Bear Stearns bailout and the auto bailout during 2008. The compression comes from expecting something which changes the trend, in those cases from down to up (momentarily), and in this case from the growing fear of a double dip to a new round of stimulus. Usually the market rises into FOMC days, expecting a continuation of policy, and drops after when they got what they expected and nothing more. This reflects the pull of bull and bear. Tomorrow, however, the compression indicates that the market expects something new, and they may be sorely disappointed as the Fed's leaks do not mean they will act pre-emptively. Often a wedge will have a throw-over above trend before it reverses sharply down. Will the hope of a Fed change pull the final thrust out of the wedge?

The psychology of Goldman Sachs is also telling. The are worried that the Fed will delay the launch of QE2 tomorrow, and fear that would be a mistake because it is already priced in! It is QE2 or bust for stocks, ZH opines cleverly. They expect:

[A]n announcement that the proceeds from maturing or prepaid MBS will be reinvested in the bond market (most likely Treasuries). [T]he gradual tightening ... that is implied by the current policy of letting the balance sheet shrink is inconsistent with what we expect will be a significant downward revision in the forecasts of the FOMC as well as the Board staff since the last meeting

This compression also is showing up in Treasuries and the USD. The Dollar may have bottomed Friday, according to the STU, or will tomorrow; it sits in a sideways fourth wave, and a final little thrust down - which may coincide with tomorrow's stock rise into the FOMC announcement - would signal the end of the move down.

Fading the Fed as QE2 Embarks

Last week the market rose into the mid-week Fed Open Market Committee (FOMC) statement and fell after. This week the market rose for one day into the Bernanke pronouncement (breathlessly touted by CNBC) and fell hard after. This is a typical pattern of fading the Fed. 

Bernanke's comments did not inspire nor illuminate. What ZH inartfully described as the "latest compendium of mendacious vomitus emanating from the primary orifice of the Fed chairman" can be summarized in this line from Ben: "The outlook remains unusually uncertain." A riff on Rumsfeld's "known unknowns"? Worse, isn't the Fed culpable at least in part for uncertainty - especially after today? If too much leverage was the cause of the crisis, why would even more leverage be the solution? It appears the Fed is in a trap of its own making. 

The market reacted by reading Ben as about to embark on QE2, another round of quantitative easing. The Fed did not elaborate on what action they are prepared to take, but two-year Treasuries made a fourth record low in a week, and commodities popped today, probably on inflation expectations. 

 Note: given that commodities pooped, it is a useful coincidence that EWI is offering an Energy Free Week for their services. I wouldn't normally tout this except the jump in commodities today means something dramatic may be about to happen over in the pits. Worth at least checking this out.

Regardless, I believe that the inflationary expectations are ill-guided. Would QE2 drive inflation? Seems unlikely. Some reasons why:

• Mish thinks that Bernanke has met his match with consumer attitudes swearing off more debt. 
• The vaunted $1T of new reserves are not waiting to be lent out, but substituting for intrabank loans, so even if the Fed stops paying a nominal interest on them, do not expect the banks to suddenly start lending again - or the consumer to start borrowing. 
• Buying more Treasuries or MBS's will hold down long rates, but even with historically low mortgage rates the housing market is in the dumpster. 

To add fuel to the fire of creating unusual uncertainty, Bernanke was ambiguous as to how much QE2 he would actually undertake. As reported by the online WSJ (emphasis added):

Bernanke calls the outlook 'unusually uncertain' and notes that the central bank is prepared to take additional action if needed. His economic outlook sees lower than expected inflation and at best a slow pace of falling unemployment levels. He notes financial conditions are hindering growth and expects interest rates to stay low for an "extended period." At the same time, he says the Fed is continuing to think of ways to shrink its portfolio, and any asset sales will come gradually. Bernanke's comments to Congress are largely as expected, but some may be a bit taken aback by his comments on shrinking the balance sheet, which doesn't suggest much central bank appetite to provide additional stimulus to a troubled economy. Stocks are taking it on the chin while the two-year Treasury yield is hitting yet another record low. The dollar is holding pretty steady.

The punditry will opine that stocks fell on the pronouncement, but they were falling all day from the opening gap up. That gap was closed, suggesting an exhaustion gap, a bearish signature. Today's STU was fairly sanguine about the market, ignoring the Fedspeak altogether and noting that the reversal back up was merely a day long and went back a normal amount for a minor degree wave 2 (60% in the Dow). In addition, they have seen a sharp spike to end rallies since the Flash Crash, and today was no exception: the gap up was due to enthusiasm about the Apple earnings after the close yesterday. The "gotta own it" stock was unable to sustain any sort of rally. After a possible gap down tomorrow, they expect another, smaller rally and then a rollover, which would be the dreaded 3 of 3 of 3 at four degrees. 

 The bullish Tony Caldaro has a different take:

Looking back, this market has now spent the past two weeks essentially between these two pivots [Sp1058 to Sp1099]. We continue to believe the market is currently building a base after the initial rally from SPX 1011 to 1099. The next couple of days should be important for this potential new uptrend scenario.

The bullish Carl Futia, who also thinks the market is building a base to run to Sp1145-1150 (consistent with the Big Tease count) had expected a start to it today, not the mid-day fade back down. Here is his mid-day chart from yesterday:

 

Tomorrow will give us a bit of a read, but the real threat is late Friday or next week if the STU Rollover comes to pass. 
 

Peak Debt

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved. - Ludwig von Mises

The Government Bubble has burst. This is the last bubble, after housing (2005), stocks (2007) and commodities (2008). The Tea Party spirit has infected concerned citizens worldwide as part of the Global Political Awakening, a term coined by Zbigniew Brzezinski to describe the effect of technology (television and the Internet) on the global community. The awakening has been a reaction to transnational elites and manifests in many ways locally. In the West it is leading to a pullback from stimulus and a return to fiscal austerity. 

The recent G20 meeting was a repudiation of Obama's call for more stimulus. Before the meeting, Geithner revealed the US agenda, to encourage the rest of the world to stimulate so as to improve US exports. After the meeting, although Obama tried to spin it as a success, the G20 communique roundly rejected any further stimulus, with a target of halving deficits by 2013 and reducing debt-to-GDP levels by 2016. 

We are all Greece now (see picture): austerity measures are being put in place well beyond Ireland, Greece and Spain, and now include the UK, Germany and France. The German efforts are focused on more than deficit reduction; they plan to cut spending as well as debt. 

China has been tightening for a while, and the effects are beginning to be felt: slower car sales, softening manufacturing, beginnings of a collapse in property sales, and rising risk to Chinese banks. The Baltic Dry Index, which measures ocean shipping costs and is driven by Chinese activity, has continued to fall: down over 50% and falling for 31 consecutive sessions. It is now back to March 2009 levels and seems headed to the generational lows of the Lehman crisis in Sep 2008. 

Even the lone holdout, the US, is having difficulty pushing the Stimulus Agenda forward. The Senate blocked Stimulus III and seems unlikely to bend. The House has tried a Stimulus Lite bill to extend unemployment through November (mid-term elections - get it?) but that too is likely to fail in the Senate. 

The US may still pass the financial regulation bill (FinReg), although even that is a bit uncertain with the passing of Senator Byrd, Democrat. (And in a truly odd moment where politics make strange bedfellows, or perhaps he just has a tin ear, the first Black President, Obama, spoke at Byrd's funeral, even though Byrd was notorious for being a leader in the Ku Klux Klan and for leading a filibuster against the 1964 Civil Rights Act.) Despite characterization as a major change in regulation, so far the banks which are TBTF seem to be unconcerned. The FinReg bill has been denuded of most of the major changes (eg. derivatives, proprietary trading), turning it into vacuous soundbites without teeth. 

The FinReg bill will have the perverse result of further freezing credit to consumers and small businesses. Instead of setting rules, it primarily sets up new regulatory bodies who will take several years to promulgate new rules. Community banks and business credit to consumers is expected to stay frozen during that period, exacerbating the credit crunch that is stifling the growth of American business. 

There was some recent blather about an improvement in consumer credit, but this was due to a new reporting requirement, not any change in the real world. (Tea Partiers like to describe the government as incompetent; but it is also ceaselessly dishonest.) As this chart from the Fed shows, consumer credit continues to fall:

 

A report today on consumer credit was stunning: it fell in May by $9B, almost $7B more than expected; and that blather about a rise in April mentioned above was revised from a $1B rise in April into a $15B drop instead! The apparent flatlining seen in the chart above did not happen; instead we kept falling and the April flatline at the end of the blue line is now a huge drop. Consumer credit is back to March 2007 levels and has fallen for 18 of the past 20 months. The only holder of consumer credit which had any growth was .. (envelope please) .. the US Government. Once again all that is going on this economy is government life support, and that is no longer capable of withstanding the drop in the private sector: 

 

Karl Denninger dissects this report into charts that show consumer spending broken into revolving (credit cards) and non-revolving (cars, etc.). The YoY drop is revolving is quite steep:

 

The drop in overall consumer credit of both sorts is also clear:

With Peak Debt comes the spectre of deflation. Since credit (debt) creates money, a tightening of credit and lack of lending can lead to a fall in money aggregates. The FinReg bill combined with the shrinking of debt worldwide will shrink the money supply as well as lower the velocity of money. The money supply has been growing slower, and on some measures actually shrinking; Peak Debt might send it negative on all measures. This is the formula for deflation. The Keynesian Cheerleaders such as Krugman are oh so worried about it now that we are hitting Peak Debt.

There is confusion around the Fed's emergency measures last year which created a $1T increase in bank reserves - why isn't that hyper-inflationary? The Fed has patiently explained what they did but this seems to be largely ignored in the blogosphere, and so this 'hyper-inflation!' meme keeps circulating. At the risk of grossly oversimplifying, consider that one of explosive risks during the Fall of 2008 was inter-bank lending. A lot of checks wing back and forth between banks, and rather than physically move cash reserves around, they lend to each other. With Lehman cratering, the risk of counter-party insolvency loomed large. If some banks went under, all those inter-bank loans with them would go down too. In order to keep the checks circulating, the Fed used various methods to assume the inter-bank risk, creating reserves in the Fed but not creating new money - simply assuming existing liabilities. (This is not inflationary, simply prudent central banking.) Money of Zero Maturity (MZM) jumped $1.5T, but total debt did not - instead it peaked at $53T just as the crisis hit and began declining on the Fed's moves:

 

A little broader explanation (than just inter-bank lending for checks) of why the new reserves created no inflationary spike  is as follows:

How is this possible? It's a direct consequence of the massive intervention by the Federal Reserve: it took problem loans and structured bonds onto its own balance sheet, removing them from the likes of Lehman, AIG, Bear Stearns. In exchange, the central bank essentially "printed" money, i.e. obligations of the US federal government. Many of those bonds have since proved to be worth a lot less than the money printed in exchange, and many of them are entirely worthless.

The increase in MZM in 2008-09 was $1.5 trillion, the same as total debt. Net-net, therefore, zero. Obviously, no 10X multiplier effect came into play here, since the Fed's money went to replace debt gone bad and not as high-powered money to make fresh bank loans.

The US is about out of weapons to throw at deflation. The final play is more quantitative easing (QE) where the Fed buys up Treasuries and other financial assets, putting fresh money into bank accounts of US agencies. A target of $5T is being bandied about. Not all Fed directors are on board to set sail on QE2. 

The problem with QE2 is the marginal productivity of debt makes it of limited if not negative value. I have posted versions of this chart several times, and it shows the same phenomenon: for each new $ of debt, we get less and less increase in GDP. We are now approaching a point of no return, where we get zero improvement for every $ of debt. If you ponder this for a moment, you realize we could borrow ourselves into a hole so deep only default would get us out: more debt with no increase in production to pay for it.

With the Fed's QE1 a sinking ship, how would they do QE2? Ed Harrison speculates they would Federalize the muni market to keep our Greeces afloat (Cal, Ill and NY in particular). The Fed has already tried QE with Treasuries, MBS's from Fannie and Freddie, and similar agency paper. 

QE2 would also mirror what is happening in Europe. The ECB is buying sovereign debt to bolster its Greeces, and although its stated policy is to sterilize those purchases by selling Euro bonds (buying sovereign bonds puts money into the system; selling bonds sucks it back up), it has had at least two failed auctions where it couldn't sell enough to cover its QE purchases. This may be its policy, disguised to avoid spooking the bond vigilantes; or it may reflect diminished appetite for Euro bonds. The Bank of International Settlements put out a warning about QE, that trying to cushion austerity with purchases of bonds to keep rates down risks continued speculative bubbles and misallocation of capital. 

ObamaCare Killed the Recovery

Fascinating analysis shows that the V-shaped bounce off the bottom and steadily improving unemployment was stopped in their tracks by the introduction of ObamaCare. Even before it passed it started to kill the recovery. Could it be that the expected increased burden of adding an employee scuttled hiring plans? 

If we had stayed on the prior trend, we would be in a clear jobs recovery in three months (Sep 2010). Now it trends out three to three more years.

That Sinking Feeling: G20 Busts the Government Bubble

The Keynesian Cheerleaders have met their moment of truth: gas or brake? Geithner went to plea for more stimulus from Europe and Japan, betting that more deficits now will produce growth and future taxes to pay down the debt. The Europeans have hit their limit and politely told Geithner where to go. 

The Government Bubble has just burst.

Hungary is about to join the PIIGS with unsustainable debt, and the Euro has broken below the recent trading range and is below $1.20 - down from $1.50 not so long ago. The next support is around $1.16-1.18. It is in a wave 5 down and could easily overshoot these levels. 

All the rescue plans have been for naught, as the wolfpack continues to call the bluff of the finance ministers. Now even the core countries of Europe are seeing spikes in their CDS spreads. This witty video from Australia gets across the point that investors have figured out: indebted nations cannot bail out the broke nations. 

While the sudden surge in core country CDS spreads may abate, it appears we have crossed a very critical threshold: belief in the wisdom of assuming debt for temporary stimulus. The Illusion of Stimulus has been punctured. The Keynesians have no clothes. 

There is anger brewing over the failure of Keynesianism: people feel like they have been sold down the river with false promises of easy money in order to line the pockets of overpaid public workers, nefarious bankers and corrupt politicians. 

There is no one in the blogosphere better at projecting that anger than Karl Denninger, who rants that the attempt to re-ignite private credit growth has failed. By his calculation, we borrowed 12% of GDP last fiscal year, and are on track to do it again this year - levels well above the 5-6% of Hoover and FDR in the Great Depression. With the backlash against this growing, the US may be forced to pull back to a more sustainable 3-5% level. That drop of around 8% will come out of GDP by the way it is calculated, whether it is a drop in spending or a massive increase in taxes, icing the coming double-dip recession.

With total government debt at 130% of GDP in the US (including State and local debt as well as unfunded future obligations), this point was inevitable here as well - our leadership simply has not been prepared to come to grips with the dimensions of the problem, blindly having faith in Keynesian prescriptions. 

 

Obama's Summer of Disillusionment is upon us. His cool, collected style is now viewed as a profound failure of leadership. Already his most visible gushers of support have begun to publicly air their disappointment (Maureen Dowd, Tom Friedman, Frank Rich, even Chris "I get a tingle down my leg" Matthews). James Carville rebukes him for his failures with the oil spill. Quietly, his army of true believers are bailing. 

What happens now is laid out by Karl: we are entering an Austrian-Economics style debt-deflation spiral, and there is no longer anything the government can do to prevent it. 

The size of potential fall in private debt is well beyond the ability of the government to fill ($52T of total debt vs $13T of Federal deficit). We were at about half that total amount of debt just a few years ago when the Greenspan Bubble began ($26T vs $52T), and we may be headed back that far. Bubbles tend to retrace to their start. Hang on to your hats. And wallets.

That Sinking Feeling: Underwhelming Unemployment Underscores the W

When a Keynesian Cheerleader says a double-dip is now 50-50, you know the recovery is in trouble. Robert Reich so opined on CNBC this morning. Clearly the recovery is not a typical V shape, and it now appears headed to a W.

Before the unemployment report, the pundits were predicting a good report, with BNP Paribas stretching to 645K. Goldman's Hatzius, whose prior predictions were pretty good, got caught touting a 600K number. It came in at 431K, below both the Goldman 600K and the consensus 536K. The key to watch is not the total, skewed by the census number at 411K, a whopping 95% of the total (see chart courtesy Innocent Bystanders), but the private payroll number, which came in at 41K, well below the consensus of 180K. 

There is evidence of systemic fraud in the census hires being hired and fired and rehired, but this should not affect these numbers as they are based on surveys. The fraud seems to be for the benefit of supervisors who must have some sort of incentive pay based on hires. What a mess. But just as the census hires should be redacted to look at the underlying strength of the economy, when they start getting laid off in droves the firings should be added back. It is the private sector trend which is critical to projecting a recovery, or not. 

The 41K private jobs is a drop from the prior month's 231K (which was adjusted down to 208K) and a reversal of five months of improvements. The moving average is around 150K. 

In addition to the 411K census, there were 31K temporary jobs, meaning permanent jobs actually came in a negative 11K. Also, the birth/death model estimated 215K jobs, meaning arguably this report should have come in a negative 226K. 

The unemployment rate fell to 9.7% because the total workforce fell from 65% down to 62.5% of the population, well below the normal level of 67% for the past 20 years. This decline comes from people leaving the workforce. Usually during a real recovery people return to the workforce and the unemployment rate paradoxically rises. We saw that last month. This workforce decline is bad news for a recovery. 

 

The best summary of the employment situation comes from Calculated Risk and the following chart. It shows how much deeper and longer our current plight is, and how the apparent bottom of the last five months appears to be rolling back down to a double-dip in employment:

 

Euro Rises as Merkel Emasculated

The Euro was expected to bounce as Merkel's move was expected to have a momentary improvement as shorts covered. The Euro bounced, but for a different reason, and one that suggests the Euro has bottomed for the moment. If so, the Euro should begin a bounce of several weeks or months.

What happened this morning? Other countries declined to go along with Germany, and after a brief short covering, everything reversed! It reminds of the moment in Animal House, when John Belushi rushes out of the frat saying "Who's with me? Let's go!" and no one does.

Merkel's move is a bust. Spreads widened when they were supposed to narrow:

Credit-default swaps on Europe’s most indebted governments fell initially on concern the restrictions on short-selling will devalue existing agreements. They erased those declines as it became clear Germany failed to persuade other nations to join in the ban.

Germany largely failed to persuade other nations to follow its prohibition and the U.K. Financial Services Authority said the ban doesn’t cover branches of German institutions outside of Germany, indicating it will have little impact on trading in London, the biggest hub for swaps bets on European government debt. 

Merkel's move now looks like an act of desperation. As Mish comments:

BaFin put the ban on short selling even after it announced that it found “no evidence” that credit-default swaps were being used excessively to speculate against Greek bonds

This explains why ZH's day of chaos never happened. Governments look impotent. London markets are bigger than Germany's, and continue trading with naked shorts. Also, the data simply does not support Merkel's fears - while shorts have increased dramatically, the types of naked shorts she worried about the short positions are not that large and are actually lower than two months ago:

The funniest story is that one of the leading shorts is the Greek central bank, betting against itself! You cannot make this stuff up. How can you take government "regulation" seriously? The banks don't.

So what drove the Euro up? It appears that the ECB and other European central banks are finally intervening:

The massive 200-pip jump in EURCHF in less than 10 minutes (13:00-13:10 BST) is the work of no other than the Swiss National Bank intervening to sell its own currency. But the 80-90 pip jump in EURUSD must also be the work of European banks intervening on behalf of the ECB to boost the ailing euro. The events of the last 2 weeks imply that coordinated central bank intervention is possible. If it took 2 days for the ECB's to make an about turn on bond-purchases and for Berlin to institute a ban on naked shorts, then the prospects for intervention are very plausible

What is troubling is it wasn't a coordinated move, but driven by capital flight from Germany (Euros) to Swiss Franks. In order to manage the conversion, the Swiss bank had to intervene to prevent the Swissie from running up! Ambrose Evans-Pritchard reports that "€9.5bn flowed into Swiss franc deposits in a matter of hours," and this came on top of €56bn interbank loans reflecting flight out of Club Med. 

This means the battle between the wolfpacks and the central banks has now been joined by panic and capital flight, which is the same psychology of May 1931 after Creditanstalt Day. This battle should last at least several weeks - it lasted a month back then - until the central banks lose patience and resources, as the flight overwhelms the interventions. 

Besides going long the Euro, it may be time to short the German bunds (their sovereign bonds). This likely also means the end of the gold rally, which I had assessed a week ago, that the momentary spike of in gold after the Flash Crash may have been a blowoff before a hard reversal. 

It was also my view in the last few weeks that once the rescue attempts were seen to fail, the Euro would bottom and reverse. The failure of the Euro-TARP so far combined with the failure of Merkel's move indicate that the market now accepts that we are done with bailouts and gimmicks. Instead, the PIIGS now have to either fix their insolvency or spin out into their own currency and use devaluation to realign their currencies. This is a foundation for a rebound in the Euro, at least for a while.

It may seem paradoxical that government intervention tends to cause the opposite of what is intended, but that is what history shows. Markets reflect real forces, and government attempts to fix prices or stem tides tends to get overwhelmed as markets find ways around obstacles. This lesson has been learned over and over going back to at least Diocletian's price controls in 300 AD. They failed.

Markets are order-seeking mechanisms within chaotic nonlinear systems. When they find order, they move very quickly, much faster than governments. Governments in contrast tend to be the slowest actor, intervening usually after the trend has exhausted. In this case, the moves to rescue the PIIGS come after they have gotten so deeply in trouble, the rescue simply kicks the can down the road and deepens the insolvency. I do not think any market participant believes Greece will escape default - even the Greek central bank bet against itself! - it is simply a matter of when. Hence the rescue was not seen as solving the problem, just bailing out over-extended banks. 

Once the rescues are dismissed, Euro deflation looms due to debt default. Hence the better bet is not against the Euro but in favor of deflation. Right now it is not clear that the market has come to that realization; we seem to have a momentary bump due to intervention and capital flight. How long and strong the bounce will be probably depends upon short-term intervention vs. long term belief in deflation, and a timing arbitrage as to whether one can jump and get out before the bonds default. 

If we remain in the Creditanstalt Month of capital flight and panic, this bounce could be short-lived. The world may seem a lot more complex and sophisticated than back then, but the psychology remains the same. Human nature does not change. Nor does government psychology. Adherence to the Euro today is acting like compliance with gold then. The parallels are striking.

My conclusion is of a near term bounce followed by a further collapse - it is after that deeper bottom the deflation expectation will emerge. Neely concurs, and put out a call to go long mid-day today. He sees the Euro in a large triangle (of course). Today's STU also sees a major move back up in the Euro, especially because sentiment has become very bearish (98%). Depending on wave structure, this is either a relatively short ABC correction, or the start of a multi-month move. More from them as the pattern reveals itself. 

In the longer run, however, the Euro may be doomed. It is a flawed currency, since it is not backed by control over fiscal policy. A lot of ink is being spilled on this in the blogosphere. EWI commented on this five months ago and their comments are worth reading (below the fold):

AUD Tumble Down Under

With the Euro in its expected small bounce - and may have more to go due to what happened overnight - the Australian Dollar continues to tumble. The AUD fell over 3c in the last day, a huge move, and broke below its Feb5 low at 85.75c, confirming a double top. A technical bounce may come, but the trend is decidedly down. There may be initial support around 82c, but the next major support level is the July 2009 low at 77c.

 

The other currency pair to watch is AUD/JPY, driven by the granddaddy of the carry trade, the Yen carry trade. The AUD bounced off a key Yen support level at 76, but seems destined to crush through shortly. If so, this confirms unraveling of the carry trade and serious weakness in the AUD. 

Note: I moved the comments on the Euro to a new post

Run From the Euro!

The Euro had its short-term bounce, but when Germany announced a ban on naked short selling, the Euro began to fall and got below $1.215 after-hours. The reaction from Goldman and other banks has been shock and awfully negative criticism that boils down to: run from the Euro!

ZH has been on a roll on this issue, predicting chaos tomorrow in markets:

One bond trader said he expected Wednesday's trading session to be one of the most volatile in living memory: "It will be complete chaos, I really don't know what the Germans think they are doing."

The Euro is not directly affected, yet. The naked short ban applies to sovereign debt and CDS's. The Euro, however, is a way to play this.

The received wisdom on short bans is a short ban has a temporary boost, as shorts close out their positions, so the Euro may initially bounce; but then the short ban undermines confidence in the instruments affected. When you remove shorts, you do not remove sellers; you remove liquidity. Shorts add liquidity for the longs - they are the other side of the trade - and if the longs can push them back, they rush to cover in a short squeeze, driving prices up, losing capital quickly, and often losing their ability and appetite to continue. Mish succinctly summarizes:

All these short sale restrictions are going to do is create a vacuum. Once the shorts are driven out these shares will plunge

The vacuum comes from buyers unable to find sellers to match their ask, and standing aside. The shorts have left. The shorts were the other side of the ask. The trend down remains, and the sellers try to find buyers at lower prices. As they overwhelm buying interest, the market falls.

The Flash Crash is an example of what happens when one side of a trade is removed: the sellers seek lower bids, and as the price drops, the market crashes.

Prior short bans have led to market crashes. Here is Mish's example:

 

Will we see a crash in the Euro? The Germans are banning naked shorts, not all shorts. This is a ban of a different character. The shorts can still play, but they cannot short beyond the number of instruments, in effect engaging in highly leveraged shorts. As an example, normally to short a stock one needs to borrow each share first, so the total shorts cannot be more than the public float, and are usually a small fraction. In a naked short, one can take a position without borrowing the underlying instrument, or in the case of derivatives, having someone on the other side. Naked shorts allow positions much larger than the float, or more commonly, larger than normal daily trades.

Karl Denninger applauds Germany for taking this move, and wishes it on Obama as well, to take control back from banks who have made huge mischief fleecing markets both before and after the financial meltdown. His point is well-taken in that traditionally the financial sector takes 10-12% of profits as a "vig" for its services, but during the Greenspan Bubble took 33% of all US profits ($2T of $6T over the period), and at the peak in 2007 was sucking 40% of all profits from American industry into its maw.

Others agree, including ZH and Jesse's Cafe Americain, and see the broader political design in the German move:

• the ban is a hammer that can be used to default on CDS's without consequence, putting more control back onto the German government
• the ban is also a reaction to the failure of the US to reform its financial system, and a repudiation of the current US financial reform bill

Put simply, the Germans are implying that the Obama administration is in the pockets of big US banks. Merkel remarked on this in a recent speech:

To some degree this is a battle between the politicians and the markets. But I am firmly resolved -- and I think all of my colleagues are too -- to win this battle....The fact that hedge funds are not regulated is a scandal," she said, adding that Britain had blocked previous efforts to do this. "However, this will certainly have taken place in Europe in three weeks," she said, without giving more details." Reuters 6 May 2010.

This is but the opening salvo. A transaction tax may follow, as well as measures impacting the Euro directly. ZeroHedge has a series of posts tonight, including this comprehensive look at what may be ahead.

Politics aside, the other big move today happened in Australia, where the RBA did not raise rates on fears of turmoil in Europe. As predicted here a week ago, the carry trade is rapidly unwinding, with the AUD falling hugely in the last two days, rushing to an 82c support level it seems.

Target for the Euro

Reports out of Europe say a huge scramble for gold coins is on. Dealers have run out of inventory. This is a microcosm of the Creditanstalt Problem: at some point bailouts no longer work, and creditors run for the exits taking the rescue funds with them. As a senior PIMCO manager said: "the risk is that investors are using the ECB as a vehicle to exit their positions." Well, duh! Amazing it would happen at the same time period in May as it did in May 1931. 

The Euro hit the next support level at $1.233, the Oct08 level, and after going slightly lower to $1.223 bounced around the time the ECB announced concrete steps to sterilize their recent purchase of PIIGs bonds (in order to maintain the supply of Euros as constant). This may alleviate inflation concerns and spark a short-term recovery. If turns down again and breaks below that level, the next range is $1.164 - 1.18, which provided support back in 2003-05. Chart and analysis from MP Trader (via SlopeofHope) below. 

Goldman Sachs in contrast has a target of $1.35. They think the Eurozone will grow about as fast as the US with Germany making up for austerity among the much smaller PIIGS, and hence think rates settle back a bit. More on that in a later post. If the ECB intervenes strongly enough, a huge short squeeze could drive the Euro back above $1.35 quickly, and it might settle back down there. 

Calafia Beach Pundit points to purchasing power parity (PPP) levels, which are $1.15 in the Euro and $1.42 in the Pound. Both these currencies might get there, fast, and overshoot to the downside. The most over-valued currencies, however, may stay that way a while longer:

• AUD at 89c is way above parity at 68c, giving it a lot of room room to drop
• Yen at 121 per $1 also has a ways to drop from its current 93 

Those two currencies are way above PPP due to the carry trade. The Yen is a major carry-trade currency, and the AUD is a major beneficiary of the carry trade in both Yen and USD. Per my recent post on the AUD, if the carry-trade unwinds due to the crash, both have a lot of room to drop vs the USD. Of course, any rate increase in Japan puts their country into a deep hole, given that interest on the debt (at very low rates) can hardily be covered by taxes. 

 

Fallout From The Crash: Gold

Gold is a hedge against bad government, not just inflation - Martin Armstrong

The biggest winner from the crash is gold, which has shot up, especially priced in Euros. The wolfpack of shorts continues to push down the Euro, rushing through the $1.25 level  to the $1.23 territory, rapidly submarining the Euro-TARP. It may be that the Euro is already headed for the trash heap of history. 

Or maybe not so fast. The net non-commercial short positions are at record levels. If the ECB is all-in, so are the shorts. I expect a big rescue mission this weekend, to try to squeeze the shorts. 

As wolfpack warfare wages on, the question is whether gold is in a parabolic blow-off top, which says get out, or is signaling the collapse of paper currencies is closer than we think, which says to protect capital at all costs. 

After persuing the pundits, my take is a near-term top which could be followed by further gold upside, but not right away. First those currencies need to crumble! The uncertainty is how close the top is. Let me walk through fundamentals, technicals and monetary economics. 

Monetary Economics

The gold spike engenders the knee-jerk reaction of impending inflation, but the money supply indicators are plummeting right now (chart courtesy Pierre du Plessis). Europe is actually contracting (below zero in the chart) whereas the US is growing money very slowly. 

With such a drop in money, it is no surprise that EuroZone GDP is flat, and may be about to fall into a double-dip. Given that velocity of money is also down, this is deflationary, and with the Fed having ended its QE program, unlikely to change. 

 

Normally such a deflationary environment is bearish for gold. To understand where gold may go, it is important to step back and reconsider the Quantity Theory of Money (QTM). Bear with me as I summarize the hyperinflation vs. deflation debate. 

Hyperinflation: I tend to skip the frenetic goldbug sites imploring you to buy gold, so I missed this Hyperinflation Watch piece by one of the leading proponents of a return to real money (gold). It came out just before the Apr26 peak, and noted how the money supply in the US was doing something that has seldom happened: it was shrinking. 

Rather than see the coming deflation, the author (James Turk) creates a new moniker, the Haverstein Moment, named after the ill-fated Reichsbank President who caused the Weimar hyperinflation of the 1920s. He is claiming inflation is running faster than money growth:

The so-called “shrinking” money supply that arises when adjusting for the loss of purchasing power from inflation is a characteristic portending imminent hyperinflation 

Deflation: I do however pay attention to the writings of Prof. Fekete, who has gone deeper into money matters and gold than anyone since Murray Rothbard, the Austrian economist, in the '60s. He finds the Haverstein Moment "grotesquely unrealistic" in a cogent discussion of the hyperinflation/deflation debate. The Wiemar Republic was the post-war Germany after WWI, with a Reichsmark no one wanted and a devastated capital plant. How to compare that with the US today, between a beggar and an emperor? The value of a currency is fundamentally based on the productive capacity of the issuer, and when capital gets destroyed the currency must fall until the capital is rebuilt (or the money supply shrunk). Fekete's point is absent a wholesale destruction of US production, a shrinking money supply and reduced velocity is a harbinger of deflation. 

He offers an alternative theory, the Black Hole of Zero Interest:

When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.

Velocity. What money-supply watchers always seem to overlook is the velocity of money, how fast it turns over:

• Velocity decreases when deflation looms, as people hoard money (save, pay down debt, spend less)
• Velocity increases when inflation looms, as people trade it for tangible things (they spend it as fast as they get it)

When you look at the Weimar hyperinflation, and other incidents (Austria at the same time, Hungary in 1946, Argentina so many times), what you see is inflation is much higher than growth in money. This means velocity went up faster than the money supply. If people expect the Riechsmarks they get in the morning to be worth half as much by evening, they pile it in shopping carts and rush to the stores. THAT creates hyperinflation.

Nothing of the sort is happening right now. Verdict: gold should drop. 

Fundamentals

I would put this economics debate more prosaically as: we have barely begun the process of debt write-off and de-leveraging. That process will rapidly reduce the money supply, since in a fiat currency regime, credit creates money (debt becomes purchasing power and turns into bank accounts somewhere). Imagine what happens if the Euro-TARP fails to prevent the defaulting of Greek (and Portugal, etc). The debt gets written off and money is destroyed despite the attempts to keep the game going. As Fekete puts it:

Charles Ponzi's dream has come true. The US Government is duplicating Ponzi's scheme in the bond market

The magnitude of the Ponziness can be seen in a chart of equities adjusted for gold: 

 

If deflation is on us, gold will drop, as the Dollar (and Euro) will rise. If the Euro-TARP fails, the Euro will drop and rapidly bottom; the changed expectations of the coming debt destruction will then cause its value to rise. Oil has already rolled over, and so gold may soon, too. It would indicate an expectation that the wolfpack of shorts will outlast the ECB. 

So: gold tops near where the Euro bottoms, after the wolfpack wins. 

When might that be? It took the Austrian government a month to fail when they supported the Creditanstalt Bank in May 1931. While stocks seem to be unfolding this time around about 1/3 the pace of 1929-31, at the rate the Euro is sliding the endgame may be only a matter of weeks. The Euro has gone all in with a poor hand, and the wolves are ripping apart the pretense that more debt can solve an insolvency problem. 

If Europe fails to mass an intervention by Monday, the game may already be over, and gold will have topped.

Technicals

Even though gold seems to be spiking, we have not yet seen the sort of piling on that signals the endgame of a mania, indicating it could still run beyond sense. Indeed, while investors are feeling the gold train has left the station, sentiment continues to indicate otherwise. Gold may longer be cheap, but it may not yet be in a bubble: Cramer hasn't touted it yet! 

The Casey Report provides this chart of technical indications in the XAU, which show no near-term top (a much larger version is at this link):

 

This morning David Rosenberg also weighed in on gold, with this chart showing that we are not yet in a parabolic blowoff. He notes that if central bank reserves were backed by gold, it would be at $3000/oz. (Some pundits have estimated that to back all currency in circulation, it would need to be $15K/oz, but that is not required under a gold standard.) Believe it or not, Rosenberg now thinks "$3000 an ounce on gold may yet prove to be a conservative forecast." 

 

A comparison of where gold could go to recent history from yesterday's NYT gives several price points:

• $2400/oz based on the 1980 peak adjusted for CPI
• $5300/oz based on the 1980 peak adjusted for GDP growth (6x)
• $5700/oz based on expansion of M3 (up 10x) over increased gold stock (1.5x)
• $3100/oz based on expansion of M1

I don't play gold, so I leave the calls to the pundits who do. EWI have been gold bears for a while, and their predictions have lost some credibility due to their Wolf! Wolf! premature calls of a gold top. The STU tonight however is quite convincing on gold: bullishness is at all-time records at 98%, which is such an extreme it has marked tops in the past in silver, currencies, bonds and equities. They say they will have more on this next week. 

When everyone is on one side of a trade, the money is made on the other.

EvilSpeculator has a crisp recommendation, artfully put, to get out. Read how they put it! Neely had been recommending loading up, but after the recent spike, says to stand back for now and be prepared to buy the next big dip. Walter Murphy has identified a pattern in the Yen/Gold charts which gives him a 25% upside target that is well-defined.

Maybe the smart move is to buy a dip on a modest or slow slide, but stand aside if instead we have the type of fall we saw in oil in Jul08: a falling knife, signaling the end of the parabolic rise. 

Fallout of the Crash: Pound Getting Pounded

First the Euro, now the Pound: the wolfpack is winning. GBP was $1.49 yesterday, and has entered $1.45 territory today, a huge drop. The Euro entered $1.25 territory and is now below last week's crash low-point. ZH suggests Europe is capitulating already. Volcker is now openly concerned over the disintegration of the EMU. 

US equities sold off on the afternoon. The Nikkei is opening down, and the Shanghai market may follow. This bodes for a bloodbath tomorrow unless the ECB and the Eurozone central banks defend their currencies. 

Stocks have been sideways for the week with an upwards bias until the selloff today. Should we expect a hard drop tomorrow, especially if the capitulation in Europe is on? Some wave musings: 

• If you peruse the bottom "wetware" chart from this post which removes the effect of 'bots gone wild, the normalized bottom occurred Friday. 
• If you then smooth out the gap up on Monday, a three-wave move has followed (with waves a/b on Friday and the gap move the start of c). 
• the c wave has broken in five waves (see chart from Market Thoughts)
• the whole pattern has retraced just over 62% of the drop: 1220 to 1094 or 126 pts down, then 1094 to 1174 or 80 pts back = 80/126 = 63% 

If the big drop was wave 1 down, this retrace is a normal wave 2, and the dreaded wave 3 is to follow. Hank Wernicki made a good short call mid-day today, and may be more right than he realized! 

 

Fallout From The Crash: Euro

On this Creditanstalt Day, the battle over the Euro has been joined! The Euro was getting crushed in after-hours trading last night, pushed down towards $1.26. The shorts are wolfpacking it. This morning central banks rushed in to intervene, and the Euro bounced off $1.261 to run above $1.27, but has fallen off again. It remains well below the "we're saved!" peak of this weekend, at $1.31. If the ECB cannot withstand this assault, the Euro-TARP bailout is doomed.

The intervention caused a 20-pt reversal flip in the S&P futures, which had been falling towards 1140.

Curiously, the biggest expected losers, the French and German banks with excessive exposure to the PIIGS, might be able to make some it back by being wolves themselves - hedging in Forex markets by shorting the Euro. This is a partial win-win in a lose-lose situation:

• If the Euro breaks, they win on Forex
• If the ECB protects, they win on the bailout

What the wolves see is simple logic: the PIIGS are insolvent. Their income cannot cover their current debt. Piling more debt on top only prolongs the problem. The Euro-TARP tries to lower borrowing rates, but if the assault on the Euro drives rates up, the ECB is left with QE to self-finance the debt, which it wants to avoid. Hence something will break. 

Right now the spreads are widening for LIBOR vs. overnight index swaps (OIS), as they did in 2007, when they ran from 13 bp to 73 bp, and then "the rout was on." Last week the spread jumped from 9 to 18 bp, and since the Euro-TARP was announced, have widened to 20 bp. Bondsquawk also notes that 2-yr rate swaps have also widened. The TED spread (Treasuries vs Eurodollars, now called LIBOR) for 3-monthers is back to levels of 3Q09.

John Taylor (Stanford Prof and originator of the Taylor Rule for Fed interest rates) writes today in the FT that what may ultimately break is confidence in the ECB, and with it confidence in central banks. 

Fallout From The Crash: Carry Trade and the AUD

An explanation for the crash that is gaining credence (according to Art Cashin) is a spike in the Yen before the crash caused a rapid unwinding of carry trade positions, an idea that may have first been noted by Trader's Narrative. The Yen has the most reliably low interest rate for the cary trade, and fear of a spike in the US rates could move money out of USD carry and back into Yen carry. As the bond market is an order of magnitude beyond the stock market in size, Forex dwarfs bonds. A little carry goes a long way to whipsaw stocks. 

We saw a bit of normalization of carry currencies Monday, but will this sustain? If the crash is the warning shot of a change across lots of bets that worked during the Hope Rally, a lot of positions need to be rotated, starting with the darling of the carry trade, the Australian Dollar (AUD). 

A quick comment about the AUD in a ZH post on the crash caught my eye about the AUD. The post noted how markets stopped at the same time worldwide across almost every type of market including futures, bonds, gold and forex. How could this be if it were merely a glitch in a few stocks? And how could this happen so swiftly unless a substantial majority of all trading is in the hands of a very small number of firms who made the decision to freeze over just a few minutes? The markets came back around the same time, but a few lagged, and this raises a red flag: 

Finally notice that the EURUSD and AUDUSD are slightly late to the game to recover. Although the auction resumes about the same time, they continue to print precipitously longer.  This is all the confirmation of Cluesix' AUD analysis I need.  No one is talking about it today, but after Asia tonight they will; Asia (and even China) are next.

I dug up the Cluesix Report: The Case Against the AUD. It observes that the AUD is the most overvalued currency in a developed market, too high by 30%. It is highly dependent on financials and commodities, and commodities may be in a huge bubble echo. The Lucky Country's real estate may be as much as 50% overvalued. Speculators and carry-traders are betting heavily on the AUD uptrend. 

The carry-trade may be rapidly unwinding in the wake of the crash. The AUD will suffer the most. 

Committing economic suicide won't help: a few days before the crash, the the Rudd government announced a 40% tax on profits from its mineral resources, to get a "fairer share" of the natural wealth of the country. Reaction was negative to shock at the utter foolhardiness of the blunder from down under. 

The Case Against the AUD

An Australian business man shared his thoughts on the Cluesix report with me (excerpted below the fold):

GDP Bends the V-Shaped Recovery Curve

 GDP in Q1 at 3.2% was below consensus (3.4%) and well below Q4 (5.6%), putting the V-Shaped Recovery at risk. As CalculatedRisk observes: "for a 'V-Shaped' recovery, GDP would already be close to previous highs." 

Still, the back-to-back growth of Q4 and Q1 are the best since coming out of the last recession in 2003. Question is what it portends for the rest of the year. James Picerno worries about a slowdown business spending and a slowing of exports. So it all falls on the backs of the American consumer. A concise summary:

These numbers are entirely dependent on an increase in consumer spending. Everything else is becoming a drag on growth.

Quick snips (all rates are annualized):

• PCE or personal expenditures added 2.5% to GDP (almost all of it!), worse than expected (4%) 
• Government spending shaved 0.4% off, meaning going forward will drag down GDP
• RI or Residential Investment fell 10.9% vs a rise of 3.8% in Q4
• Inventory added 1.6%, down from 3.8%, and should not help going forward

PCE increased 3.6%, up from 1.6% in Q4, which is promising, except it was driven by a decline in savings and transfer payments, which is not sustainable. Disposable income only rose 1.5%. 

Government spending increased at the Federal level by 1.4% but decreased at the State level. State spending drops offset Federal stimulus, and that offset should increase over the rest of the year, particular in the big "Blue" states with huge budget disasters. 

RI is a big concern. No recovery sustains without an increase in new home sales. RI was only up in Q4 due to a Cash4GDP program, which was restarted in March, so I expect this to reverse to positive in Q2, then fall in Q3 as the program ends again.

The one bright spot was technology investment by business skyrocketing at 13.4% growth. Perhaps "skyrocketing" is hyperbole, since this rise was less than the 19% of Q4.

Inventory rebalancing has driven the recovery so far, but is getting back in balance. In the whacky world of GDP, inventories fell in Q4, but added to GDP, since it had fallen less than the prior quarter. Inventories rose in Q1, but added less to GDP. 

Predicting GDP with inventory in balance comes from using "Final Sales", GDP less inventories, which rose less in Q1 (1.6%) than it had in Q4 (1.7%). If government spending is also removed, it shows final sales of private goods/services at 2% in Q1 and 1.9% in Q4. The private economy seems to have come back and is stabilized at a relatively low level of growth. 

Since disposable income is flat, the somewhat higher consumer spending cannot grow the economy absent a big change in employment. Higher growth will depend upon investment, plus a continuation of growth in Asia since the rest of the world is in the same funk as the US. 

Investment as measured by capital expenditures overall rose but at a declining rate from Q4. I think this is an artifact of Cash4GDP programs going in and out. I would expect CapEx to grow more in Q2, partly driven by continued tech spending plus the gimmicky residential investment, then flatten or fall through the balance of the year. (The WSJ reports that the gimmicky homebuyers credit is not driving a frenzy of buying, so RI may disappoint.) Here is the current trendline:

 

Karl Denninger has his usual rant with a point: The US borrowed $462B over tax receipts in Q1, but only $87B showed up in GDP, mostly in PCE from transfer payments - where did the other $375B go?

That is 10% of GDP, meaning a huge amount of stimulus fell down a rabbit hole while the little that spilled over kept the economy on life support. Karl supplies this chart to make this point vivid. Compare the red line (GDP) with the blue line (deficits) to see how many gobs of debt are being thrown down the rabbit hole for a modicum of life support:

 

The death of the V does not yet mean a W double-dip. Instead the debate will be over 3-3.5% going forward vs 1.5-2%. From CreditWritedowns: 

Bottom line: the government is removing the stimulus prop to GDP growth before the recovery has become self-sustaining. The inventory cycle is already starting to fade. That means weak 1 or 2% growth at best by Q4 2010. Unless job growth picks up tremendously by the second half of the year, this recovery is in trouble.

PIIGS in Poo

"The Titanic is SINKING!" ledes John Mauldin's latest newsletter. Greek bonds shot to super-junk levels at 18%. The Euro has continued to freefall, now below $1.32.  It was above $1.50 just last Dec. Breakfast with Dave notes that the cost of the bailout for Greece has risen to €90B, and with Portugal (€40B) and Spain (€350B) next, the cost has become an astounding €480B! The IMF can only cobble together €200B.

John summarizes why the Euro-tanic is sinking:

In order to get financing, Greece must willingly put itself into a multi-year depression. And borrowing more money when it cannot afford to pay back what it has will not solve the problem. 61% of Greeks now favor leaving the euro. How has Greece responded? By banning short selling on its stock market for the next two months. That should make things better. Greeks are responding by rioting and going on strike. But you truly know when a country is dysfunctional when its AIR FORCE goes on strike. Yesterday Reuters reported that hundreds of Greek pilots called in sick in protest. The response from government? The Minister of Defense said he was "profoundly disappointed." Now that had to make the pilots feel bad.

The S&P cut Greece's bond rating to junk status (BB+), and cut Portugal two steps (from A+ to A-). Spain is the next PIIGS to step into poo. An inadvertent leak shows Spanish unemployment is now above 20%, making it that much harder for Spain to live within any sort of workout plan. The S&P cut Spain's credit rating one notch today, to AA. 

A deal with the IMF seems likely this weekend, possibly as much as €135B, but it won't do much more than kick the can down the road. What complicates the rescue is that the PIIGS are not suffering a liquidity crisis, which could be solved by a flood of central bank money, but a deep structural crisis from too much borrowing relative to income. Simply put, a solvency problem, not a liquidity one. 

 

Gold is soaring in Euros. Gold is not so much a hedge against inflation as a hedge against bad government policies. The barbarous relic is benefitting from all the problems. 

 

I posted last weekend about how it looks more like history will repeat. On May 11, 1931, the Creditanstalt bank went bankrupt, and the Austrian government rushed in to save it. The run on the bank accelerated as creditors saw a chance to get whole. A month later, reserves exhausted, the Austrian government fell, the first of a series of domino defaults across Europe. This spawned the second wave down of the Great Depression, after a period in which optimism ruled and we thought some sort of recovery was on. Sound familiar? 

The Greek deadline is May 19, when a bond issue needs to roll forward. The rescue deadline seems to be May 9, when the Germans have elections, although wouldn't it have been better to wait until after? The bailout is very unpopular in Germany. In any event, these dates bracket the Creditanstalt date. 

Already we see a run on Greek banks. The bailout this weekend, if it occurs, runs a huge risk that the run on Greece accelerates as creditors rush for the doors. Greek bondholders could lose as much as €200B in a default, well beyond the €135B of the rescue. Total Greek debt is touching €300B. First ones out may stay whole ... 

Take a look at these charts, showing how near the end the bonds go parabolic - the signature of an impending default. These charts cover Greece, Portugal and Spain.

 

Charts courtesy Greg Weldon from Mauldin's newsletter.