Planet Yelnick

Big Bond Bubble Beckons Bears, Buries Treasuries, And Busts Fixed Income Investors

Back in March, Barron's ran The Case For Bonds, poo-pooing a spate of articles back then on a bond bubble. The expectations were that the ending of Quantitative Easing (QE) would lead to a rise in rates. As we know now, didn't happen. 

What did happen was the Euro debt crisis drove money to safer havens in Treasuries, and the pronouncement of a continuation of QE led observers to expect a bigger QE2 ahead. Bonds soared as rates dropped. In the last few weeks, however, we have seen them reverse dramatically (chart from StockTiming):

 

Marty Chenard (of StockTiming) notes how the 30-yr has come back to a recent resistance level at 38.34 (see chart), suggesting a break will lead to a bond bust of very broad proportions. The bust is already being felt. Monday's WSJ will report how the last ten days have shaved 2.5% off the 10-yr, a sharp drop after a five month stunning rise. Bespoke noted late last week how the drop in bonds was already being felt in bond funds, and had raised the spectre of a breakdown in fixed income:

More ominously, the 10-yr has has not broke above the five-month trendline, an indication (if it doesn't reverse quickly) of a change of trend for a considerable period:
  
 

Credit for an auspicious call goes to Jeremy Siegel in the WSJ, whose op-ed The Great american Bond Bubble published on August 18, right as the trend reversal was starting. He noted how a reversal from the 2.8% rate then to the 4% rate of a mere five months ago would cause a capital loss 3x worse than the low yield. This led to a new spate of Bond Bubble articles. An update is here. 

An even earlier call came from ZH, which noted that global industrial production got back to pre-recession levels, and drew the implication that a Global Bond Hiccup was soon to come:

 

Before the bears celebrate, they should ponder what changed: expectations of the double-dip abated around the time the bond yields bottomed. If you have been following my posts on the Double Dip Countdown, I put the count on hold in early August, started it again around August 18, and have it on hold again - reflecting ambiguous economic signals. This has two big implications for rates:

• a flat patch would cause the Fed to hold off QE2, which suppresses rates
• a real recovery would cause market rates to rise, and the Fed to follow

Now fixed income investors face a dilemma: if the recovery is on, rates will rise; but if this is a mere blip before negative double-dip news begins to come back, rates will fall back. Should they stay (in bonds) or should they go? 

I will comment separately on munis in a later post, bit as to Treasuries, these are the circumstances where technical analysis may give better advice than struggling with conflicting and ambiguous fundamentals. Friday's STU has a wave count which is pretty daunting: the recent low rates reflect a 62% retracement from the low rates in 2008 to the recent highs in April. This suggest rates are going to continue to rise. Right now the technical indicator to watch is a definitive break of the trendline (see chart above). 

SuperAngel VC Smackdown!

This morning I attended a fascinating session in Palo Alto that points to the future of venture capital in Silicon Valley. Provocatively framed as a "smackdown" between traditional VCs and a new class of Super Angels, it instead highlighted the future rebirth of innovation in Silicon Valley.

Venture Capital has been in its own Lost Decade with negative returns since 2000 after three glorious decades during the Era of Moore's Law. Moore's Law continues, but innovation has moved higher in the technical stack at the same time as the Politics of Envy have greatly plucked the Golden Goose of American innovation. This last decade brought us horrific laws like Sarbanes-Oxley, which raised the cost of IPOs, and tragic policies such as the demonization of stock options which have been pecking the growth engine to death.

Silicon Valley, however, finds ways around blockages. 

We have now entered the Era of Cheap, where great companies can be launched on the cheap. The first wave of Consumer Internet franchises are racing towards big IPOs: Facebook, Zynga, Twitter, Chegg, Groupon. These ventures were started with capital from a new breed of investor, the so-called SuperAngels - institutionalized seed funds that embrace the Era of Cheap. As this chart from CBInsights shows, in the past year the SuperAngel seed funds have grabbed over 25% share of new fundings from the traditional VCs.

What the smackdown series of debates (which you can find on VideoCrunch) show is how the Era of Cheap is disrupting the venture business itself. After funding disruption to traditional industries for thirty years, the big VC funds are finally getting a taste of their own medicine. How they will respond is unclear. There is a lot of chatter that the traditional VC model is broken. Certainly with the poor returns for the past decade, the pension funds which invest in the venture category are pulling out. 

But is the model itself at fault, or the exogenous factors that have plagued all financial sectors in the past decade? I argue that the New Normal of low returns for an extended period affects venture capital as well. I conclude that even granted the effect of exogenous factors, the VC industry should stop expecting it to go back to the old normal right away. Instead, venture capital needs to figure out how to deliver returns in its new nromal: an environment with few IPOs and smaller m&a exits. They need a new model. 

The SuperAngels have been the first to figure this out. The Era of Cheap lets them fund Internet deals which can be quickly tested on small capital. They may exit with a quick flip, or raise boatloads of VC capital and go for the big win; but the modest capital allows them the time to experiment and find a market before big money removes the quick exit. 

The final smackdown event went back and forth on this issue. The Big VC argument is that you need the big money to build a real company. The SuperAngel counter is that for both founders and buyers the small exit might be a better outcome, and they can preserve the big win if the company hits in the consumer Internet lottery of consumer appeal and fickleness. 

My take: in the old model, after the seed round, traditional VC was a necessity, In the new seed model, Big VC is but an option.

Corporate Bonds: The Next Safe Haven?

In the New Normal of low interest rates and low returns, institutional investors engage in a Global Scramble for Yield which makes them stretch for a few extra basis points, often assuming a disproportionate level of risk, as we all found out since 2007. Now we see a whipsaw market, which bounces between a jump back into risk or a Global Scramble for Safety, such as the run on gold coins that infected Europe after the Flash Crash. When the obvious safe havens get driven up, such as Gold, Treasuries and even cash (Dollars); and the hoped-for safe havens get their day, such as Munis; where to put the marginal safe investment? Jennifer Gordon of ForexIndicators.net (not .com) weighs in with high quality corporate bonds as the next place to catch before the scramble for safety drives rates down here, too - but with an eye to the exit! 

This is a possible safe harbor not well covered in the punditsphere, so your comments are encouraged. 

The New Normal in Venture Capital

The "New Normal" is a characterization popularized by PIMCO, the big bond fund, to describe a low-rate, low-return environment that they expect to persist for a considerable period. This environment is affecting all aspects of financial investing, and it should be no surprise that it is transforming the venture capital industry. 

What has emerged is a new venture ecosystem, characterized by "capital efficient" funds which raise a modest amount of capital and can deliver good returns to their investors with $50M "quick flip" exits. When there are few IPOs and the number of Billion Dollar Babies can be counted on a couple of fingers, this is the only approach that makes sense for the limited partners (LPs) who invest in venture funds. The big funds are refocusing on long-term capital-intensive cleantech projects, which are more in character private equity deals. The statistics are vivid: as reported by Silicon Valley Bank and summarized in the attached chart, small funds have returned dramatically better than big funds. The funds below median are 24x more likely to return over 2x cash-on-cash to LPs than the funds above median (48% vs 2%): 

 

To make this work, the capital efficient funds are investing in lean startups: ventures that follow a set of principles to enable a small amount of capital to go a long way:

• Open source - which is low cost and has been stress-tested
• Cloud services - low capital to the startup and easy to scale
• Browser/App-phone clients - free to the startup and wide-spread 
• Rapid product iteration - letting the market give feedback quickly
• Socially-connected - very low cost customer acquisition
• Pervasive mobile - enabling a whole new set of applications

Venture capital produces great returns during waves of innovation. John Doerr, the inimitable leader of one of the premier funds, Kleiner Perkins, calls this the Third Wave after the PC revolution (1978-1983) and the Internet (1994-2000). This wave has not yet been succinctly characterized, but the leading candidate name is Cloud Computing. 

An immediate criticism of capital efficiency is who builds the big infrastructure, if not venture capital? The answer is already clear: the big Internet winners are scaling out cloud computing platforms (Google, Amazon, Microsoft), and the PC leaders are clearing the forest with new client devices, such as the iPhone and the iPad from Apple. 

The technology model of every era of innovation defined the predominate venture capital model - the funds designed themselves to leverage the trends. The last era drove megafunds to lay the railroad tracks of the Internet. This era in contrast is about working at higher levels of the technology stack than operating systems, computers, cellphones or networks. Now that the tracks have been laid, what are the new apps that people will love?

The always-connected Internet cloud provides the answer: the eternal beta application, launched quickly, changed constantly, always seeking to find the combination of fun and function that captures the hearts and minds of users. 

The disruption of the New Normal venture model is likely to affect a whole passel of current funds. It has been much noted how the amount of money going into to venture capital has decreased, and this is putting the squeeze on mid-sized funds. What has been less noted is that the New Normal model may cause LP capital to rapidly switch from traditional VC funds to the new breed of capital efficient funds. 

The New Normal model comes with Logan's Run: if you are over thirty, you won't be funded. The mantle of what is cool has been passed from the Boomers, who still rule the funds, to the Millennials, the new generation of 20-somethings who grew up tech-savvy. The Millennials first flocked to Facebook, Twitter and Zynga, the darlings of the new era, and are feverishly checking-in with Foursquare, Gowalla and other iPhone apps. 

The New Normal entrepreneurs care little of the old brand names of traditional VC. Indeed, the capital efficient funds believe the traditional VC model is broken. Maybe so - we shall see how the adapt. As this Third Wave crests, it is likely the capital required to make serious companies will increase, as it has in the past, bringing the traditional funds back into the game - or leading to a new breed of larger capital efficient funds. 

Right now it appears the venture capital jungle is soon to be ruled by little furry mammals running rings around big funds. 

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):

Bonds Predict the New Normal

The bond market is predicting PIMCO's New Normal environment: slow growth, little inflation. The bond funds are signaling no confidence in the direction of US fiscal policy.

Inflation is not the issue. The inflation-adjusted TIPS are showing very low real yields, close to real LIBOR. 

A strong recovery is not the issue. This chart from Bloomberg as analyzed by Calafia Beach Pundit shows the current yield curve in red, and Boomberg's forward projections in purple (one year out), yellow (two years) and green (five years). The projection shows the Fed raising the Fed Funds rate to 1% in one year and 2.25% in two years on its way to 4.5%. These future curves show little to get excited about; real growth would drive the long end more steeply. 

The US deficits are the issue. The risk for bond investors is a rise in the longer rates due to the need to finance the huge deficits. After a flurry of poor auctions following the ObamaCare bill passing, the Treasury markets have settled down, at least for the moment. Yet this may be a calm before the storm. 

When gold rises, it is usually looked at as an inflation indicator, but that is too simplistic; it is really a hedge against bad government. The bond market also can indicate a lack of confidence in government - just watch Greek bonds right now. The major bond funds in the US are voting against Obama by becoming seriously underweight in Treasuries: 

• PIMCO has dropped in to 27.5% and shortened durations
• Templeton owns no Treasuries in its Global Return Fund
• Wellington has only 13.5% whereas a typical bond fund would be well over 50% 

Bonds at Resistance - 7th Time the Charm?

Bonds are at the cusp of a breakout to higher yields. This chart from StockTiming shows the 30-yr Treasury hitting the down-sloping resistance line for the 7th time in 17 years. With the end of QE, it seems poised to break above, and if it remains above, signals a major trend change - the end of the Bond Bull Market of the Great Moderation since 1982. 

We almost broke the trendline recently (Oct), but the market did a head fake away from it. We have now returned. 

The STU's wave count has the 30-yr in a wave 5 up to above 5%. This would break the trendline, but it would also complete the wave structure, leading to a drop back below. As mentioned, a break above a trendline confirms a change, unless it quickly falls back below. 

The WSJ has reported on a divergence on rates between Morgan Stanley and Goldman Sachs: 

• MS sees a rise of the 10-yr to 5.5%, which puts the 30 yr above 6%
• GS sees a 3.25% rate, which pulls the 30-yr near or even below 4%

The Sunday NYT chose the MS position, citing Bill Gross of PIMCO, which believes the thirty year bond bull market is over. If so, the impact on the economy could be rough, as mortgage rats could rise 25% to over 6%, and consumer credit costs may seriously erode household discretionary income (see chart).

David Rosenberg summarizes the argument in a recent Breakfast With Dave, and concludes that bond yields do not tend to rise with high deficits after a credit contraction; instead they rise from increased economic activity or inflationary fears. He points out the contradiction in the NYT's position: if they do rise, as the NYT suggests, "there will never be a sustained improvement in the pace of economic activity." His view comes down to his expectations of inflation vs deflation, and he is in the deflationist camp:

Fiscal deficits that are designed to cushion the blow from a credit contraction, especially among households, generate far different results. With credit contracting, rents deflating, the broad money supply measures now declining and unit labour costs dropping at a record rate, it hardly seems plausible that inflation is a risk at any time on the near- or intermediate-term forecasting horizon.

Paul McCulley of PIMCO hangs with their "New Normal" view of prolonged low rates. He sees real GDP settling down to 2-2.5%, and expects 10-yr rates to settle to 4-4.5%, somewhat above where they are now, but not much, and only after unemployment normalizes to 5%. That could take a while, hence his view of prolonged low rates by the Fed. His view can be summarized as "never fade the Fed." Of course, with a huge bond portfolio, the last thing PIMCO wants is a sharp raise in rates, devastating their holdings, hence they have been very vocal promoting their New Normal.  

The primary counter to Rosenberg is that the current deficits are unprecedented in size and stretch (ie. indefinitely forward). Even WWII had an end to it, and was financed by forced savings by the public due to deprivation as production was targeted to the war effort. Sure, Japan has extended their deficits for two decades, maintaining low rates, but they have benefited by huge savings domestically plus relatively strong capital markets globally. 

ZH did a deep dive into this topic, beginning with analyzing how the problem has been kept in check for the past two years: the Fed's QE plus lots of short-term Treasury borrowing has resulted in modest interest costs, with 40% of the Treasury holdings being let out at essentially no interest. With QE ending, they think it unrealistic that the blended borrowing rates will remain low. They present several scenarios, focusing on what percent interest becomes of Treasury receipts (ie taxes):

The most likely case would be a rise from 6% to 16%. If MS is correct in their 5.5% 10-yr rate, this grows to 25%. If inflation rockets out of control, possibly this climbs to a catastrophic 50%. Worse, if tax receipts continue to fall, this could go towards Japan levels of 100%, the point of no return. 

The ZH analysis basically says that the Fed cannot use inflation to get out of the mess we are in. (Paul Krugman would do himself and all of us well by doing the math for himself.) Of course, the Fed believes it has a way to tighten without unleashing the $1T reserves it created for banks into a hyperinflationary lending binge: raise the rates paid on the reserves to keep them in the Fed. 

It always amuses me how fundamental analysis can come up with scratch - sound positions both ways. Sure, the fundamentalists can take comfort in the contradictory TA assessments as well, but often they provide stronger warning signs. Here is a classic TA pattern to watch, a head & shoulders in the 30-yr:

 

If we break the trendline, we could see bonds drop below par (100) as the H&S setup suggests a drop below the neckline the distance of the head above. Rates would shoot above 6%. Confidence in the US would drop, and the Treasury auctions would become more difficult. 

A lot if technical indicators are hitting extremes. The STU tonight reports that the USD's recent drop signals trouble: either a much deeper drop ahead, or sideways for a while. A further drop tomorrow pretty well confirms a downtrend. Weakness in the USD is another warning sign of weakness in bonds to come. 

Unemployment, Stocks, and the Fed's Emergency Meeting

The unemployment numbers continue to suggest a peak in unemployment last Oct/Nov (see chart, from a veritable unemployment chartfest at The Big Picture). This points to the Fed raising rates in Q4. (History says the Fed tends to raise a year after unemployment peaks, or three years after a recession starts, which both put it in Q4. 

This timing for a rate increase should be bullish for stocks, in a Goldilock's sense: it seems good enough to support he 2010 earnings expectations but not so strong as to pull forward a Fed rate increase. While markets were closed Friday, futures markets had a short opening, and stock futures went up a bit. The financial press pointed towards this and the unemployment report as signaling a recovery ahead. I will comment later this week on that, but for now I wouldn't make too much of this report, since stocks seem to be fully-valued against expected 2010 earnings, and the small futures pop was largely technical (specifically, the S&P seems to have completed a triangle, which is typically followed by a sharp thrust, which we might see continue Monday morning). 

The Fed called for an emergency meeting Monday morning, which likely means they will raise the Discount Rate a second time. They raised it on Feb 18, and the USD strengthened. Monday is a bank holiday in Europe. so reaction may be muted until they Euro banks wake up Tuesday am. (Also, the recent pattern of a Monday Pump up may be delayed to Tuesday, due to this holiday.) 

I have seen it mentioned in the blogosphere that the Fed typically waits until the Discount Rate is 1% higher than the Fed Funds rate, or at 1.25%, before raising the Fed Funds rate. I expect a rise to 1% tomorrow, meaning more time until we hit 1.25%. Question is whether the rapidity of the recent rise of the Discount Rate suggests an earlier end than Q4 to holding the Fed Funds rate low?  At six weeks betwixt & between raises, the next window is end of May for 1.25%, followed by mid-July for over 1.25% - both well before Q4.

Or is something else going on? After ObamaCare passed, the Fed had a hard time with auctioning off Treasuries, and has more to offload this week. Perhaps this emergency meeting will reconsider ending QE so the Fed can prop up the auctions.  

Also, last week the Fed revealed that its Maiden Lane program (where it bought mortgage backed securities - the toxic waste of the housing bubble) has left it holding well over $100B of assets of questionable value. The Maiden Lane III portfolio is only worth 39c on the Dollar. Maiden Lane II is 44c on the Dollar. This means the Fed has assumed an impaired balance sheet, and needs to fix it. It also holds over $1T of mortgage-backed securities (MBS) soaked up in the past year, which include a lot of poor mortgages. One way to fix its balance sheet is to sell off or swap out the toxic debt and MBS, and buy Treasuries to slowly return to its historical quality of reserve assets. Thus rather than explicitly continue QE, it may begin a swap program - but notably at a discount (ie a loss) to what it paid. 

Whichever, the Fed is in a bit of a pickle: it needs to successfully fund the huge deficits, and at the same time exit from extraordinary measures. In effect, the Fed rushed in where a resolution process would have treaded, to shore up the bank balance sheets by swapping out some of their toxic debt and buying the MBS that they would have been loathe to pick up this past year. Now in unloading this stuff it will take the loss the banks would have had to - and given the Fed's ownership, the loss would be spread back onto the major banks. A neat trick, that, if it works. More after the Fed's meeting. 

Bond Market Forcing Fed's Hand

With US markets closed today, the only action is with bonds, and the concern is that rates will continue to rise. The Fed likes to present an aura of omnipotence, but the bond vigilantes can force its hand. The Fed has kept short rates low, but the market drives longer rates. As the Fed has been ending its QE policy, long rates have gone up. 

Pacifica Partners notes rates have moved much faster than most market participants have recognized: up 90% since the 10 year Treasury hit 2% a little over a year ago, and a spike up in December concurrent with a bottom in the Dollar (see chart):

 

Barron's notes that since Thanksgiving, the 10-yr yield has gone up 20%, and appears to be on the verge of a big breakout. They point to a bullish flag, which has broken to the upside.

 

The current tumult in the bond market (see my ObamaCare Spooked Bonds post) seems to be caused at least in part by a supply imbalance with Treasuries. US households are back to spending again, so they won't cover. European buyers are pulling back to solve their own Greek tragedy. Social Security is going into deficit, which means instead of buying Treasuries they will be a net seller. They used to cover a huge percent of our deficit (50%). 

The big buyers, China and Japan, appear to be headed for the door, often by trying to hide the sales by funneling through proxy accounts. Their obfuscation makes it somewhat difficult to figure out if they have been selling, but given that China may report a trade deficit in Q1, the capital flows almost require them to be lightening up. ZH has estimated a $300-400B differential between forex holdings and Treasuries, one measurement of their selling. When rates turned in December, China began selling, visibly. ZH speculates that instead of selling, they are letting shorter-term Treasuries mature, and not buying anew. One columnist who says not to worry believes they are letting short term bills mature and then buying longer-term bonds. He also thinks the official TIC accounting may be missing some transactions, particularly if China obfuscates what it is doing. In any event, TIC measurements makes it clear that foreign flows into Treasuries have been dropping:

 

Normally forex holdings track trade flows. China has to hold a bunch of US assets to manage their Dollar trade, and to keep their currency pegged at a cheap level, has to hold an excess to "sterilize" the exchange of their currency inside China for Dollars. During the Great Recession, global trade dropped, and with that the need for the same high level of forex holdings of Dollars. Significantly, Dollar holdings dropped more than trade. This puts pressure on rates to rise, since due to less trade there are fewer foreign Treasury buyers. 

 

The Keynesian cheerleaders for fiscal stimulus interpret the steep yield curve in the normal way, as signaling a recovery ahead. I discuss this in my The Logic for Bonds post. Normal steepening is due to increased demand for longer-term commercial loans, which we still do not see. Instead, we see a rush to float junk bonds. Sometimes the yield curve steepens due to inflationary fears, but the inflation-adjusted Treasuries, TIPS, still have a mild spread vs. Treasuries. Likely the steep curve is due to artificially low short rates, and long rates creeping up due to the supply imbalance. 

The most interesting argument is that the private sector has pushed their own risk onto the public sector (TARP, Fed buying toxic debt, etc.), and now may turn on the chumps saviors. As Bruce Kasting puts it:

With the end of QE the cycle is now complete. The maximum amount of risk in the form of credit exposure and aggregate debt has now been passed to the public sectors around the world. As markets are wont to do, they are likely to turn on their benefactors now that they have succeeded.

Did ObamaCare Spook the Bond Market?

While financial pundits have been watching stocks rise, bonds have fallen sharply with yields spiking up. We have just had three bad Treasury auctions in a row - demand was weak for 2-yr notes on Tues, 5-yrs on Wed and 7-yrs on Thurs. The signature 10-yr is rising towards 4% (see chart). As the Fed is now ending QE for mortgages, rates for a 30-yr mortgage have risen above 5%. 

The most inexplicable moment this week came when interest-rate swaps priced corporates BELOW Treasuries, a first. Treasuries are supposed to be the safest bet around, and should price below corporates. No one is sure if this is a blip or a trend. It may be just a blip due to a lot of corporates being issued right now. (Instead of bank borrowing, US companies are issuing debt - which means a lot of moaning of lack of bank borrowing is missing this alternative path to credit). Morgan Stanley takes it as a signal that Treasury rates are about to spike up to their target of 5.5% in the 10-yr. ZH has a long treatment, worth reading. 

Technically, Treasuries are breaking out of a channel/triangle since December, and fairly sharply. How far they will run is unclear. Triangles often end with thrusts. The STU expects this thrust to go above the prior highs, which is only  4bps higher on the 10-yr, and a bit more on the on the 30-yr (4.84%). This suggests the break could be fast, followed by a reversal. It is noteworthy that the triangle in Treasuries is also seen in other markets, like Shanghai equities and certain currency pairs, such as the AUD/CAD, so this sharp spike & reversal may be mimicked across other markets. More on currencies below. 

The next chart shows a heads & shoulders pattern, which would suggest a run up from the neckline as far as the dip below the neckline - or to above 5% in the 10-yr, and 6% in the 30-yr. Head & Shoulders are often seen and seldom fulfilled, so be cautious on this projection.

Yields are NOT rising due to inflation, and hence the real rate is rising as well, which should slow the economy - double dip coming? There are no particular economic woes which should push rates higher. Could the rise be a return to normalcy, with a 3-4% GDP expectation ahead? Perhaps, but that view would not explain why the bad Treasury auctions this week, nor the sudden spike upwards. David Rosenberg notes how a similar rise (90bp) happened from March to June 2007, right before the big credit crunch hit. Have we started that again, in March again? Are we seeing a shot across the bow, a warning shot of the coming second wave of the crisis?

Another explanation is that Bill Gross of PIMCO caused a rotation out of bonds by saying that the three-decade bull market in bonds is over. Real rates are expected to rise, especially after the Fed begins raising short-term rates. PIMCO is now moving into low-deficit sovereign debt (Germany, Canada - but not the US) and stocks. No surprise, the spread between the 10-yr Treasury and the German bonds have widened this week. So if this turns out to be a blip, blame Bill.

 
Related to this is the continued Greek Tragedy. A deal was announced, or maybe not; but the critical fact is that Germany decided not to bail out Greece. The best analysis of this I have read comes from STRAFOR's Mitteleuropa Redux report. Germany is going to strengthen its position and let the profligate Club Med economies fade. No surprise that the bonds of the PIGS are sinking. Greek problems first spilled over to Portugal, and now Spain. These are all countries whose debt-to-GDP is way too high. 

The USD is surging, and the Dollar Index has breached 82. The Euro has dropped precipitously - not so long ago it was above $1.50, and now it seems headed below $1.30. The Yen has also begun to weaken, falling over 1% with the USD, and breaking a major trendline back to Aug 2009. The Yen might be a play - SlopeofHope suggests a double-short Yen ETF. In any event, the USD has broken out and should continue to surge. The anti-USD plays should now unwind, including the CAD, AUD and NZD. 

 

With the Dollar strengthening, why are Treasuries weakening? We need to ask the question of whether ObamaCare is a straw that is breaking the camel's back. Its deficit impact is years away (although tax increases come first), and it is easy political hay to claim it is spooking the markets. Yet the sum of the indicators above is that US Treasuries are beginning to lose their pre-eminence as the lowest risk, best quality place to park money. ZH did an analysis which observed as many others have that "the US is on a collision course with an unmitigated funding disaster" then added "with recently passed healthcare reform, look for the redline indicating total debt to go increasingly exponential". Here is their chart with that red line, showing how fast it has risen over the past 18 months:

 

Their most interesting insight is the Fed has been pushing the lengthen the maturities of this debt. They can continue to sell short-term bills at essentially zero rates, but want to push buyers into longer maturities. As they do this, they begin to lose control over rates. Simply put, they can keep short term rates low, but the market determines mid- and long-term rates.  

Perhaps the market is digesting this revised deficit chart, which was quietly let out on March 5, a few weeks before the ObamaCare passage. It shows the structural deficit is much worse than imagined, and we will hit ZH's collision with funding disaster faster. Now adding ObamaCare and its full-ten-year cost of $2.4T, these numbers would be dramatically worse than even the higher revisions. Of course, it is really difficult to truly assess the impact of ObamaCare, but every program like it since Medicare has come in grossly worse than estimated, not better. 

Even without ObamaCare, the CBO estimates the "deficit held by the public", which excludes intra-government holdings like social security, increases from 53% today to over 90% of GDP by 2020, putting us into the PIGS arena. The book by Rogoff and Reinhart, This Time is Different: Eight Centuries of Financial Folly (2009), which looked systematically at these sorts of crises, found that the 90% level was the tipping point to lower growth, making it near impossible to grow out of the debt burden - and hence instead fall into sovereign debt default. 

China and the New American Manufacturing Paradigm

"Mercantilism works" - Paul Krugman

Krugman's call for 25% tariffs on China are based on a profound misunderstanding of how the Great Recession will transform US manufacturing. The US is rapidly moving to a higher-value and sustainable position in global production from an older model of unskilled labor gaining a middle class salary on the assembly line. The greatest threat to this repositioning comes not from China but from within, from policies that hinder innovation and burden production. 

I have written how the Great Recession will transform the West by accelerating a drop in core manufacturing and replacing it with high-value jobs in the layer of design, software and services that I call the IP layer (for Intellectual Property). A simple look at how value flows to Apple for the iPhone should convince you. Click on the sidebar thumbnail of a chart of value in the iPhone (courtesy GigaOm, sourced from Column Five Media). In sum:

• Apple gets $579 from the mobile operator
• Apple pays $179 to build it
• China gets $6.50 for core manufacturing

The assembly line manufacturing component is about 1c on the $. Apple gets about 70c, and that does not include the service income from downloadable apps and music. Most the rest of the cost to build it is IP frozen into chips and software. The mobile operator subsidizes the purchase by $351 and gets about twice that in data fees, even before including voice minutes and sms fees. A similar model applies to the new iPad. 

The IP and Services layer is where the value is. Traditional manufacturing of the sort Krugman wrings his hands over is no longer what "manufacturing" is all about.

You could argue that Apple is an outlier, but there are a myriad of similar companies in Silicon Valley, Redmond, San Diego, and elsewhere across the US. The web industry is largely centered in the US. The smartphone industry is almost wholly in Silicon Valley (Apple, Android, Microsoft's Danger division, Palm). The social networking winners are largely here as well. And of course the US and Europe have huge bio-tech and pharma industries.

It is passing strange indeed, then, that what passes for industrial policy in the US is to bailout car companies, enable huge profits in financial services, empower increased public sector union jobs, jawbone about green jobs - and continue to pluck the golden goose of innovation with:

• Sarbanes-Oxley, which has quadrupled the price of going public and at least doubled the cost of staying public
• Demonization of stock options
• Imposition (potentially) of more expensive health benefits
• Imposition (likely) of increased taxation on small business
• Increase (likely) of capital gains tax rates
• Worsening (possibly) the tax treatment of venture capital

Certainly China is catching up, but a look at history shows that China is still a paper dragon. When the US went through its period of remarkable growth to become the China of its day back in 1900, US companies were the world innovators in both technology (telegraph, telephone, lightbulb, electric generation and transmission) and process (ruthless efficiency in oil, steel, transportation and retail). When Japan emerged as a world power, it too showed innovation, particularly in commercialization (VCR, walkman) and process (just-in time manufacturing, quality). As China has emerged, it shows neither. Instead, it is a story of cheap labor and rapid flow of capital. 

This is all too apparent looking at Chinese profitability. The Chinese exporters are hanging on by a thread,with a profit margin of less than 2%. They are at huge risk of failure if the Chinsese currency rises. As an equity analyst noted:

2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins.

If Krugman gets his way, the sort of assembly line manufacturing of China would not come back to the US. If the Chinese currency goes up 25%, or we throw on a tariff, the rise is from $6.50 on an iPhone to $8. Instead, it would go to Vietnam or other low cost areas. 

The bigger threat to the US is a continuation of bad industrial policy that hinders US innovation, while China makes great strides to move beyond cheap manufacturing to the IP layer. Already we see R&D moving to China out of the US. Several Chinese companies are gaining world scale and competitiveness with Western companies, such as ZTE in cellphones, Haier in telecom infrastructure, Lenovo in computers, and Baidu in search. 

An encapsulation of the problem with the path we are on is that government workers now surpass goods-producing workers in the US. 

 

The last time a transformation of this magnitude occurred in the 1930s when workers left the farms and went to the assembly lines. Farming dropped from 40% of the workforce to a few percent, and yet farm production kept increasing. We had huge gains in productivity, and after WWII were able to absorb those new workers into manufacturing. 

We have gotten to the point where the number of public employees in the Agriculture Dept is said to rival the number of core farmer workers. I don't know if this is quite accurate, but the joke is, why was the Agriculture employee crying? His farmer had died. 

Yet that old saw misses a deeper and more important observation: while the number of core farmers has decreased, the workforce in the layer above farming - call it Food Processing - has grown dramatically, and adds a lot more value than farming itself. Food processing and the food service industry to deliver it to supermarkets and restaurants has proliferated an incredible assortment of food products. In many respects this is equivalent to the IP layer above the assembly line, and has its own intellectual property in genetic engineering, flavor enhancement, organic products, preservation, packaging and distribution. Sadly, it too is being starved of innovation, and hampered by fears of genetic modification of seeds, while China is moving ahead. 

Similar to what happened in the '30s, as core manufacturing has declined, manufacturing output has not, and the jobs have shifted to the "manufacturing processing" layer above, the IP layer: 

 

As with farming, we can promote innovation, or starve it. Right now the punditry seems intent on starving it. The most astounding fount of bad policy is the Economist Who Wants To Be Taken Seriously but says really dumb things - Paul Krugman. In a recent post in his NYT blog, he actually said that "mercantilism works". Adam Smith wrote Wealth of Nations to show the mercantilist fallacy, that the "beggar thy neighbor" policy lowers overall trade and hurts the mercantilists' citizens. The victory of Capitalism over Mercantilism was decisive, to say the least. The errors in Krugman's argument are dissected here and here. He wants us to become China. He says things this dumb:

• Virtue becomes vice: attempts to save more actually make us poorer [comment: tell that to the Japanese and Chinese, who force their citizens to save at high rates]
• Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster [comment: tell that to the Chinese, who are now deathly afraid of inflation scuttling their miracle]
• Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense [comment: really? we grew a whole China in GDP from 2004-7]
• For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies [comment: only in an academic fantasyland]

A much more sophisticated discussion of the topic comes from Professor McKinnon of Stanford, who points out that as long as the Chinese currency is not accepted as a widely-tradeable reserve currency (like the Yen, Dollar or Euro), it cannot be floated without severe internal consequences to China. Simply put, it would rise without much to limit it, as the Chinese themselves would be loathe to recycle their savings by investing in Dollar assets since the rising RMB means their Dollar investments drop. It should come as no surprise then that mercantilist economies tend to force their citizens into huge savings while restricting their ability to spend outside the home market, since that spending would unwind the beggar-thy-neighbor cheap currency. All of this means that the clumsy Krugmanian solution (of the US becoming a mercantilist like China) would fail to change China and would lower global trade whole hurting the US consumer. 

In spite of poor US policies, I see a tremendously exciting and lucrative future for the US in remaining the leader in the IP layer above manufacturing. We have already vastly increased the size and scope of our college-educated workforce, and the IP layer can absorb college graduates just as the assembly line absorbed unskilled labor off the farms. The speed of change and innovation in engineering, design and marketing mean that training for specific jobs is less valuable than being broadly skilled in learning, creativity and adaptation, all areas in which the US culturally excels. 

We need the patience to ride out the Great Recession, the forebearance to let the transformation work its way across industry, and the wisdom to accept the Creative Destruction of Capitalism, rather than fall into the politically expedient trap of intervening to forestall the change. 

How The Great Recession Will Transform America

Warren Buffett bought a RR anticipating a major change in America driven by high energy costs. The article Warren Buffett vs the Soccer Moms lays out the thesis that "Buffett is betting on higher energy prices and a different transport focus." In effect, Warren is betting that the American Dream is over. Instead of living in a suburban McMansion with a green lawn, an SUV, and suburban schools, the middle class will be force to re-huddle in cities and rely on public transportation, with trains rather than trucks moving goods between city cores. 

I think America will be transformed by the Great Recession, but not in such a dispirited direction. 

Let's start with Warren's energy bet. The bet seems plausible, given fears of Peak Oil and Obama's intent to regulate and tax energy under Cap & Trade or similar schemes. The bet reminds me, however, of the bad policy and misleading extrapolation of the '70s: 

• Then, as now, we had a weak Dollar policy which led to rising commodity prices, especially oil. 
• Then, as we intend now, we regulated oil prices, which led to shortages. 
• Much doom & gloom was extrapolated from those bad policies, including the demise of the American Dream.

But the story ended the other way. For those too young to remember, in 1971 Nixon first took the Dollar off gold, leading to a terrible decade of inflation; and Nixon tried to stem inflation with ill-fated wage & price controls, which he had to soon remove, except inexplicably he kept them on for oil & gas. We had lines at gas stations, capped wells, and increased dependence on imported oil. When Reagan stopped the price controls, the shortages vanished, the lines disappeared, and perhaps most paradoxically for central planners, oil prices began a long slide lower, to $10/bbl in 1999. Even with Bush's weak Dollar policies, oil was still at $16/bbl in 2001, and was around $25/bbl after the quick Iraqi strike in 2003. Only when Greenspan's Indian Summer of monetary stimulus took hold in 2004 did oil began to rise, reaching $147 by July 2008. Near the peak policy makers once again wrung their hand over Peak Oil and extrapolated a dismal future of high energy for American soccer moms and their despised SUVs. 

Seems to me investors are once again are in grave danger of being driven down the wrong path. Policy changes create high prices and (potentially) shortages, and drive extrapolation of transformation from high energy; but those policies can and likely will be reversed if we have another decade like the '70s. Anyone investing in high energy in 1980 found their plans were busted by the continued drop in energy prices, and the gradual loss of government subsidies. Governments are always the last to react to a change in underlying conditions, and relying on them to hold dis-economcial policies for long enough to get out is fraught with risk for investors.

Yet it is likely that America will be radically transformed by current economic conditions. The Great Recession is of a kind and scale seen three prior times in American history: 1929, 1873 and 1837. Each of those had a serious depression following a credit bubble, and led to rapid transformation of American business and power centers. You could see glimmers of the future change extant already, but the entrenched power centers were able to withstand the tide and hang on. The crash and subsequent depressions seemed to break open the constrained forces. Here are the prior three transformations:

1837: Andrew Jackson broke the Bank of the United States (the Fed of the day) and in doing so broke the power of Philadelphia bankers. The financial center shifted to NY, which has held it ever since; and the food processing center shifted from St. Louis to Chicago, where it has remained. 

1873: German reunification led to a global bubble and crash, and also came with a global shift from silver to gold, bringing about a long grinding "long depression" of over 20 years. The mill towns of New England, which were the foundry to the Civil War, gave way rapidly to the new manufacturing powerhouses in the Midwest. Cities like Pittsburgh, Detroit and Cleveland became the foundry for the world. 

1929: A poorly-designed return to gold in 1925 by England led the Fed to loosen credit to bolster the Pound, and the Roaring '20s were off. Hoover's meddling after the crash exacerbated the problem, and a global banking crisis in 1931 led to the Great Depression. The US was dramatically transformed from agriculture (40% of employment before the crash) to manufacturing. After the recovery, power shifted from the Midwest, soon called the Rustbelt, to the suburban splendor of the Sunbelt. 

If the pattern continues, I would expect a step function down in manufacturing, much like the vast shrinkage of agricultural jobs last time; and a shift away from the Sunbelt to a new power center. If we shrink in manufacturing jobs, what will the basis of production shift to? It won't be services, nor construction, nor 'green jobs' which tend to be temporary construction projects, not permanent new factors of production. (Spain provides a good case study in green jobs being a mirage for a new basis of production.) 

Instead, the US will drive for value in encapsulated intellectual property (IP), embodied in drugs, software, chips, web services (like Yahoo), data (like Google) and products (like the iPhone). We already see this happening in technology products, and now that the floodgates have opened will become the new factor of production across all industries. One of my favorite thinkers, Will McDonough, is the leading thinker of ecological architecture. Among other achievements, he rebuilt the famed River Rouge plant of Ford, the very model of a modern major assembly line, into a sustainable model with pavers instead of asphalt, natural lighting, and grass on the roof. He is urging a technology cycle similar to a biological cycle, where manufactured products can reduce back into the ecosystem. An example is to redo plastics based on organic carbon, not petrochemicals. These plastics look and feel like petro-plastics, and yet dissolve when thrown away.The whole plastics industry can transform itself into a new range of products. With a little extension of thinking, this approach can go into architecture, autos, food processing and across many other industries. Rather than the lame green jobs of Obama, to build wind farms and similar, this is the real green revolution. 

And this is but one example. Similar revolutions are occurring in pharma, biotech, entertainment, telecomm, lighting, marketing-media and other industries. 

What therefore changes is a drop in blue-collar manufacturing jobs and a rise in high-value-add knowledge jobs. While manufacturing flies overseas to China and India, we retain the marketing, design, control systems and materials science that goes into those products. It is no accident that the center of smartphones is now rising in Silicon Valley (Apple, Android, Palm), and the web world is also centered there (Google, Yahoo, Facebook, Twitter). This is but a sampler of what is likely to happen across the whole US. 

How will this change the power centers in the US? One of the most interesting thinkers of this potential transformation is Richard Florida. His view of the coming transformation is set forth in his books, and is most accessible in a recent Atlantic Magazine article. He is a proponent of the 'agglomeration effect' first popularized by a brilliant economist, Jane Jacobs. She is best known for saving Greenwich Village from a debilitating freeway through its heart, ending Robert Moses's remaking of NYC and starting the NIMBY movement to preserve the charming and inviting city centers of major US cities. I discovered her work in an Atlantic article that reprised her book, Cities and the Wealth of Nations. 

Simply put, "agglomeration" means a city-region becomes the center of a technology and holds it for a long time. Detroit for cars, Pittsburgh for steel, Chicago for food, NY for finance, LA for entertainment - these were the prime US examples. Today, we would say Silicon Valley for technology, Shenzen for contract manufacturing, Tokyo for cars, Milan for design, and London for finance. Birds of a feather flock to the center to be part of it. The efficiency and networking of being in the center lead it to get stronger. With globalization, the centers are no longer within protected boundaries. Where we had three car centers - in Stuttgart, Detroit and Tokyo - it appears the center is accreting to Tokyo. This also happens within a country, as the venerable Route 128 around Boston has given away to Silicon Valley. 

The implication of agglomeration is a shift from the Sunbelt to Knowledge Centers, denser areas in semi-urbanized settings such as Ann Arbor, Austin, Palo Alto and Cambridge. This is not the RR dream of Buffett, back to the urban core; but neither is it the continuation of suburban sprawl and transplant factories in far away cities. 

This transformation-by-innovation will not happen quickly. In another inestimable article, Houses of the Future, The Atlantic provides a model of how this will come about. The article looks the burgeoning housing innovation in New Orleans, post Katrina. First, the government had to get out of the way. After a failed stimulus and political squabbling between FEMA and local authorities, grandiose schemes with no follow-through gave way to bottoms-up innovation. A number of competing visions are emerging throughout the city, from Will McDonough's zero-energy green homes to much simpler "Caribbean" homes linked to the lifestyle of the locals. The key message seems to be for the government to back off gold-plated regulations and attempts to "help" and let innovation thrive. 

Similarly, after yet another Stimulus bill and continued attempts to impose costly regulations across our economy (healthcare, energy, autos, etc.), we should see these efforts peter out due to their own failure, to political squabbling and lack of follow-through. At this point (2014? 2017?) the ground will have been prepared for innovation from the private economy to emerge. 

For investors, the key is to invest in the leaders of the new knowledge industries. For society, the key is to promote the rise of knowledge industries. Until then, we will have to suffer through a self-destructive decade of high taxes, hostility to small business and venture capital, false promotion of ebbing unions, and malinvestment in the wrong priorities. Caveat investor. 

The New Normal

The bond fund PIMCO popularized the term New Normal to explain the investment environment for the next five years: low growth, high unemployment, slow banking, slower securities, and steady erosion of productive capital stock. In their words:   

Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation. ...

The result is a prolonged pause, or in some cases, a violent reversal in certain concepts that markets had taken for granted. 

McKinsey and others had also used the phrase The New Normal to describe the next few years: less leverage, more government, new protectionism, less consumption and a focus on Asia. They think innovation will continue, and investment in human capital. 

Now John Mauldin in his weekly newsletter takes issue with these projections as too optimistic, dismal though they may seem. He had been a proponent of the Muddle Through economy, one of slack growth (1-2%) and slack employment - kind of like the New Normal. He developed his Muddle Through concept before we had $1T deficits as far as the eye can see. He is even more worried that the optimistic projections underlying the White House estimates (see chart) are unrealistic: they assume 3% growth and a return to 5% unemployment, much better than expected in the New Normal. Hence $2T deficits may be the real New Normal. 

The problem he sees is that deficits of this magnitude crowd out private investment, and will continue to suppress consumption in favor of savings (in this case buying Treasuries mostly!). GDP is measured as:

 GDP = C + I + G + X

or Consumption + Investment + Government Spending + Net Exports (exports in excess of imports). 

The Keynesian plan is for an increase in G to make up for a drop in C. But if that G is funded by huge deficits, it crowds out private investment, and I drops. In order for GDP to continue to grow, we must have an increase in I to fund the private sector. It would have to come from the outside, measured as a positive X (net exports); but for a long time we have run a trade deficit and have had negative X. Will that change? One of the common themes of the New Normal is for capital to leave the US for Asia. This will not create a positive X.

You could take issue with the chart above, as the worst case deficit projections come from the Heritage Organization, a conservative group opposed to Obama. But Société Générale came up with a similar analysis, concluding that we will quickly have a Trillion Dollar Gap with no clear way to fill it. See chart, courtesy The Big Picture. 

Now, heretofore the overseas US investments have had returns back in higher than the trade deficits have bled out. This seems likely to change, and also puts pressure on X and how to fund the huge deficits. Right now the US banks are getting deposits at very low rates and buying Treasuries at 2% or higher - such a deal! It enhances the Fed's QE but does nothing for investment in the private economy. 

Picking up on my theme from yesterday, as we starve private investment and send capital overseas, we starve the Golden Goose.

Prognosis: after the inevitable dead-cat bounce in GDP, we should see slow growth with periods of negative growth: The New Normal. Taxes should go up first in 2011 with the Bush cuts expiring and then in 2012 and beyond if any of the bills get passed (the healthcare bills all raise taxes, as does Cap&Trade). Tax increases will further suppress GDP. 

In this environment, hard assets and bonds should do better than stocks. 

Dollar Demise is Premature - A Discourse on a New Gold Standard

Lots of people sending around this story of a secret cabal working to get the oil trade off the US Dollar. The story seems to have engendered a lot of comment on the web; the mysterious Web Bot Project has called for a financial crisis on Oct25 that could lead to a Dollar Crisis. It apparently tracks web trends and attempts to make predictions. I wouldn't take this prediction to the bank but if it is widely crawling the web it may be showing the level of chatter on the demise of the Dollar is high.

I find this waaaay overblown. The cabal is not so secret and the timeline is not so fast (2018, not tomorrow). Mish does a good job of showing the impotence of the effort. Foreign Policy writes a really good piece on how hard it would be to push the US out of its hegemony.

The global reserve currency falls into the lap of the dominant power, and it does not leave easily. Even under the classic gold standard, it was the Bank of England that managed it, until 1914. After WWI the dominant power had moved to the US, and even then the global standard stayed in England. When the gold standard resumed in 1925, it was managed again by the Bank of England; but it had to create a bastardized standard, a gold exchange standard, where the Pound was backed by the US Dollar and the gold in the US. Only after WWII did the standard shift to the US, under Bretton Woods. Even when the US broke with the Bretton Woods gold exchange standard, the USD has continued to reign supreme against attempts to replace it as the reserve currency. 

Consider what is required to make the alternative work. The secret story says it will be based on gold. Now, a small amount of gold can go a long ways - global trade in 1913 was huge, and not matched until the mid-1990s. (I know that may seem hard to believe, but things fell a long ways down due to WWI and then the Great Depression). It was based on a 90-day instrument called a Real Bill, backed by gold held in the Bank of England. This Bills could be used to borrow against, and traded multiple times. A merchant in England contracted for cotton in the US to be shipped to a plant in China to be manufactured and shipped back to a store in London. The same, single Bill would be used at each step and often got traded or 'discounted' over 20 times. It all got cleared within 90 days and everyone paid off their debt - the many swaps down the chain simply paid off each other. (If you play with the math you can see it works.) As long as the balance of trade of the Bank of England was even, no net gold went in or out; it simply got shuffled in the vault from one bin to another. A small pile of gold could support a huge and growing trade system.

To make the new secret system work, the net gold flows in and out of whatever the bank or clearinghouse is have to balance. In the classic gold system, exchange rates were fixed and nations had to adjust their trade policy to make sure gold did not run in or out. Under a floating exchange system, the rates would adjust. Now in both systems nations could try to cheat, and did, much as the mercantilist countries like China today keep their exchange rates low by holding excessive Dollar reserves. So such a new system has to deal with the cheaters. (If you list who is behind it, you find them likely to want to cheat!)

Real Bills worked independently of such shenanigans. They were an emergent property of capitalism, arising early-on in the Italian city states, and hence were a very resilient system. Yet they died during WWI and have been largely lost to economic history. Instead we have commercial paper and other short-term instruments to finance trade, and are beholden to the whims and fancies of the banking sector.

To remain in balance, the secret system would need to handle much more than just oil purchases; it would have to set up some form of clearinghouse with relatively stable trade flows across a wide variety of trade. This is very hard to pull off. Perhaps if the cabal thinks it through, they will establish in effect a clearinghouse for a new form of Real Bill, and use it for only half of what banks do: the commercial supply chain trade, not investment or venture finance. The central authority might be called a bank but would function more like a clearinghouse.

As an aside, a lot of people do not appreciate the power of the Real Bill system. The Federal Reserve when created in 1913 was supposed to be a Real Bill clearinghouse. WWI threw a monkey wrench into that. The Austrians never got Real Bills, and have called for a 100% reserve banking system. This would be an utter disaster. Even the normally astute Mish went into a recent rant about fractional reserve banking being fraud. He got seriously slapped down by Karl Denninger's rebuttal. A 100% reserve system would lack sufficient capital to grow; fractional reserves are a marvelous way to leverage a small amount of cash-on-hand. Anyone serious about changing the global financial system must separate the trade finance system of the Real Bill (or its modern equivalent of commercial paper. factoring and A/R finance) from the investment system of bank loans, private equity and venture capital. A banking or trade system backed by real stuff (houses, cars, goods-in-transit) does not need to have much in the way of reserves, since the financed properties themselves are collateral.

While hard to pull off, it is not impossible for the USD to be replaced. Mish is too sanguine on this as well in his first article linked above, under-estimating the benefit for the US to power the oil trade. Other nations need to hold excessive Dollar reserves to finance the oil trade, and cannot easily convert out of it without impacting the value of the USD itself or of their own home currency. The US gets the benefit of seigniorage, and can run trade deficits much longer than possible under the classic gold standard.

I have a bet that by 2020 the US Dollar will be replaced or supplemented by some form of gold-backed reserve. It would take a much more serious Dollar Crisis to get there than anything going on right now, but if you look at the long term chart of the US Debt (see chart from CBO) you will see it is complete fantasy that the US can continue with the current policies - and this chart is from late 2008; the picture is much worse today. At some point we will face a huge Day of Reckoning. My 2020 bet looked far off when I made it a couple of years ago .. we shall see if it is far enough out.

The US can continue for a while with increasing deficits. Right now we are deleveraging faster than the Federal government is borrowing; see second chart. This is why we are in a fundamentally deflationary environment. And why the Dollar Demise is not imminent, nor is a new gold standard somehow imposed from our trading partners.