Planet Yelnick

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.

Fade the Fed on Housing

A common aphorism for traders is "never fade the Fed." Great import used to be placed in the money supply, and the Fed's FOMC statements were scrutinized for nuance to give a hint as to future direction. As inflation faded, so did that scrutiny. Today great import is placed on the Fed Funds rate, and FOMC statements are analyzed for any change of language. Nothing much changed today, and the market went up. 

I sometimes wonder if our society has gone Medieval, arguing over how many angels could fit on the head of a pin; or today, how many angles can fit within the spin of the Fed. 

The Fed initially was formed to handle bank panics, specifically the Panic of 1907. It had a regional structure, much like what existed before the Fed was formally made the central bank in 1913, and the regional banks issued notes with varying rates depending on the health of that part of the country. They stood ready to back a failing bank and prevent a run, and then failed their first major test in 1931. 

The Fed was expanded in the 1930s to manage Treasury issuances, and hence the money supply; and in the 1970s was expanded again to be required to push for a full-employment economy. This made no sense, as controlling money and pushing employment can be contradictory goals, as we all found out: the pressure to inflate to keep the economy going led to a debacle that tight money had to settle. 

Today the Fed has been expanded again, and is now seen as the overseer of the whole economy. This adds even more contradictory goals to the Fed's role. When an institution is pulled in conflicting ways, how can the "never fade the Fed" aphorism make sense? 

To me this was clearly spelled out in recent FOMC statements about the economy. Today's statement was that the economy was improving, but rates would be held low for an extended period. Isn't this what got us into a bubble after 2002? Of course you can rationalize why it makes sense, especially if you worry over a repeat of 1937 again: the economy was on life-support, and was growing, but when the extraordinary measures were just slightly pulled back, the economy tanked. Is this then the fate of our overly-stimulated economy? If so, something is terribly wrong with how we are attempting to manage the economy. 

We cannot answer such a question yet - history will tell. But we can ask whether the FOMC statements have been good or poor guidance, particularly on their latest role, managing the economy. If poor, this bodes really badly for following their extrapolations. 

Maybe it would be better to fade them? Big money is made in investing when the herd is all on one side - the smart investor fades the herd. 

CalculatedRisk's assessment of the FOMC statement gives a great example of where fading the Fed makes sense, in this case on real estate. Just consider their FOMC statements, and read the tea leaves of their inability to predict the housing market:

Nov, 2009: Activity in the housing sector has increased over recent months
Dec, 2009: The housing sector has shown some signs of improvement over recent months
Jan, 2010: No comment
March, 2010: Housing starts have been flat at a depressed level
April, 2010: Housing starts have edged up but remain at a depressed level

A Sneak Preview of Goldman's Closing Speech to Congress

"You want the truth? You can't handle the truth. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who's gonna do it? You? You, Middle Class Consumer? 

"Goldman Sachs has a greater responsibility than you can possibly fathom. You weep for Lehman and you curse derivatives. You have that luxury. You have the luxury of not knowing what we know: that Lehman's death, while tragic, probably saved the financial system. And that Goldman's existence, while grotesque and incomprehensible to you, saves pension funds. You don't want the truth. Because deep down, in places you don't talk about at parties, you want us to fill that investment gap. You need us to fill that gap. 

"We use words like credit default swaps, collateralized debt obligation, and securitization? We use these words as the backbone of a life spent investing in something. You use 'em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it! We'd rather you just said thank you and paid your taxes on time. Otherwise, we suggest you get an account and start trading. Either way, we don't give a damn what you think you're entitled to!"

courtesy: CalculatedRisk

Greek Metaphors Converge on Creditanstalt

Greece finally begged for a bailout today. "Greece Declares Unilateral Withdrawal from Reality" was the faux headline of ZH, worthy of the best of The Onion. 

The metaphors have moved from Bear Stearns to Lehman to now the grandaddy of all defaults, Creditanstalt, the Austrian default in May 1931 that led to a series of other defaults in Europe and the second wave down after the 1929 crash.

What is perhaps overlooked by many is that Creditanstalt was rescued by capital from the Austrian government, the National Bank and the Rothschild's, but the announcement of the rescue caused a run which took the bank down. This run drained the government, and by mid-June its credit had run out and it fell. 

The rescue caused the ruin. 

Why the run? The creditors to the bank seized a chance to get out and dump their bad debt on the government. Could that happen this time? Mish provides this chart of the exposure of various banks by country. What if the French and Swiss banks, who are particularly over-exposed, decide to get out and dump their debt onto the IMF? 

Curiously, then, the lesson is that the very rescue of Greece may cause its demise. Or, that the private banks will stick the hot potato into the taxpayer's lap. 

Is the Greek Tragedy About to Erupt?

While US markets tease the bears near a possible top, the action is over in Europe. A Euro bond offering failed to complete in German Bunds, the first failure in over a year. Greek CDS spreads rose to record highs, and the Euro has dropped for the fifth consecutive day. German opposition intensifies to a bailout of Greece. Leaks indicate that the cost of the bailout may be more than twice as high as previously thought.  Shanky's technical analysis site has a good summary. 

And Portugal is next. Their CDS spreads surge to within 7 bps of a record.  The Big Picture puts this succcinctly:

The Greek 10 yr bond yield is rising another 40 bps to 8.25%, the highest since Oct ‘98, the 2 yr yield is up 35 bps to 7.65% and 5 yr cds is up 25 bps to 485 bps and is fast approaching the Ukraine. Portugal continues to get dragged into the mud as their 10 yr yield is up 17 bps to 4.79%, the highest since March ‘09 and 5 yr cds is up 20 bps to 220 bps.

The maco-economic speculation is that the Euro may be acting as that "barbarous relic" which caused serious problems in the early 1930s. Keynes thought that adherence to a gold standard had limited the ability of distressed countries to reflate their currency. Brad Delong (Keynesian professor at Berkeley) has a chart to capture this point, below. Question is whether keeping Greece on the Euro will prolong their travails vs letting them go back to the drachma and inflation. 

Unemployment May Not Be Getting Better

I have been expecting a better recovery than the consensus ("every W starts as a V") and with it improvement in unemployment, at least until we go back down in a double dip (if we do so). While the official rate is that we peaked in October and have improved since, a look at unemployment claims suggests that we have been flat since October and possibly slowly worsening:

 

For investors, this is an important issue: if we peaked last October and have been improving (slowly) since, it raises the odds of the Fed normalizing rates in Q4. The consensus view is probably captured by recent statements by Geithner, who expects a flat unemployment rate for a while (as census workers come in and leave the rolls) and then a steady decline. The analysis above suggest that the "New Projection" may turn out to be as optimistic as were the original projections, with and without stimulus, also in this chart:

  

In California, hiring is picking up in Silicon Valley, but the State's overall unemployment rate has increased to 12.6% and the "underemployment rate" (U6) is approaching 24%. The recovery such as it is remains highly uneven. We should not be surprised that areas with high value-added jobs improves, but overall the situation is still tenuous at best. 

After the March unemployment report, Obama gushed about how substantial the improvement was and opined: "we are beginning to turn the corner."  Politicians will of course jump the gun, but investors need to be more circumspect.

The WSJ noted how large the margin of error in these reports can be:

The ranks of unemployed individuals grew by 134,000 last month From February to 15 million, the Department of Labor’s Bureau of Labor Statistics says. But it is also plausible, the agency says, that the number of unemployed rose by 500,000.  Or, it could have fallen by 200,000. ...

In other words, it isn't even clear whether the number of unemployed rose or fell last month. 

Art Cashin of UBS then gave us the last word: 

Wow! To think that markets react to these numbers as though they were truly meaningful.

Who is Sue Goldman?

I was asked a marvelous question in a comment to the last post: who is Sue Goldman? 

Sue Goldman is a seductress that always comes along during periods of financial flimflam innovation and with the most meager of bribes campaign contributions can bend Congress to her will and permit her to do her tricks on the unsuspecting public. 

History Rhymes

I will spare you the Santayana quote, but clearly we have not learned from financial history.

Financial flimflam touted as innovation always seems to come with a credit bubble, often powered by government sanction:

• 1929: "Sue Goldman" got caught with The Goldman Sachs Trading Company, a leveraged investment trust, that collapsed in 1929. Goldman was the largest promotor of investment trusts backed by enormous leverage, the flimflam of 1928 foisted on a blissful public.
• 1907: The Knickerbocker Trust, started by a close friend of J.P. Morgan, the Goldman of his day, tried to corner the copper market, and set off the Panic of 1907. (It is fascinating to study how the oligarchical control of banking and these trusts led to instability, an indictment of putting all the financial eggs into a few huge interlocking banks that are, of course, now "too big to fail").
• 1873: J. Cooke, the Goldman of its day, had prospered selling War Bonds during the Civil War. J. Cooke helped drive one of the first big RR Bubbles in the US using the flimflam of that day - buying RRs with excessive leverage - and sparked the Panic of 1873. 

What we saw with the recent S&L crisis is the government privatized the upside but socialized the downside: it released S&Ls to pursue broader markets with higher interest rates, but maintained government deposit insurance. Then the problems emerged, not before. Deposits flew in at higher rates, and the S&Ls participated in the financial flimflam of the late '80s: LBOs. This time around the government backed the mortgages packed into these these synthetic instruments (CDOs, SIVs, etc.), which were sold with CDS's as insurance. 

Sensible, But The Wrong Fix

Geithner's course, to fix the system first and prosecute later, is a sensible choice, but he chose the wrong fix. Now we have the worst of both worlds: 

• the moral hazard of banks "too big to fail" remains high, so bankers will continue to do bad things
• the system is in zombieland, engaging in speculation not lending (did you notice how Bank of America's just-announced large earnings were driven by trading, not banking?)

What is missing from reasonable discourse is this: banks are not too big to fail, but too integral to fail.

Yet this does not mean they should get bailed out. 

Instead they should have been cleansed, and quickly - wash-out the equity and unsecured debt, reduce secured debt positions based on the value of remaining collateral, and restructure to attract fresh capital. Sweden did this by separating each bank into a good and bad bank, and letting the bad banks work off the bad stuff. The US did it in the S&L crisis by using a resolution process: a rapid, pre-packaged bankruptcy with a resolution trust working off the bad debt and the cleansed banks being restored to solvency. 

After that, which could have 'saved' Lehman, then we prosecute.

The Biggest Bank Robber of Them All?

The most curious character in the Sue Goldman story is John Paulson, the guy who caused Goldman to set up the vehicles he could short while Goldman sold them to the unsuspecting public. He reminds me of the characters in the Panic of 1907 who used Knickerbocker to help them pull a short squeeze on the big owner of the copper interests. Paulson may have done nothing wrong, just something too clever. 

I have seen a lot of anger directed at Paulson:

• Is it conceivable that Paulson did not know Goldman was lying to the clients?  
• Is it conceivable he was not in cahoots with Goldman? He is said to have directed Goldman to figure out what toxic debt to put in these things, but do we expect he picked the stuff out himself? 

We could have dealt with Paulson by a stroke of the pen: declare certain types of CDS's as fraudulent instruments and unwind them. Paulson would be required to pay back his ill gotten gains. Goldman pays back their fees. The owners of the risk get paid the higher interest the instrument would have required absent the CDS. AIG would have become solvent overnight. The system would be back in balance. 

Are CDS's Fraudulent Instruments? 

Karl Denninger is on a crusade to consider CDS's fraudulent instruments. At a minimum, he thinks they should trade on an open exchange, as should all of these sorts of derivatives. Absent that, he argues they are subject to manipulation, especially when the CDS protects an instrument that itself does not trade or is hard to value. Here is his logic (simplified) for why CDS's can be at their core fraudulent:

• a CDS acts as an insurance policy to protect the principal on default
• an instrument that pays 8% without a CDS might have paid 6% with a CDS
• the 2% spread is pocketed by the banker after paying for the CDS
• the nominal value in the aggregate of CDS's is so huge there is inadequate capital among AIG and other issuers to cover any run on CDS's, or if you like any systemic risk
• the meager 20 bp or whatever that is paid to AIG does not make up the 200 bp of risk

How can 200 bp of risk go away for a mere 20 bp? Or 30 or 40? CDS's becomes another form of leverage, and makes these instruments more risky than the 6% rating says they are - indeed, still close to 8%! Hence the fraud. 

Is this argument compelling? If the underlying instrument the CDS backs is itself traded, this argument is not convincing, because the buyers can price the underlying risk. If the CDS also is traded, the premium paid for the insurance will also be less subject to manipulation. So, for example, if you had bought WaMu corporate bonds, which traded, the CDS on them was not fraudulent, and probably highly useful to determine the real underlying value of the bonds. Greek bonds trade on broad sovereign debt markets, and the CDS's on them seem quite good at reflecting the underlying risk. 

On the other hand, the class of CDS Denninger is crusading against were not traded, nor were the underlying instruments. They were complex combinations of mortgages, stripped and repackaged, and very difficult to evaluate. In retrospect, the ratings agencies were way too generous. They did not trade on public exchanges, and as markets froze up, didn't trade at all. While they were not sold to the general public, but to sophisticated investors who should have had the tools to evaluate risk, the lack of transparency made them easy to manipulate at issuance - hence the fraud risk.  

Further, in a credit bubble, these tools are often put aside as people chase yield. I like to say that there is not fear & greed, but only fear; in a bubble "greed" is fear of falling behind. Forcing the derivatives onto an open exchange would have helped investors protect themselves. 

Where Denninger scores a direct hit is on a second reason why there is fraud: the instruments in the Sue Goldman case were created specifically because Paulson wanted to short them. As Karl asks, if the essential purpose of the instrument (to fail!) were disclosed, would anyone have bought them? 

Is Regulation the Solution?

I am not taking a position on Goldman or Paulson's liability here, but exploring what should be done about the recent bubble and fixing the system. The NYT runs an interesting set of opinions today on whether regulation would have caught out Goldman ahead of time. The conclusion seems to be that it will be hard come up with sound regulations. 

The derivatives mess, however, can be fixed. In 2000 at the end of the Clinton Presidency, a Republican slipped into an appropriations bill an act to completely deregulate derivatives. No oversight at all. No public exchange to trade them on. Since we have a commodities regulator already, and a stock exchange regulator, this seems like an extreme gift to Wall Street, not sound policy. At a minimum we should force derivatives onto public exchanges. 

Beyond that, one of the big risks we are running is over-reaction, too much re-regulation. I do not want to go back to the bank strictures of the 1970s - I welcome innovation and derivatives in general. Put them on open exchanges for honesty. But the larger issue is psychological, and may not be possible to regulate away with stifling the whole system: during bubbles, financial flimflam emerges and wreaks havoc under the guise of innovation, and investors feel compelled to participate to keep up. 

"This time is different!" they say. They always say that.

We need to bring back moral risk - make nothing too big too fail - to restore balance. It may be time to end deposit insurance, government backing of lending for housing, and the implicit Greenspan Put. Or, create a safe banking sector, highly regulated, with deposit guarantees, and keep it completely separate from the robust and innovative unprotected banking sector. Suing a mid-level Goldman banker makes great PR, but is not the solution. 

Why Sue Goldman Now?

Karen Finerman on Fast Money after the close today opined that the Goldman lawsuit is a concerted effort to help pass financial reform and signals that the war on Wall Street is just starting. Curiously for CNBC (not Fox), this sentiment echoes Rush Limbaugh's morning opening today. And indeed, Obama sent out a message today to his supporters, saying now is the time to hold the banks accountable

So why now?  An interesting take comes from Inside Man, an in depth look at Geithner, which I recommend. It will reassure you on the youthful Treasury Secy critics call Tim Terrific. Apparently, he counseled Obama to first restore confidence in the banks before looking for villains, a sensible approach. He primarily did this through the stress tests, plus holding the dogs of law on the leash. As he put it:

Are you going to solve the problem, or are you going to teach people a lesson?

The dogs now have their day. With healthcare passed and the recovery seemingly underway, no need to hold back. Expect more to come.

What could this mean? Severe headline risk in the coming weeks may drive the B wave correction, if not a deeper correction. Other indictments may come down, such as against Steve Rattner, who is under investigation. AIG is up, and may now also sue Goldman. The STU believes wave B has started, with a likely target in the Sp1150-1170 range; but if it breaks Sp1107, it will have gone farther than the recent X wave (Jan19-0Feb5),indicating a larger correction than a B wave. 

Greece Going Lehman On Us UPDATED

Big news this morning is Commerzbank pulling its repos that are supporting the Greek banks. These are overnight facilities, and may lead to runs on Greek banks. Unless someone steps in (IMF? IMF?) this should put the Greek banks into a liquidity meltdown. This chart from ZH shows the yield curve "pancaking" - going to flat - because the short term (3-6 month) rates have shot up, with spreads at an "all time record for a developed country."  This usually indicates a default coming. ZH predicts:

• failed next bond auction for Greece
• Euro drops below $1.30
• Greece pushed out of EU
• Euro to $1.15

Update mid-day: ZH reports that Greek banks have now called the remaining E17B of a 2008 backstop plan. Deposits have dropped E8.4B since Dec. The Bundesbank may be also close to pulling its life-support backing. They need to fund E8.2B rolling over in Apr20, and E27B over the next seven weeks.Tomorrow the head of the ECB is expected to provide its plan for Greece Last chance before they swallow the bitter pill the IMF is offering? 

(photo courtesy Telegraph.) 

Those contrarians among you may consider that if Greece accepts IMF's tough terms, default will be avoided and these bonds will pay handsomely (since their rates will drop all the way back on a bailout). 

ObamaCare Strikes Back UPDATED

Besides spooking bonds, ObamaCare may be about to trash stocks. And its costs are supposed to be years away! Karl Denninger notes how Obama said there would be no financial impact until 2014, but already it is causing reduced earnings for major US companies. 

AT&T's charge is 8% for this quarter. Caterpillar's was 11%, and Deere's 16%. These are against retiree costs - the WSJ explains that the bill removes a deduction for providing drugs, hence the charge. An excerpt here. We should expect this percent to increase as employee healthcare costs themselves are driven up. 

This charge is non-cash today, but indicates higher taxes in the future. One estimate is $4.5B of charges. As this spreads across US companies, expect charges around 10-15% of quarterly earnings, which is 3-4% of annual earnings. Actual future cash losses will be about half of that due to higher State and Federal taxes. This suggests that the S&P became a 4% over-valued on earnings and 2% on cash flow when Obama signed the bill, not the 10-15% that Karl Denninger feared. 

The WSJ provides a handy chart to explain the changes. 

 

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. 

Be Wary of Friday's Retail Report

As we anticipate the pattern of a Monday Pump up at the open, consider that a lot of positive excitement last week came from a positive retail report on Friday. This led to gushing that consumer spending was now likely the fastest in three years, and upwards revisions in GDP forecasts for Q1 to 3.1% from 2.7%. The V is on! We're saved!

This premature exaggeration could lead to a flurry of buy orders over the weekend. Yet consider:

• retail was up in Feb, but only because Jan was revised down
• higher oil prices were half the increase (oil has doubled in price YoY)
• a big slug of tax credits went out in Feb
• the Jan numbers were suspect when issued, and proven wrong
• Consumer sentiment is souring, not improving - indeed it was dismal
• Gallup Consumer Spending surveys do not support the surge (see chart)

 

You wonder how a month of blizzards and bad Toyota news could lead to a good report. Although I am not a conspiracy guy, and tend to blame purported manipulations on incompetence, this report looks an awful like we have a rolling manipulation of data, with positive reports and later revisions. Expect Feb to be revised down - to make March look better! 

The trend over the last three months is a 1.2% annual rate of growth (0.7% ex gasoline). Weak. Hard to see how that supports a 3% or higher annual GDP increase, let alone the close-to-6% from Q4. 

Worse, in inflation-adjusted real terms, retail is down although trending as if bottoming: "[W]e are in the recovery phase, i.e. declines have stopped [but] this phase is very anemic, kind of like a patient on life support." This chart shows real retail (orange), a twelve-month moving average (black), and an extrapolation (blue) as if the Great Recession had not occurred:

 

A lot of retail experts gushed with excitement on Friday. Maybe the experts are out of touch with reality?  Especially because Peak Stimulus is rolling over. if so, the downside surprise in a few months could be shocking. A "gap and crap", on Monday, as Mish predicts, might presage a gap & crap quarter in markets. 

The Logic For Bonds: California Munis

California is issuing more munis to bridge the state through a huge $20B deficit (on a $87B budget, which used to be an astounding $110B). The credit default swap rate of California has grown towards Greek levels - yet the offering sold out 25% more than expected. Floating $2B, Cal sold $2.5B at 5.65% for 30 year bonds. That interest rate is 1.2% higher than comparable munis elsewhere, a bigger spread than last time Cal did this (in Nov) where the spread was 'only' 90 bp. As the deficit in Cal has widened, the spreads have increased, but does this really indicate a risk of default?

My view is no. The last thing Cal will do is stop paying on these bonds. It needs them to manage through the ups and downs of tax revenues. 

An analogy for muni bonds is to the dot-com era, where the dot-coms threw everything overboard to stay afloat - except their web hosting. Their web sites were their lifeblood. The leading hosting service, Exodus, was a huge short waiting to happen, since its stock held up past the bubble bursting, until finally the dot-coms had to shut their sites down. 

You can see the behavior of the issuer in this over-subcribed issuance: rather than worry over the high interest rate (120 bp higher than other States), California issues even more, fearful of buyers at all. Hence the rates rise due to market noise, not the underlying risk. (Also note that the higher muni rates of Cal are still not anything like a junk bond rate - as long as Treasuries are still below historical norms, the bond market will keep munis relatively lowish).  Don't believe an efficient market hypothesis for California Munis right now - rates are driven by fear and greed. Fear by the issuer, greed by the happy buyers of relatively high tax-free rates. 

Historical Default Rates

Muni's historically have had low default rates, even when the issuer itself went bankrupt. In the Great Depression about 2000 cities defaulted, which led to Chapter 9 of the bankruptcy code, allowing them to go into restructuring - and save their bonds. Since this was passed in 1934, around 600 cities have had to file for Ch 9 - out of well over 40,000 municipal entities. A very low rate. 

The big one to fall in 1994 was Orange County, California, which initially defaulted on part of its debt, but eventually the bondholders were made whole. Orange County led to a series of reviews of muni default risk. The studies concluded that general obligation bonds have a very low default rate of about 1/4 of 1%, especially if Orange County is taken out as an an outlier due to unusual circumstances. Much riskier are special districts and industrial-development finance that issue under the name of a municipality. 

The lessons learned for munis are twofold:

• diversify, so one Orange Count does not hammer the whole portfolio (obvious)
• look inside the issuance to the real party at risk, and avoid special project finance

On the last item, there were higher electric-power project defaults in 1982 coming from a court ruling, but very low since, especially after changes in the 1986 Tax Reform Act. This suggests two risks in buying industrial development bonds: the underlying project may fail, and laws may change. Consequently, be wary of muni bonds fronting:

• industrial development
• green projects/renewable energy
• hospitals and education projects

Despite the desire to see reneweable energy get built, if the project relies on subsidies and coercion to survive, rather than underlying economics, laws can change and subsidies can evaporate, especially in a streesed financial climate - as in California! A similar risk may be there for hospital and school projects, given the likely changes in healthcare and education.

The Union Stranglehold

Make no mistake of fear despite the low historical default rate, even back in the Great Depression. Bloomberg issues a "bankruptcy bloodbath" story about Vallejo, Calif, the most recent major city to go into Ch 9. Vallejo is in trouble due to excessive demands of city unions, and the worry is that bondholders may have a partial default as part of a packaged deal. 

The new factor in munis is how laws have changed to advantage state unions. Still, Ch 9 would allow excessive union contracts and benefits to be voided. About half the States, however, prohibit by law their municipalities from using Ch 9, presumably to further entrench union contracts. Fortunately for California, it is not one of those States. (The list is in the Bloomberg story.) 

 

A recent article, Plundering California: How Public-Sector Unions Brought The State To Its Knees, has now become the book Plunder!, discussing how public sector unions like Visigoths have sacked States across the nation. The author posted the Readers Digest version in the WSJ. Memorable anecdotes include:

• the average pay in Orange County for a fireman is $175k, and allows retirement at 90% of the final year's pay for life, including the life of his/her spouse
• 82% of chief-level Highway Patrol employees discover a disabling injury about a year before they retire, which gives them extra benefits; very few seem job-related
• teachers and police get shielded from dismissal, to the point that school districts don't even try to remove misbehaving teachers

It used to be public workers took lower pay but had better retirement. Now they get higher pay and much better retirement. Such a deal! 

It used to be most of the spending on K12 education went to teachers, principals, buses and schools. Cal actually ranks low on support people at the school level, but I recall that in the '90s California spent only 60% of its education budget on actual education (teachers, principals, buses, schools) and the rest on an over-paid bureaucracy in Sacramento, the State capital. A decade later and that 60% is down to 50%, with half of the education budget now flowing into those nefarious bureaucrats. These percents are probably overblown for effect, but the impact is clear: unions and administration are bleeding the State budget dry while letting the vaunted California K12 system fall to the bottom of the heap. Something has to change. 

What Happened to the Golden State?

Californians sigh thinking of how golden the State was in the '60s. On lower taxes and spending per capita, it had the best public schools in the country, new freeways that flowed, cheap housing, almost-free universities, cheap energy, heavy industry, and seemingly unlimited growth. Today on higher taxes, something like 2x the real spending per capita on education, and very high energy costs, it has the second worst K12 public schools in the country (thanks, Mississippi!), crumbling roads, riots over tuition in colleges, and a list of woes that overwhelms. 

I went to a rally for Meg Whitman for Governor, and the first question she was asked was, why would you want such a hopeless job? 

Most Californians can point to the key forks on the road to perdition:

1. 1977: Jerry Brown as governor allows State employees to unionize
2. 1978: Prop 13 freezes local taxes & pushes education funding to the State level
3. 1988: Prop 98 fixed the percent of spending on education at 40% (it is now above that)
4. 1999: Calpers (public employee retirement) sharply increases pensions

Jerry Brown is running against Meg Whitman. He admits that his biggest mistake was the 1977 law which allowed State workers to unionize. This, not Prop 13, has busted the budget and put California into chronic financial crises. Prop 13 combined with Prop 98 created a great flow of power to the State level, and with that power the giant sucking of funds out of education and into administration.

The pattern in California is for the surpluses in good years to be doled out to political favorites. In 1999 the huge dot-com surpluses went to public-sector union benefits. In 1996 surpluses went to K12 by reducing class size. And so forth time and again. During the bad times, these constituencies buckle down in a fight to hold their benefits, and the State in desperation issues more bonds to bridge the difference. The legislature remains eternally in deadlock. It is a terrible political situation when state unions can use campaign finance and other muscle to shake-down the taxpayer for benefits. This is a whole different dynamic than normal bribery of the legislature, since the state pays for the union benefits, state laws make it hard to remove the benefits, and the taxpayer is stiffed without apparent recourse. 

Clearly reform is necessary, but it is not clear the crisis is yet bad enough to cause the change that is required: to repeal Jerry Brown's 1977 law. 

The potential risk to munis is that attempts to fix the budget run into a rock and a hard place: education has to remain at that 40% level (which has crept higher than that under the Prop 98 rules) while unions fight to maintain their inflated benefits. Are bond payments now a weaker political constituency than schools (by law) or unions (by force)? This will be tested in the Ch 9 settlement in Vallejo. 

The Need for Tax Reform

The underlying cause of the boom/bust cycle is the highly progressive tax system in California. It in a sense is more profit based than income based. During good times, it provides too much revenue to the State, which spends it and ratchets up the budget. During bad times it provides too little, and as unions fight to maintain their ill-gotten benefits, the muni bond market fills the gap, putting the muni market through its periodic conniptions of fear and greed. 

This is good for munis, since it drives rates up without materially affecting the risk of default. It is NOT good for the State. 

There is a tax reform proposal floating through the halls of Sacramento which makes sense: flatten the tax rates by broadening the tax base, and change to a more stable system that collects about the same in good and bad times. Simplified, it changes the sales tax to a business gross receipts tax, and the income tax to a flat rate. The plundering would continue, but with less of a pool of excessive tax revenues to feed off of in good times. 

My take is that the tax reform is more likely than the repeal of the 1977 union law. It would improve the climate for muni bonds, since it would make tax revenues more reliable. Also, after Orange County default, the muni market recovered quickly. Any mistake in Vallejo that partially effects bonds is likely to be met by even stronger support for avoiding bond default elsewhere. And momentarily higher rates, a great buying opportunity.

There still is gold in the Golden State, in muni bonds. 

----

note: this is the second in a multi-part series on bonds

The Economy Abides

We have a lot of confusion in economic forecasts right now. I have mentioned how in the middle of a correction, the market reaches a moment of maximum entropy, in a Chaos Theory sense, with energy flowing about evenly in and out (buying/selling). This ends with a sharp break, a bifurcation one way or the other. The entropy period reflects the market seeking order, and the break finding order.

Something similar seems to be going on with economic forecasts:

• There are V-like indicators (manufacturing, GDP, retail) surrounded by contrary indicators (real estate, unemployment, commercial loans)
• Krugman and deLong want more stimulus, and fear it is too late (see picture)
• Roubini, Rogoff, PIMCO and even Goldman Sachs think we are stuck in a slow U recovery
• Roubini adds that we still risk a double dip, as positive indicators like ISM are fading a bit, and others like housing and durable goods are down
• Shilling, Rosenberg and others expect a double-dip W

After the huge stimulus, both fiscal and monetary, we might have expected a more obvious recovery, if stimulus indeed works. The firehose certainly has some impact, but is all we are seeing it? 

We stand at a point of confusion, where this could still go either way. Maybe we have a sharp V up from here, or maybe a flat to down patch. 

The international picture is also mixed:

• Greece in trouble, the Euro in trouble? Ireland and Latvia both take deep cuts to regain solvency, but will Greece? And then Spain? 
• Japan just revised GDP down after a negative Q3 (see chart)
• UK and much of the Eurozone is skimming the treetops on GDP
• China tightens, real estate is falling hard, but inflation is climbing. Can they muddle through?

I see positive factoids like an increase in floating corporate bond issues, an alternative to bank lending, even as commercial lending is frozen. The retail numbers and revisions look positive, although a lot may be due to tax refunds and Stimulus tax credits, not a sustainable change in consumer behavior. I also see negative projections that GDP may not be that robust in Q1, which puts a damper on the V. I could go on. The factoids are, on the whole, inconclusive.

I hold with the view of a V first, then a rollover back down in Q4 or Q1 2011. Every W starts with a V. Here is the logic:

Inventory levels are quite thin. We have had declining inventory even thru Q4 - what seems like inventory rebalancing is really a smaller drop QoQ, which shows up as positive in GDP calculations. I suspect we have an inventory surprise in Q1 and maybe Q2, where we see a real increase for the first time in a while, adding to GDP and maybe making Q1 and Q2 better than the current modest expectations. Combine that with temp workers fro census, and we can seem to be well on the way to a V shaped recovery by this summer. 

Then we have the inventory rebalancing the other way, the dramatic drop in Stimulus (QoQ) and the letting go of those temp census workers - a surprising change of GDP and unemployment to the worse. We hit the Summer of Disillusionment. 

The impact of this scenario on stocks would be a flat or rising period into the summer, then a sharp break down. A lot of pundits marvel at how high the Hope Rally has bounced, but they seem to miss the broader context:

1. After a deep drop, we always have a sharp bounce
2. American businesses cut deeply, and now have reasonable earnings expectations even on modest revenue: say $75 in the S&P, which puts the PE at just 15, about average
3. The firehose of stimulus seems to have bounced us off a deep bottom

The rumblin' stumblin' rise in stocks fits this circumstance. Economic indicators remain mixed, but the trend is up. With continued concern over GDP in Q2 and a possible early double dip in Europe, stocks might just be flat more than up. I had mentioned in my prior post a possible triple top ending by late March or April, but this economic scenario suggest a slower, rolling triple top:

• First top in Jan at Sp1150
• Next top over the next two weeks at Sp1158-70
• Drop down to the range of the last major low, in July, of around Sp900
• Summer Rally heading into the Summer of Disillusionment
• Third top in late summer at around the same level as the first two tops

Krugman in Wonderland UPDATED

Sometimes you cannot make this stuff up. The lead Keynesian Cheerleader, Paul Krugman, contradicts himself when trying to throw a Repub down the rabbit hole. In his textbook on macoeconomics he blamed "Eurosclerosis" (persistent high unemployment) on unemployment benefits:

Public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. . . . In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker's incentive to quickly find a new job. Generous unemployment benefits in some European countries are widely believed to be one of the main causes of "Eurosclerosis," the persistent high unemployment that affects a number of European countries.

Now he encourages extended unemployment benefits. From a blog wonderfully entitled Krugman-In-Wonderland, here is Krugman's case:

What Democrats believe is what textbook economics says: that when the economy is deeply depressed, extending unemployment benefits not only helps those in need, it also reduces unemployment. That’s because the economy’s problem right now is lack of sufficient demand, and cash-strapped unemployed workers are likely to spend their benefits. In fact, the Congressional Budget Office says that aid to the unemployed is one of the most effective forms of economic stimulus, as measured by jobs created per dollar of outlay.

The snarky remark is what he touts as "what textbooks say" is the opposite of what HIS textbook says. So it is ok to create persistent unemployment and Amerosclerosis since it somehow stimulates the economy? There are so many things wrong with this sort of advice it is hard to know where to start. I happen to favor extended unemployment right now for reasons of compassion, to bridge people through the downturn, but not to somehow stimulate the economy. 

Stimulus is not the end, but a means to the end. What good is "stimulus" if it leaves us stuck with high levels of unemployment and reliance on government life support to sustain a moribund economy? 

Amazingly, Krugman goes back through the looking glass again today on this issue, as also reported by Krugman-In-Wonderland: 

I hear through the grapevine that the usual suspects at the WSJ have put out something along the lines of “Krugman says that unemployment benefits won’t raise unemployment, but in his textbook he says they will, neener neener.” Are they really that stupid? Probably not — but they you think that you, the reader, are that stupid.

"Neener neener"? That passes for sophisticated dialog? It bodes very poorly for the punditry to be so thin-skinned that any criticism is met with childish ridicule. I guess that is why Krugman goes on to make this naive and childish comment:

What’s limiting employment now is lack of demand for the things workers produce. Their incentives to seek work are, for now, irrelevant.

The Krugman in Wonderland post dissects that remark. It assumes that at some times incentives work, and at other times they don't, a proposition with no foundation in theory or practice. 

Ask yourself why there is a lack of demand for what workers produce? Could it be the huge Stimulus has primarily gone to things people have little demand for, specifically, the continued increase in government jobs and wages at the expense of the productive sectors of the private economy? Or, the rathole of subsidies for Clunkers and Homes that simply pull future demand forward, but leave no lasting improvement? 

This is but one of a number of Krugmanisms. More on Krugman's follies here. 

UPDATE: I want to elevate an interesting discussion on this post that occurred outside of the comments. A reader's ripose was the following:

His textbook addresses a general situation: 
 "Public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect."

but his column addresses a specific situation:
"when the economy is deeply depressed, extending unemployment benefits not only helps those in need, it also reduces unemployment."

If that distinction isn't clear, let's try an illustration:  Does it matter at all whether the gov't funds its spending via taxes or via debt ? 

Answer (you can Google Stiglitz on this; trust me please): it depends on whether the economy is at or above full employment or substantially below that level.  Deficit spending is harmful in the first instance, but beneficial in the second.

Good stuff. I got the distinction, but clearly should have expanded on why it fails to convince. 

Krugman is asserting that giving people money (under any rubric - unemployment, tax credits, welfare) stimulates the economy such as to reduce unemployment. My counter to it that any such effect (which is really hard to substantiate) only lasts as long as the money is being given away. When govt life support ends, so does the faux stimulus and those jobs.  

What Stiglitz, Krugman et al overlook is that "aggregate demand" is not a fungible lump of spending. It matters a lot where the deficit is put, where the govt stimulus goes. If it goes into more govt jobs at higher pay it reduces investment into private and productive jobs. 

Until we restart private investment, we remain in a limbo that is sustained only as long as the bond market or the voters allow. While we can fool the bond market for a while longer, the voters are restless. Maybe they can see beyond Krugman's claims? Or more likely stopped listening to Keynesian Cheerleading a while ago. It boggles sense that a government can borrow its way into the poorhouse and create prosperity. 

For investors, we have the following dilemma: some sort of recovery seems real, but it is based on government life-support, and is being led by people with a very ahistorical view of how economies work. Rather than rely on real incentives and reform, they rely on gimmicks and puffery. The economy needs a revitalization of the private sector, which creates real jobs, not Keynesian cheerleading. I stand by the view that after a "recovery-less recovery" in 2010 we slip back down in a double dip as the real problems have not been addressed.

Explaining Why Retail is Up When Sales Taxes are Down (Hint: Retail is Survey, Sales Tax is Real)

A Recovery Conundrum: retail surveys say up, tax collections say down. Excuses were made, that Walmart results weren't included, or that better results would come in Dec or Jan.  No dice, Walmart reported weaker holiday sales, and Dec retail sales fell. 

A second shot at this: unemployment is up but the employed are spending again. A Tale of Two Economies. No dice. They would have to be spending a lot more to make up the huge drop in employed, down 8.4M; or to use the broader measure of unemployment, a 17% unemployment rate. This argument is made even more implausible by the dramatic increase in savings.

Mish explains all: the retail data are based on bogus surveys:

The published numbers are based on "same store sales". Think about all the companies that have gone bankrupt. Take Circuit City for an example. Gone. The doors are closed. Some of those shoppers went to Best Buy where same store sales rose.

Also remember that Best Buy and many other chains closed weak stores. The result: same store sales went up again.

Government methodology for reporting retail sales is based on sampling stores in existence. It does not factor in stores not in existence but recently were. Nor does it handle closed stores when the chain is still doing business.

Believe the sales tax numbers. They are real. As of Nov 2009, no State had any growth; as of Dec, 13% had growth (I guess that means 7 if DC is included), but this does not include big States like NY and TX. This might include Cal in the growth side, but it doesn't help - Cal raised its sales tax rate which increased receipts, but underlying sales were down.

Hard to have a real recovery when home sales are down, car sales are down (ok, blame Toyota and weather), and retail is down.

GDP Revised Up But Future Growth Revised Down UPDATED

This is discouraging news: GDP for Q4 was increased to 5.9% from 5.7% but the sustainable components were revised down. This table from Calculated Risk shows consumption (PCE) and investment dropping while the most transitory part of GDP, inventories, made up the increase:

	Advance	Second Estimate
GDP	5.7%	5.9%
PCE	2.0%	1.7%
Residential Investment	5.7%	5.0%
Structures	-15.4%	-13.9%
Equipment & Software	13.3%	18.2%

Worse, deflation also added to GDP. The nominal GDP stayed the same at 6.3%, but the price deflator was reduced by 0.2%, meaning less inflation, pushing real GDP from 5.7% to 5.9%.

Excluding inventory rebalancing, GDP would have been revised down from 2.2% to 1.9%. 

Let's look forward, starting with inventories. Will inventory rebalancing continue? It has gone back to a "healthy" ratio of 1.25 months, but the actual increase is modest, remaining about 10% below YE2008 levels, and actually declined in December. The good news in this chart is sales (red line) are rising faster than inventories (blue line) giving credence to continued inventory restocking in Q1 and Q2. 

 

Durable goods have been rising, supporting positive manufacturing data, but excluding aircraft ticked down in January. It had been rising for a number of months, and this it should be no surprise that business activity shows a V shaped recovery:

Parsing the durables, however, shows this chart, which says a lot of the growth is due to defense spending, not the private economy:

 

Overall the GDP chart looks like a V shaped recovery, but as The Big Picture reports, "even with the big Q4 GDP, U.S. GDP was down 2.4% in 2009 — the worst showing since 1946 (down 10.9%). [Also] 'In 2009, business investment fell the most since 1942, while imports fell the most since 1946.' "

All in all the data is a mixed bag, as manufacturing still seems on an uptick even as organic growth seems sluggish at best, with declining new and existing home sales for example. I have noted how leading indicators seem to be flattening if not beginning to dip. ECRI still insists that a double dip is out of the question:

“with the 6 percent GDP growth and the jobless rate having peaked back in October… a double dip is still out of the question.”

Hmmm. Unemployment is not looking that promising right now, having just spiked up. What if it rises again after the census temp workers flow through and out? ECRI says their flattening indicators suggest that the recovery "will begin to ease off by mid-2-10." They conclude that it is all but certain now:

 

An even more negative view comes from looking inside the leading indicators. A steepening yield curve is considered a positive indicator, since (as described in my recent Bond Fundamentals post) it normally means that business activity is picking up, and demand for longer-term debt is increasing; yet right now commercial lending is not increasing. Instead, the wide rate spread is an artifact of the Fed keeping the short end artificially low. Without that steep curve, the LEI would have dropped 0.1% last month. 

Mish's take on the leading indicators is the double dip may begin as early as Q2 this year. 

GDP models summarized at Briefing.com are begin to show a drop in projected Q1 GDP to 1% growth, albeit based on increased inflation not decreased business activity:

The Logic For Bonds: Fundamentals

When the Fed truly begins to back off its low rates and quantitative easing (QE), we should expect bond rates to rise and bonds to fall. The right strategy is to buy the short end, let the rise happen, then swap to the long end. This seems to encapsulate the Chinese strategy, which has been to sell the long bond and buy in the shorter end (two year primarily). Even if rates jump, and the short stuff drops, they can be held to maturity to maintain value - but moving short too early risks dreadfully low rates and dismal returns while the longer instruments reward their holders. 

It is tricky to throw the magic sticks and divine the Fed, since the Fed purposely obfuscates its intentions. Case in point: after the recent raise in the discount rate it has gone out of its way to say real tightening is a ways off. 

It is also tricky to listen to the pundits. Right now they go both ways:

• The Black Swan guy, Taleb, says "every single human being" should short Treasuries
• Everyone's favorite analyst, David Rosenberg, says to go long Treasuries

Too bad they are on both sides: 

the greatest returns are when a widely-held belief of investors proves incorrect

Instead we have a balance of views. You can see this in the behavior of bonds recently. The long bond was climbing (rates fell) through most of the Hope Rally, but beginning in October began to fall (rates rose). So far in 2010 it has been sideways. We sit on a cusp: will rates continue to rise to above 5%?  Or are they about to drop? 

This is a complex subject, and I will walk through it in a series of posts, beginning with the conventional wisdom of fundamentals. 

Dollar May Have Topped For the Moment

Be prepared for a moment when technical analysis (TA) trumps fundamental analysis (FA): fundamentals say the Euro should weaken and the Dollar strengthen, but technicals say instead the opposite is due. 

Big expose in the WSJ on how currency swaps and other off-balance-sheet tricks in Euroland allowed Greece cheat on the EMU (Euro) rules. (Swaps allow countries to accept liabilities for currency fluctuations that do not show up as current liabilities.) Of course Goldman Sachs structured these vehicles. That is what they are paid to do. Get mad at Greek leaders, not clever bankers. 

Assuming a Greek rescue goes through, according to fundamentalists it will force the Euro to remain weak and allow the Dollar to strengthen:

Greece, along with Spain, Portugal and Italy, all need to increase taxes to reduce the deficit, and higher taxes in a recession reduces economic growth. Consequently the central banks will have to keep the liquidity high and the rates low. This means the US, with an anticipated quicker recovery, will be in a position to raise rates quicker than the eurozone bankers, goes the argument. 

In contrast both Neely and today's STU think the USD has completed a wave pattern and may have topped for the moment. If so, the Euro is about to have the strongest bounce in a while. 

Later this week we will have an onslaught of Bernanke presumably to explain away the rate hike. He also may have to address weak Treasury auctions - another one today, where 30 year TIPS went out poorly. The yield came out 6 bp higher. Also markets are digesting the rolling over of ECRI's leading indicators, as well as China's. These are signs that the Fed may have to slow down its exit from QE, meaning it has to keep rates low.

 

 
In the race to the bottom of currencies, the turtle currency rises relative to the hare. While FA tsks tsks about the Euro, TA is signaling that regardless of exogenous forces, a USD drop is due. Later pundits can concoct the explanation that the US has to race a little faster over the next month to maintain Treasury auctions and deal with rate expectations even as the Euro hare struggles to figure out how to bail out the PIIGS without causing the internal politics of Germany & France to rebel against supporting their wastrel brethern in Club Med. Whew! Complex sentence. At least TA explanations are concise. 

Rate Hike Skewers Options Friday and Starts its Exit Strategy

Remarkable that the Fed would hike the night before options expiration, giving no chance to unwind positions. Karl Denninger notes they have done this before: in Aug 2007 just as the market was topping at all time highs. Did anyone notice that 2 million SPY shares were dumped right in front of the announcement?  

No surprise, futures have erased the whole day's gain in the after market. Right now the March S&P is down to 1095, below where it started this morning. Here is what we should now expect in stocks:

While the Fed made sure to say that this does not signal tightening, and it shouldn't affect commercial rates, it is and it will. The FX market knows what it means: the Dollar reversed a small slide and got above DX81, and the Dollar Carry Trade may be over. Higher US rates means stronger US Dollar. 

The discount rate hike itself is not a big deal - it is largely symbolic, since the intrabank borrowing action is elsewhere - but it is the start of the tightening process. Next we should see the Fed offer higher interest rates on reserves held in the Fed using term deposits: higher rates but locked up for a term. Think of them like Fed CDs. This is meant to keep the $1T of bank reserves in the Fed and not out in the wild, where they could be lent at up to 10x multiples and spike inflation. This as all part of their exit strategy. The actual Fed Fund hike that starts the tightening rise of rates should follow. 

The historical context is fascinating. Back in 1931, the Fed faced a brewing banking crisis out of Europe, with sovereign debt defaults starting with Austria and eventually ending with England getting off gold. The Fed had dropped rates after the crash as vigorously and quickly as Bernanke, but then began raising the discount rate too quickly as a reaction, as shown in this chart (courtesy Jesse's Cafe Americain):

Are we about to repeat, with Greece taking the place of Austria? The Greek debt is roughly the size of Lehman! It may be that the sovereign debt spreads "blowing out" over the past few months, starting with Dubai, is a consequence of the ending of QE and the beginning of tightening, meaning this specific hike isn't the catalyst; the whole reflation attempt and inevitable tightening is. This time we are tightening ahead of the sovereign debt problems, but consequences may be similar to 1931.

One scenario for investors to consider is that the Fed slows the tightening as the Euro crisis waxes, maybe slowing rate hikes into 2011 (which Goldman predicts). The Fed may also have to continue QE longer than they wanted. The other place to watch is the Treasury auctions. We had a nearly failed auction a few days ago. The Fed may find itself between a rock (the need to sell Treasuries) and a hard place (the desire to protect the European banks from the PIIGS). 

How to Handle Keynesian Cheerleaders

This trumps Dramatic Chipmunk! Thanks to my daughter for finding it - she is helping to promote Woman's Professional Soccer and posted it. 

Obama Declares Mission Accomplished! UPDATED

The Obama administration is out touting the Stimulus as causing a recovery, or at least averting a worse disaster. Is it time for Obama to declare Mission Accomplished? Perhaps he should have instead applauded the ability of the US economy to pick up from a deep drop, and kept himself out of the story. He risks jumping the shark. 

Let's first give him his due. We can all debate who gets credit when - my view in general is the prior administration gets tagged for the first year of the new one, so Bush was still to blame until a month ago!  Yet the chart he put out is pretty interesting. It shows monthly job losses bottomed in January (the last red bar is actually Jan 2009) and began recovering. We are still losing jobs, just not as fast. A curmudgeon might note that the worst months started in Nov 2008 when Obama was elected, arguing businesses anticipated a change an policy and fired faster; but more likely it shows decisions made previously taking effect. 

 

You will see a lot of Keynesian cheerleaders out, such as Brad Delong arguing the $100M a day interest cost of the Stimulus is really only $40M a day given the hypothetical Keynesian Multiplier effect (you'll have to follow his logic to get there). Obama still claims he "saved" 2M jobs even as 8.4M have been lost so far, and well more than 2M have been lost since his blue bars above began shrinking towards zero monthly losses. His people can find only about 600K of them, most in Q4, which is similar to a hard estimate by the CBO of 640k new or saved jobs, although the CBO can "find" a possible million more by using those vaunted Keynesian multipliers in their estimates. 

UPDATE 2/18: The Stimulus claims turn out to be preposterous. Obama's web site claims 1.2M jobs "funded". Funded, not saved, and certainly not created. Andrew Cline comments:

The administration switched from jobs "created or saved" to jobs "funded" for accuracy's sake. Or maybe to stop the mockery. Either way, it's a telling methodology.  

Cline dissects the claims from the site itself: of 634K jobs "funded" through Q3, 601K were funded by grants to State offices, meaning it went "save" government jobs and suppliers to government. What happens when the life-support runs out? These are "Cash4Clunker jobs," not permanent jobs, and not private sector jobs of the sort necessary for a sustainable recovery. No surprise that CBS/NYT poll finds only 6% of Americans believe the Stimulus created any jobs. 

In any event, this switch to jobs "funded" at least politically helps them hold on to the dwindling circle of faithful, giving them hope that their vote wasn't just a change for the worse. It provides Obama a better position to be in then their original claims of how the Stimulus would keep unemployment below 8%:

 

The problem with this cheerleading is it is premature. The data remain mixed. We seem to have what Forbes calls Two Economies: we have continued drop in employment and long-term unemployed that does not appear to be turning; and we have recovery of spending among the employed that is helping GDP. Total employment to population is not yet turning - it isn't even flattening. See chart:

 

John Mauldin has taken to calling it the Statistical Recovery - in the case of unemployment, the chronic unemployed who drop out mean the statistical base of potential employed shrinks faster than job losses, so the rate improves! 

UPDATE 2/18: We might do better in the next two years. The Stimulus is shifting from saving government jobs to *finally* funding infrastructure. Only about $20B for infrastructure was let out in 2009, but $160B remains to be released. Also, one of the innovations in the Stimulus, the Build America Bonds, seem to have worked pretty well to allow muni bonds to continue flowing for public works and infrastructure. About $64B were issued in 2009, 3x the amount of Stimulus for infrastructure. While infrastructure spending leads only to modest job growth (much of the work is mechanized) and these can be temp jobs, it can build a better foundation for future economic growth (assuming it is spent on wise projects, not just slush jobs). 

My take is we have a W that starts as a V. Evidence of the V is mounting, including a continued increase in industrial production. The infrastructure spend in 2010 should help add an estimated 1.4% to GDP. We shall have to wait a couple of quarters to see if the balance of GDP growth is still inventory rebalancing or the start of a real recovery. ECRI has been bullish on the V for a bunch of months (they publish a leading indicator index) but now they see growth "throttling back" by summer 2010, the Summer of Disillusionment. They do not yet see a double dip. 

Japan too claimed their stimulus "saved" them from a depression, but they still haven't found a recovery going on twenty years. Let's hope all the cheerleading does not put lipstick on bad policies that lead to a twenty year flat patch. 

France Disenchanted with the Euro

Yves sent me a fascinating poll from France, that the Euro is more unpopular than ever before:

Eight years after euro notes and coins hit the streets, 69 percent of French people said they regretted the passing of the French franc, the Ifop poll for Paris Match said.

That compared to just 39 percent a month after the arrival of the euro in February 2002, and 61 percent in 2005.

The Euro may implode faster than anyone thinks (although not presently). The rescue of Greece is not done, since they first must show some fiscal restraint. While this is unlikely to be ratcheting the stock market - the moves in and out of the Euro have a bigger impact - it will have an impact over the bond market. The moral hazard of rescuing the Greeks is pretty clear, as the rest of Club Med (Spain, Italy, Portugal) will wish to also be rescued. While Greece is affordable, is a bailout of Italy? Yet backing off the rescue risks the concept of the Euro. How to square the two needs?

Lies, Damned Lies, and Unemployment UPDATED

Unemployment went up but the rate went down. The total unemployed rose a whopping 1.4M more than we had thought, from 7M to 8.4M. And yet the unemployment rate improved!? We have entered the the Bureau of Labor Statistics (BLS) twilight zone.

Let's start with the 1.4M increase in unemployed. Several days ago the BLS admitting that they had "created" 1.8M statistical jobs, which is more than the Obama administration claims the Stimulus "saved or created" in real jobs! 

These statistical jobs come from the BLS birth/death model, which they know is flawed. Today the BLS began adjusting away those statistical jobs, dropping 1.363M jobs (617,000 in 2009 and some 750,000 in 2008). Total unemployed since the Great Recession started is now higher than we thought, at 8.4M. The BLS "thought" it was only 7M as of three days ago. 1.4M more jobs lost, and the unemployment rate improved! These jobs were "lost" in prior periods:

 

The workforce is still shrinking, and except for a blip in Nov due to temp workers (retail!), has dropped for 25 straight months (over 2 years!). Yet the unemployment rate has improved.  

We remain in a land of statistics that are masking the underlying reality. One reason the rate improved is the post-Christmas seasonal adjustment; without seasonal adjustments the rate would have risen to 10.6%, not fallen to 9.7%. With them, the rate now looks like it peaked in Oct and is dropping:

The pop up in Oct provoked a rant about seasonal adjustments from the NYT, that the rate should have held steady at 9.5% at that time since the seasonal adjustments were based on flawed retail patterns. Retail has many fewer outlets after the bankruptcies in 2008, so using the prior pattern of temp hiring into Christmas overstates unemployment by expecting more temp jobs than occur. In the same way, using the prior pattern of a drop in those temp jobs in Jan would now understate unemployment by adjusting as if more would be lost than were. 

You can see in this next chart how large the January "not in labor force" adjustment is (the blue line below, with that steep drop every January). These are guesses that get adjusted again later, and you can see how far the adjustments have gone in the last two years (the red line that ends in a hockey stick):

The rate also went down because the total population seeking work dropped more than unemployment. The way the BLS figures it, if you are not "actively seeking work" for 4 weeks, you disappear. You can see how large the disappearance is in the lengthening period of unemployment, spiking up to levels not seen since 1949, when they started measuring it this way:

 

The really scary part of this is it appears we are rapidly creating a huge chunk of the workforce that will be chronically unemployed. I suppose that starts with the housing bubble, which drew a huge workforce into pounding nails in places like Nevada. After a real estate bubble, jobs don't come back for 5 - 7 years. One of the tragic consequences of a credit bubble is it gives misleading signals of what jobs to pursue. The Austrians call this malinvestment; in human terms it means chronic unemployment. Here is how bad it is in construction:

The chronic unemployed are left out of the unemployment rate.  The BLS concluded this month that the "number of persons unemployed due to job loss decreased by 378,000 to 9.3 million". They do this every month, and the cumulative miscount is now huge:

There are now a whopping 2.5 million people without a job but want one, yet are not counted as unemployed

This breaks down into 1.1 million discouraged workers who not currently looking for work because they believe no jobs are available for them, and 1.5 million people who had not searched for work in the last 4 weeks. You can see from the next chart that:

1. removing the seasonal adjustment pushes the rate to 10.6%
2. including the discouraged workers sends it to 11.2%
3. including the ones who haven't looked for four weeks sends it to 12%
4. throwing in the underemployed (U6) sends it to 18%

 

Let's look at the unemployment problem a different way, which removes all those statistical adjustments: TOTAL EMPLOYED, not the unemployment rate. Sadly, it continues to drop. Our total workforce is back to 2000 levels. A lost decade indeed! When this figure begins to turn up, we will know a real recovery is underway. 

 

Karl Denninger points out what is striking about this chart: things looked like they were improving for a bit in Q2, but then we faded back down. 

The good news is that the rate of loss is lessening. This chart shows the rate of loss, which looks like a V-Shaped recovery, but is still below the 0 line, meaning jobs are still being shed, just at a slower and slower pace. 

 

The official rate should now improve for reasons having nothing to do with a real recovery: we are hiring 3x the normal census workers over the next 6 months, and the addition of 1.4M temp workers should be visible in the rate. 

UPDATE 2/8: Mish has a great analysis of how the seasonal adjustments are getting out of control, causing larger swings in results. January was 50% higher than the swings for the past ten years. Even if we have no change in unemployment in the next three months, he says the seasonal adjustments alone can drive the rate up 1.3% to 11% by May! Even with the census temporary hiring, the overall effect will be for rate to rise on seasonal adjustments. And even if the census keeps the rate low, when the census hiring abates, the rate could skyrocket up - right about the time of a double-dip in GDP (Q4).

I expect some big adjustments in the next few months. The BLS marries together two separate surveys: one of households and one of big business, or 'establishments'. The household survey got way out of whack with the establishment survey, and one or the other will have to be adjusted:

 

UPDATE 2/8: The King Report looked inside the numbers and found an oddity in the recent Household survey. The blip in the chart is of 541K new jobs, half are part-time, is entirely due to one category of workers: "Woman, 20 years and over" which increased by 529K. Further, this is only because of seasonal adjustments; this number actually only increased by 7K. Also, withheld taxes declined in Jan, which suggests that employment didn't rise at all. The King Report's conclusion is the Jan report is bogus, whether from faulty methods or a "clumsy attempt to craft a better employment report for political expediency (fraud)."

I still see a V-Shaped recovery for the next few quarters, and with it a real underlying improvement in unemployment. I just think the "unemployment rate" is a poor place to look to understand the underlying dynamic. Too many shenanigans. As Ed Harrison concluded after looking at the BLS report:

the unemployment rate downtick has nothing to do with people dropping out of the workforce; it is an statistical aberration due entirely to seasonal adjustments in the household survey in the number of people employed and unemployed

GDP & Unemployment: The Morning After

We are coming up on another unemployment report. Preliminary indications are not good. So far we seem to be in another jobless recovery. A deeper look at the recent GDP Report plus the upcoming unemployment report supports my view that this will be a V-Shaped recovery, albeit a jobless one, and not much of a V, with a high risk of a double-dip W to come.

The Q4 GDP report was driven by inventory rebalancing, a transitory factor. David Rosenberg's morning-after comments start with "expect big-time revisions", meaning downward. A key insight is that real domestic demand slowed from 2.3% in Q3 to 1.7% in Q4, as shown in this chart from Prieur du Plessis, where inventory is removed and the underlying final demand trend is bared:

 

This chart is bad news, as it says there really isn't any recovery. One would expect a sharp V after the fall we had in 2008, and we do not appear to be getting it. Pierre comments that this pattern "doesn't live up to past recoveries at all. ... Without stronger demand growth, a V-shaped recovery is not on the cards and the unemployment rate will not start heading south."

The Pragmatic Capitalist has a series of comparison charts of production, retail, employment and income, and all of them show more an L than a V so far. Here is the production chart:

 

An even bigger problem comes from unemployment: 

We saw history in the making — an eye-popping 5.7% GDP growth rate the exact same quarter that the unemployment rate rose 40 basis points, to 10%. It is like Houdini’s rabbit! This has never happened before. Normally, when we see a GDP number like this the unemployment rate declines 20 basis points during the quarter in question. The flip side is that in the past, when the unemployment rate rose as much as it did in the fourth quarter, believe it or not, in those quarters real GDP actually contracted fractionally (at a 0.5% annual rate).

A huge red flag was just raised about unemployment, which makes you wonder how far off the official stats have become from reality. The BLS is going to revise down its job estimates from April 2008-March 2009 by a whopping 824,000 jobs. This chart from Bloomberg shows how the prior reports change:

The whole Bloomberg article is worth reading, as it has other charts on point that make this issue vivid. The recount is due to how the BLS counts birth/death of job positions/companies, which they admit is flawed, but have no plans to fix. Instead, the next revision comes out in 2011, and will affect the whole Hope Rally period from April 2009 to March 2010. Over 990,000 jobs were added based on their flawed model.

The total over-count is 1.8M jobs. Wow. This means rather than the initial 4.8M jobs lost, it actually was 5.6M, and with the added miscount since, 6.6M. Oops, only off by 45%. I wonder what that would have done to the 10% unemployment rate?  Up 6% fromthe prior low rate to up 9%, or 13% overall? 

Obama claimed in the SOTU that he had saved or created 2M jobs. Only 600K or so could actually be counted from his own people, so that was a bit (!!) of an exaggeration. The BLS actually "created" more jobs than the Stimulus. 

A third shoe to drop is the Stimulus itself. I have written how once it passes its peak level per quarter, it will act as a drag on GDP. GDP is calculated using the change quarter to quarter, which is why less of a decline in inventories in Q4 ADDED to the GDP number. In Q4 government spending contributed a negative 0.2% to GDP, even though stimulus outlays remain high. From now on Stimulus outlays will decrease, even though a lot remains unspent. It will drag down future GDP even more. 

Now, all of this stresses my point of view that every W starts as a V. What if we get no V? So I dug deeper to find indications of a V: 

First, the trend seems to be turning to positive. The BLS birth/death model added fewer artificial jobs in Nov and Dec than earlier in 2009 and back in 2008. Maybe the revisions next year will lower jobs early in 2009 and increase them later in 2009, potentially answering the problem Rosenberg flags of how can GDP rise when jobs are falling?Regardless of that, the worst fall is behind us, leaving room for the V-shaped recovery despite Rosenberg's misgivings. 

Second, we are in another jobless recovery, as we had in 1991 and 2001. Many economists follow the Okun Rule, that a 2% drop in GDP causes a 1% rise in unemployment. This rule no longer works, probably because it was constructed in a time of cyclical unemployment: the job is lost but the position remains so the person gets hired back. Instead we have entered a period of structural unemployment where the job is lost and the position goes away. After 1991, it was defenses jobs - the so-called peace dividend. Movies were made of disgruntled middle-aged defense workers. After 2001, it was dot-com workers. Commercials were made of lonely sock puppets. After 2007, it is construction jobs. Not much work pounding nails in Nevada these days. 

Third, we are really in a 100-year-flood type of event. Looking at what is usual or unusual since 1946 misses that this Great Recession is not like any other since the Great Depression: it is the morning after of a huge credit bubble. In a normal recession, Fed tightening strangles a boomlet that usually comes with excess inventory. As we go through inventory rebalancing, things slow sharply but not for long, and away we go with growth again. Unemployment rise quickly, then shrinks quickly as workers are brought back to factories and retail. In contrast, we just came through a different dynamic, where people were using their homes as ATM machines, and when the real estate party ended, they began cutting back, well before unemployment rose. To the extent they retained savings, they can start spending again before employment begins to go back up - explaining what Rosenberg found unusual.

Supporting that perspective is this chart, which shows PCE (personal consumption) rising in a V-shaped recovery off the bottom. If PCE is increasing, employment should follow. 

 

How to square this chart with the chart above, where "final demand" dropped in Q4 over Q3? Well, this chart is a year-over-year comparison and we were in serious freefall in late 2008. The quarter-over-quarter comparison has a downtrend, but Q4 was up over 2008. More to the point is an informative look at PCE by Ed Harrison at Credit Writedowns:

• personal income has fallen off a cliff, and we are in the worst patch in 50 years, but we have begun digging out of that hole since Aug 2009
• disposable personal income fell as well, but not as much, meaning the tax rebates and transfer payments have softened the fall, which is good - my position has been we should bailout people and not banks - but is still the worst performance since DPI records were first kept
• consumer spending also fell off a cliff, but dropped BEFORE income, which while unusual fits my scenario (above) that we used housing as a big ATM machine, and pulled back once the machine went dry, before jobs were lost
• savings spiked up, then went down, then up, and are now trending down - meaning we are reactive, tending to spend as the bad news abates and save as it returns

He concludes that PCE has been on a 4-5 month increase. Let me add that we had spikes up in PCE in July/Aug and then again in Oct due to one-time government gimmicks (cash4clunkers, first-time homebuyer credit), followed by deep drops. These gimmicks perversely disguised the trend up in PCE by pulling demand forward a few months, followed by a "morning after" air-pocket down. The retail and housing drops in Dec and now Jan are a result of the last of those gimmicks, which ended in Nov, but the trend may reverse back up presently. 

A further data point is retail sales. It came in good in Nov, softer in Dec, and now ominously softer again in Jan. But not by much. Yet.

Business loans are weakening, yet the ISM index shows manufacturing is strengthening (more inventory!). Also, while net exports have been a problem, there has been some improvement. With cheaper oil (lower imports measured in $ not #) and a continued increase in exports, net exports could surprise in Q1. 

So it appears that Q1 should also come in up. If Q4 gets revised down, even a modest Q1 increase could be up QoQ. 

This bodes well for a V-shaped recovery, albeit a shallower V than typical. My primary caution is that PCE is doing better than income tax collections, which indicates a lot of it comes from tax-free contributions, such as Stimulus transfer payments (tax rebates, unemployment extensions, etc.). As with inventory rebalancing, this is not sustainable. 

It looks like Q1 (and maybe Q2) will be driven by continued transient inventory rebalancing plus government temporary transfer payments, but not by increases in income nor business investment. 

I stand by the double-dip. Every W starts like a V.

The Mother of All Banking Conspiracies

During bear markets conspiracy theories run rampant. (Why? Human Nature: success in a bull is my cleverness; failure in a bear is someone else's fault.) Here is a doozy: that the current market drop is caused by Goldman Sachs. I suppose it should be considered a companion piece to Karl Denninger's argument that Bernanke intentionally crashed the market in Sep2008 to spook Congress into passing TARP, but at least that one has a clear factual basis; intent is the open issue. This one is pure speculation.

The article picks up on Murray Rothbard's view that the monetary history of the early 1900s is largely a fight between the Morgans and the Rockefellers. (Rothbard is a well-know Austrian who wrote a good assessment of the Great Depression, and his banking fight argument has some basis in fact.) When JP Morgan merged with Rockefeller's bank, Chase, it supposedly signaled the two former foes had aligned for some reason. The article argues it was to fend off the growing power of Goldman Sachs, and especially "Goldman Sachs South", formerly know as the US Treasury Dept. Goldman had gone too far by front-running the market and getting away with naked shorts. 

The recent ascendency of Volcker, who came up through Chase Bank, and his proposal to end the proprietary trading desks of places like Goldman, is to curtail these excesses. The particular proposal was a bit of a puzzle, since it seems a bit small time when compared with Volcker's prior calls for a reinstatement of Glass-Steagel, and his editorial in the Sunday NYT. This article suggests it is targeted at Goldman and can be seen as a shot across the bow. 

So far nothing particularly alarming as conspiracies go, but the article drops this bombshell: that Goldman is deliberately driving the market down in a game of chicken to get Obama to back off real banking reform. That slide started when Obama announced the Volcker Plan. Obama's reiteration of banking reform in his SOTU speech shows he is fighting back. The sharp drop since SOTU is the purported reply from Goldman. 

If this theory is substantive, the market should drop hard next week, even crash. 

If you love this stuff, I suggest you follow the links and come to your own conclusion. I discount conspiracy theories. Oswald killed Kennedy. Fluoridation is not a commie plot. Aliens do not abduct people. Area 51 does not contain spacecraft. And I don't buy this one, even if the market crashes. 

The US Might be Better Off with a Global Currency

The Greek Drama got me to thinking about the calls for a new Bretton Woods and the US role as the global reserve currency. It gives the US an advantage of seniorage, which in a fiat currency (as compared with specie) lets it print more Dollars than ever come back home to cause inflation, as a float must remain out of the US to be used for global trade, particularly in oil. Yet this purported advantage ends up creating a persistent trade deficit, where the gap is not really due to loss of trade but due to excess demand for Dollars. (The accounts must balance - a Dollar surplus begats a trade deficit.) 

Under Bretton Woods, the US avoided this for years due to returns on overseas investments, repatriating Dollars back home, but the debt-driven hunger of the expanding welfare state eventually overwhelmed that and threw the US into a persistent trade deficit. The expansion of government, particularly the "guns & butter" Great Society in the '60s, resulted in gold flowing out, and the US having to 'cheat' on the gold standard to stem the flows. Eventually Bretton Woods broke down, and Nixon went off gold. Memories my be short, but did you know that the US sent gunboats to South Africa around 1968 to force them to release gold they were hoarding? Such was how low we sunk, and with it the Dollar.

The floating exchange system that replaced it was brilliant - thanks, Milton! Rather than having fixed exchange rates and relying on the flows of gold in and out, leading to gold gamesmanship and cheating on the standard, floating rates punish poor government policies much more quickly by sinking currencies. Within a broad currency like the Euro region, the punishment comes from the bond market, but more slowly. (We can see this drama unfold with Greece.) 

Floating rates can be self-correcting process, as falling currencies enhance exports, which can cause the currency to rise again. Floating rates can act like tariffs to protect developing countries, whose cheap currencies make imports expensive, and drive the internal economy towards import-substitution and later export-expansion. It is probably lost to political memory that the Repubs used to be the party of tariffs to protect nascent industry, and the Demos the party of hard money to protect the value of King Cotton. The parties somewhat have flipped, where the Repubs support free trade, and the Demos support easy credit to pay for the welfare state; but it was Nixon who went off gold, and Clinton who pushed for NAFTA.  

Floating rates, however, have one troubling flaw: having the USD the reserve currency means US domestic policy gets exported to the rest of the world. Off gold in '71, we exported our inflation. Saved by Volcker in '79, we drove too strong a currency. Worried about Japanese imports in '86, we coordinated a devaluation of the Dollar in half (in a year!). What followed was the crash of '87, the Japanese bubble of '89, the S&L crisis, and the seeds of the Greenspan Put, which created the moral hazard that we now call the Greatest Asset Bubble of All Time in the 2000s. 

Compounding this flaw is the capability of mercantilist economies to peg their currencies to the Dollar and preclude the readjustment of floating rates; if they peg low enough, they have erected effective tariffs to protect their internal markets, created incentives for high savings (which are cycled back into business investment), and baked-in a competitive export advantage. In places like China, mercantilist currencies would normally have risen against the Dollar and Euro to compensate for the huge reserves they have accumulated. 

Ed Harrison at Credit Writedowns discussed this today, commenting on the Triffin Dilemma:

The Triffin dilemma, less commonly called Triffin paradox, is the fundamental problem of the United States dollar’s role as reserve currency in the Bretton Woods system, or more generally of a national currency as reserve currency. Briefly, the use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but must also flow in to the United States, which cannot both happen at once.The dilemma is named after Belgian-American economist Robert Triffin, who first identified the problem in 1960. 

Harrison goes on to explain:

[T]he reason credit has surged dramatically over the last generation has much to do with the monetary system; unless we successfully reflate asset prices, the claims on dollar-based assets cannot be met under this jerry-rigged monetary system with the U.S. dollar at the core. I see this as a Ponzi scheme which is now in its final chapter.

He sees two ways out: follow the easy money path and keep pumping out US-denominated debt (the course we are on) until it blows up; or follow the Volcker path of backing the Dollar and risking a deflationary spiral. Neither are attractive, and neither would fix the Triffin Dilemma.

Let me propose a way out: an independent global currency against which all others would float. This approach can distance the rest of the world from US domestic politics, and get the US off the hook of running persistent trade deficits in order to provide persistent Dollar surpluses. 

I have mentioned that I have a bet that we will be back on some form of gold by the end of this decade, but neither that bet - nor this proposal - necessitates the classic gold standard, nor the bastardized Bretton Woods gold-exchnage standard. Gold can play a role in this new global currency without going back to fixed exchange rates. Gold in effect would circulate with fiat currencies, and help keep the float honest. 

To make the new system work, the US would have to be a major backer, and likely the Fed (or several central banks acting in concert) would have to become the lender of last resort of the world. I have thought that politically the US would oppose such a new system vigorously, down to the last ounce of value in the Dollar; in other words, we would have to be forced by our trading partners into the new system. If the global economy falls into a double-dip after the huge monetary and fiscal stimulus, the political dynamic of shock & awe in the failure of reflation & easy credit should be much more open to a new direction. Paradoxically, our potential failure leads me to have more hope in this change. 

Dubai, then Greece, then perhaps the other PIIGS; this is much broader and worse than prior financial crises like the Asian Flu. The last time we had broad repudiation of debt and sovereign defaults was in 1931, and it resulted in the abandonment of the gold exchange standard. This time it might drive a similarly radical change of the world financial system. 

Beware Greeks Baring Gilts

Ok, one of many bad Greek puns in financial headlines today. I want to get your attention: this news item could hammer markets when it comes to fruition. Greek sovereign bonds are now baring to the financial world an impending financial debacle in Euroland. 

Greek sovereign bonds (Treasuries to the US, Gilts to the Brits) are falling off the cliff, and Greece may default within days. This chart from ZH shows the CDS (credit default swap, or insurance premium if you like) spread has gone to 400 bps, and it kept going after this chart was posted to 420 bips. Just a few days ago it was 320, which is also awfully high, but to change this fast means the end is nigh. At this rate it will close the 55 bp gap with Dubai in hours. (In comparison, Treasuries are at 43 and Gilts at 84.)

 

This is the tip of a huge iceberg. The PIIGS spreads are now higher than BRIC spreads. The ECB has tried to hold value in the Euro as all other major countries (including the US) race to the bottom. One of the many incredulous promises of Obama last night - the AP found 10 other whoppers - is to double US exports. How to live up to that promise? Debase the USD by half? Hard to do, especially if the ECB does not sacrifice Euroland and instead joins that race to bail out the PIIGS, one by one. 

The ECB is Titanic in search of that iceberg, and it may be about to hit it. 

The Greek prime minister did the obligatory "we are in fine shape" and "rumours can cause problems." ZH's take is it sounded a lot like Lehman the night before - or Cramer in 2008 on Bear Stearns! The IMF may need to step in and lead the bailout, or it comes from the ECB, which starts the debasing of the Euro. The prime minister had done the obligatory call to the world's lender of last resort - no, not the US, nor the IMF - China!  China is likely to pass, although Goldman is trying their best to package the deal. (For all of Obama's bashing of bankers last night, Goldman can be really useful at times like this.) The Greeks denied the involvement of Goldman. More fools they. The Chinese put is neatly: the Greek bonds are "more risky than US Treasuries." Ouch!

Where this may end is a breakup of the EU. That seems a ways away. Where this starts is with a continued sharp rise of the USD and the beginnings of the next global financial crisis. Problems in PIIGS-land may quickly spillover to emerging markets. Bet on the Dollar, or even the Yen right now.

3 Things To Know About Bernanke

He has politicized the Fed more than any other Fed chair. He seems easily manipulated by politicians. His fate is entwined in the new-found populism of Obama. His compatriot in populist ire, Tim Terrific, may already be walking dead at Treasury. Yet he may be reconfirmed! Should he? 

1. He Was Behind the Bubble in the First Place

Greenspan takes blame for keeping rates too low for too long, and removing all sorts of restrictions on banks. It turns out the biggest cheerleader behind Greenspan was Bernanke, who was part of the FOMC before he became chairman; and when he took over, he continued the very policies which created the credit bubble. He gets credit for pushing liquidity out when needed after Lehman fell; but if he hadn't, he should have been fired on the spot. The central bank MUST do what Ben did under a fractional-reserve system. 

Bernanke knows he blew it on credit. He proffered a defense, arguing implausibly that the Fed had not caused the housing bubble, and claiming that under the Taylor Rule, rates weren't too low. Economists didn't buy it. John Taylor, the creator of that Taylor Rule, excoriated Bernanke: Bernanke had NOT followed the Taylor Rule, but had concocted a bastardized version of it. 

This does not sound like an independent Fed, but a highly politicized Fed trying to hide its mistakes. 

2. He May Have Caused the 2008 Crash

This is pretty shocking, and should immediately doom Bernanke: the Fed withdrew 65% of liquidity from the system in the four days after TARP was first announced to a very tepid reception, the same week McCain suspended his campaign and ran to Washington: Sep19-24, 2008. The facts are written in the record:

The market fell 500 pts in the next 10 days - it crashed! Check out this chart. 

 

Was it intentional? Karl Denninger thinks so. The legal doctrine of res ipsa loquiter (let the thing speak for itself) would concur. This draining of liquidity was precisely designed to panic Congress into passing TARP. Bernanke would use the Jack Bauer defense: it was necessary to torture the victim in order to achieve the result. As things turned out, TARP was not needed. In fact, it was a huge bait & switch: Paulsen turned around and used it for different purposes than he said it was for to Congress. It was not used to stabilize mortgage markets, but to use the AIG bailout as cover for funneling the funds to the over-stretched banks. Was Bernanke in on out, or a dupe? 

You decide: is this the type of independent Fed we want?

3. He is Fighting the Wrong War

First Anna Scwhwartz, Milton Friedman's co-author, and then John Taylor, Stanford economist behind the Taylor Rule for interest rates, criticized Ben as trying to fix the problems in the 1930s, not those of today. Now economist Steve Keen wrote a devastating dissection of Bernanke's thinking: 

Bernanke is popularly portrayed as an expert on the Great Depression—the person whose intimate knowledge of what went wrong in the 1930s saved us from a similar fate in 2009.

In fact, his ignorance of the factors that really caused the Great Depression is a major reason why the Global Financial Crisis occurred in the first place.

Steve tells the story of Irving Fisher, the American Keynes, who is oft used as a foil for this unfortunate quote, in October 1929, right before the Great Crash:

Stock prices have reached what looks like a permanently high plateau.

Irving went on to truly understand what drove the 1931-32 banking crisis and deep depression, and came up with his Debt-Deflation Theory of the Great Depression, still the best analysis. As Steve writes, his analysis

 [C]ompletely inverted the economic model on which he had previously relied. 

His pre-Great Depression model treated finance as just like any other market, with supply and demand setting an equilibrium price.  ...

[H]e realized that his equilibrium assumption blinded him to the forces that led to the Great Depression. The real action in the economy occurs in disequilibrium.

His debt-deflation theory is summarized in this chain of logic:

1. Debt liquidation leads to distress selling and to ...
2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes ...
3. A fall in the level of prices, in other words, a swelling of the dollar [we would call that deflation]. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be ...
4. A still greater fall in the net worths of business, precipitating bankruptcies and ...
5. A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make ...
6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to ...
7. Pessimism and loss of confidence, which in turn lead to ...
8. Hoarding and slowing down still more the velocity of circulation. The above eight changes cause ...
9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

This sounds pretty close to what has been happening, again, 80 years later. 

Steve points out that Bernanke dismissed Fisher's theory because he presumed a form of equilibrium: 

[D]ebt-deflation represented no more than a redistribution from one group (debtors) to another (creditors).

This argument has been disproven by the very events under Bernanke's watch as Fed Chair: after a credit bubble, debt does NOT get repaid, it gets written off. Wanna buy some toxic debt? No one does. How about some subprime? This bad debt is being written off or rolled forward, despite Trillions in TARP & Bernanke's credit facilities. It is not being repaid, except to pick the pockets of the taxpayers and feed it back to Goldman Sachs and their ilk. 

Bernanke's views on the Great Depression are simply wrong, and proven wrong before our eyes. He learned nothing from studying it! His economic prescriptions are colored by his ideology. His economic assumption, of equilibrium, is stuck in 1928. Is this the type of leadership we need right now at the Fed? 

Steve's conclusion:

Bernanke, as the neoclassical economist most responsible for burying Fisher’s accurate explanation of why the Great Depression occurred, is therefore an eminently suitable target for the political sacrifice that America today desperately needs. His extreme actions once the crisis hit have helped reduce the immediate impact of the crisis, but without the ignorance he helped spread about the real cause of the Great Depression, there would not have been a crisis in the first place.

The January Club

I am in a debating society called The January Group, whose only rule is we can never meet in January. Perhaps the Powers-That-Be would like to join that club, since January has become a cruel month for them. They would rather the market not meet (its end) in January. You see, January has been very cruel to stocks and politicians all decade long. 

Friday's STU has a fascinating chart of how January has ruled the last ten years: we had significant tops in every January, and the first (in 2000) and now this one (in 2010) may bookend two big stock moves of the decade. Neely places the end of the Greenspan Bubble and the start of the Big One down to Jan 2008 as well, and the S&P began its deep dive into the Oct02 bottom on Jan 2002. The Iraqi War Triangle began its final dive in Jan 2003, and the War Rally topped in Jan 2004, as did Bush's popularity.

 

January is the god of beginnings and endings, so we seem to be at not the end, nor the beginning of the end, but the end of the beginning of the Greater Depression that is about to unfold. If you believe in Prechter and his devastating P3 wave down, this is the beginning of the end of equities.

If you are watching the Democrats in panic ("no seats are safe! no seats are safe!") after they lost the Kennedy seat in Massachusetts (did I spell that correctly?), they may be prepared to throw Bernanke under the bus, and Tim Terrific with him. If so, I hope Volcker takes the Fed seat, at least on an interim basis. Truly a great man, finally being listened to again.  But more likely this poor economic teams hangs on. Regardless, watch our erstwhile leaders try to become latter-day Populists to try to get in front of the mob that is storming their ramparts.

Whatever happens in the merry old land of Oz (Washington DC), this January is the end of Hope and the beginning of Change. Will Obama change by triangulating to the center as Clinton did after 1994? Or will Obama be not just a lame duck, but the Albatross around the neck of the Democrats, as the electorate changes out the incumbents in Nov, which happen about when this market may be ending its drop to retest the lows?  

Tectonic Plates Shifting: Time to Short the Market? UPDATED

An interim bulletin EWT today reiterates the 200% short position. I hadn't commented on it, but that position was pulled in an interim bulletin a few days ago, but today everything is now working out as the January 4 EWT predicted: Dollar up, Gold down, and stocks down. He says go back short. Neely also called the top in a special bulletin today. Suttmeier notes we have broken below the lower trendline of the Hope Rally in the Dow, and if it doesn't recover quickly it would signal a change of trend:

 

For you technical analysts, the drop today is deep enough to end the prior wave and start something new. The S&P got to 1115 and bounced, slightly; that is a key level to watch today. If it breaks, likely we have a "bifurcation" off the top and a much longer and deeper drop ahead.

For you skeptical fundamentalists, note how tectonic plates are shifting globally: 

• ECB likely to have to bail out Greece, and the Euro has dropped below a double-cross of moving averages, pointing to a fall to $1.38
• China's vaunted stimulus (pundits said "China sure knows how to stimulate better than the US!") has caused a huge real estate bubble, with ghost cities, empty buildings, and skyrocketing home prices in major cities - oops! China is the new Japan: Japan 1989
• Dollar is taking off, probably now into wave 3 off the bottom, heading from 78 to over 90 in the Dollar Index
• Earnings reports have been disappointing, and even good ones get faded - and when a market sells off decent reports, the Bear has returned
• Unemployment had a weekly spike, throwing cold water on the recovery
• FHA is tightening lending due to horrifically increasing defaults
• Housing may be in a double-dip down
• Obama is *finally* listening to Volcker and in a huge about-face now wants to reinstate Glass-Steagel
• Democrats in disarray as the "Scott heard around the World" seems to put the stake into Obamunism 

Simply put, the assumptions that drove 2009 up are now up in the air, and the market needs to digest the fallout. Meanwhile outside the US the chickens are beginning to come home to roost. 

In 1930 we had an apparent recovery from the crash, and then slowly developing problems; but in 1931 the crisis came back in the form of banking failures in Europe, and overwhelmed the US economy.  Is history repeating, this time with China as part of the potential brewing crisis?  This chart from today's WSJ shows how the Chinese Stimulus has not gone into real production but into hoarding and speculation, just as in the US:

 

Cramer Has Another Monica Moment

CNBC's Cramer kept telling us in 2008 that Bear Stearns was not in trouble - oops! Last Friday he said if Brown won the Kennedy People's Seat, stocks would soar - oops! Buy on rumor, sell on news? Or maybe news does not move the market beyond Cramer-fed blip? I just wonder when the ever-entertaining and often-wrong Cramer will finally have his Monica Moment, the blunder that dogs him like a cheap cigar for the rest of his career. 

Obama is nearing his Monica Moment. The political tectonic plates are shifting this morning. Warren Buffett threw Obama under the bus by trashing his bank tax proposals. Congress may balk at Obama's morning proposal to nationalize the student loan program, after effectively assuming huge mortgage liability by backing Fannie/Freddie to the hilt last month. It is no longer clear if any of Obama's agenda can be passed, especially those which lead to further socialization of risk. 

While Obama continues to blame deregulation for the current credit mess, a simper explanation is that we privatized the upside and socialized the downside of the shadow banking system, the same mistake we made in the '80s with S&L's, just at much huger scale. Pushing high-risk loans and backing them with Fannie/Freddie implicit government guarantees led to a classic example of Moral Risk in mortgages. 

Finally we begin to see financial leadership pushing back on continuing this foolishness, starting with the former Obama supporter, Warren Buffett. This tectonic sea change will ratchet through investment thinking over the next few months. 

Vampire Market: All the Action is at Night

I have been commenting about how overseas buying of US equities is driving this market, most likely as a hedge against Dollar weakness. It is hard to see this continuing as Greece goes into meltdown today and China tries to rein in its excessive stimulus. The erstwhile buyers have to tend to their home markets. Now here is an interesting confirmation from the UK's Market Oracle, sent in by a reader:

1. Robert McHugh, a famed technical analyst, 80% of the market gains occurring since March 2009 have come on just 30 Mondays. Put another way, you could have bought stocks on Friday afternoon, sold them on Monday at noon, and ignored the rest of the week and roughly mirrored the S&P 500’s blistering performance.
2. Tyler [Durden] of Zero Hedge also points out that the market actually hasn’t produced a gain since September during the 9:30-4PM trading session. Instead ALL and I mean ALL of the gains produced between that time and year-end occurred during the overnight session in the futures markets: 

Unemployment Disappoints, Dollar Drops

Unemployment came in a 10% where the market expected a drop from Nov's 10%. The major immediate impact is to adjust assumptions about the Fed easing out of QE and raising rates - history shows this happens about a year after unemployment peaks, or at the end of 3Q10 if we had kept dropping. But the flat month may spook investors out of the USD and back into commodities. Gold jumped on the news, and Oil spiked up today, but has since eased; and the Dollar Index dropped.

This flip of assumptions may flip back, but not until April or so. As I have written, the 10.2% jump in Oct was a bit spurious, driven by seasonal adjustments which are based on assuming more retail outlets than we have anymore, and the Nov and Dec reports have this problem baked in. The next report (Jan numbers, reported early Feb) is beyond the seasonal (holiday shopping) adjustments, and may pop back up. After that we get the offsetting flood of census workers, which could drive the rate down even though those are once-a-decade temp jobs. A bit of an election-year scam, according to Mish, since we are hiring 3x the number of workers from last time. The excess hiring starts now and accelerates in April, pointing to a drop in unemployment rate in March or April, reported in May or June. This would start the Fed Rate Raise clock ticking again. Note that by around August those temp jobs will be gone, so any positive impact in Q2 is washed away by Q3. Did I hear double dip? Or in this case, roller-coaster?

Here is the latest chart:

Innocent Bystanders has an interesting take on this, comparing the predictions of an independent analyst (Zandi) with the government projection to give a different with- and without- stimulus chart. As you can see, hitting Zandi's "without-" projections suggest the Stimulus is having no impact over what would have happened without it:

 

Calculated Risk points out that despite the Unemployment RATE flattening, the Jobs-Lost PERCENT continues to get worse. The rate is the percent of reported unemployed over predicted workforce; the percent is of jobs lost from peak employment (it is more accurate, since it avoids the adjustments to the purported workforce):

There are a number of ways to square the two percents in the real world, not the surreal world of govt statistics. One way is to look at unemployment exhaustion: unemployed dropping off benefits is at record highs and increasing. The easiest way is to look at the number of former workers who have dropped out of the labor force:

 

As the purported workforce is shrinking, the rate can drop even as unemployment gets worse since it is based on employed/workforce, with the remainder the unemployment rate. Fewer employed, but even fewer in workforce, and unemployment RATE goes down even as unemployment goes up. The adjustments to workforce size have a large impact, as explained by Reuters today:

Then will come the second-take stories that will notice the shrinking labor force, which dropped by nearly 700,000 from November. Had it stayed stable for last month, the jobless rate would have been 10.4 percent. Had it stayed stable since August, the jobless rate would be 11 percent!

The adjustments also work distortions the other way: as the economy improves and those dropouts come back into the workforce, it will keep the RATE highish despite improving employment. Here is how Peter Boockvar put it in The Big Picture:

Household employment fell by 589k but because the labor force fell by 661k, the unemployment rate remained unchanged at 10% and this continued drop in the labor force is why the unemployment rate will remain high even when jobs are being added b/c these people will eventually come back into the labor force

This means things will be "lumpy" over the next year, and "sticky" after we really see private sector improvement. Investors will be whip-sawed a bit - another reason for 2010 to be a choppy year, not the dreaded debacle of a devastating P3 wave down to lower lows. 

Adding to the choppiness will be Q1 residential numbers, which the Fed in the recent FOMC minutes now expects to be poor to down:

It appears residential investment will disappoint in Q1, and prices might already be falling again - and that is before the massive government support programs will be wound down over the next 6 months. Of course CRE is getting crushed, but residential investment is usually a key to a recovery - and residential investment will remain sluggish.

The Fed Slipped Up Big Time: Deflation Coming

Ben Bernanke made a very revealing slip this week: he admitted he had refinanced his optionARM mortgage with a 30-yr fixed rate at 5%. He said he had to, as his loan had "exploded", but it appears he was engaged in FedSpeak obfuscation: an analysis of his ARM showed it would not have exploded, and that he just refied at a higher rate! So why refi? The implication is he knows higher mortgage rates are coming, and wants to lock the rate in.

The implication of this unintended admission is: deflation!

For those of you who believe that inflation, even hyperinflation, is ahead, and take confirmation in the recent blip up in PPI and CPI, this month's EWT is required reading. The deflationary forces are growing rapidly.

Normally higher rates presage either a recovery (demand for longer term loans) or inflation. We are not in normal times. Higher rates are the cost of financing huge US deficits. Bernanke is trying to exit QE, which was used to keep rates down, except he may be boxed in due to a deficit of foreign buyers. As this chart shows, foreign investment in long-term Treasuries is falling, as is the trade deficit.The trade deficit is the other side of a Dollar surplus (since the deficit results in Dollars flowing out). As the trade deficit shrinks, fewer Dollars are falling into foreign reserves, and hence they have less need to buy Treasuries to recycle them back. The Bank of China has admitted such. 

 

At the same time they are pulling back, we are seeing more and more short-term Treasuries being placed, which need to be constantly refinanced. Think we can keep pushing short-term T-Bills and rolling over prior issuances? This makes it extremely problematic to exit QE, since if short term rates rise, we have a serious problem with the cost of financing the deficit.

Bernanke has focused most of the Fed's activities in the past year on keeping mortgage rates low. He knows that the US won't come out of a recession without a rebirth of housing; and he is painfully aware that most of the toxic waste clogging bank balance sheets are based on mortgages. Hence both to restart the economy and repair bank balance sheets, he has tried to keep rates low and spur the housing sector. Now he refinances his cheaper ARM! The end is nigh to QE.

To date his QE has not been inflationary. He hasn't really created new money; he has swapped assets for reserves. He expected banks to then lend, because of reducing the uncertainty of those assets, but just as in the 1930s they have sat on those reserves. The excess liquidity has gone to Wall Street, not Main Street. This won't change as he swaps those bad assets for Treasuries. What will change as he exits QE is the unleashing of deflation.

Robert Pechter was one of the first to predict a crushing deflation is ahead. His case is summarized here. He is now being joined by others, including Gary Shilling (who has been on this for a while) and Harry Dent (who has called this decade really well). In this EWT, Prechter continues building a case he started last month of deflationary forces gathering before a storm that should hit in late 2010 or in 2011. His case has two primary arguments and a prediction:

The Fed May Have Made a Fatal Mistake

The EWT explains that the Fed first used TALF to back hedge funds and similar who invested in consumer debt, backed by collateral; but the collateral turned out to be bad. The Fed now owns a deserted shopping center in Oklahoma City as well as some bankrupt hotels. Thanks, Bear Stearns! So the Fed switched to directly buying mortgage-backed securities (MBS) in swaps with banks. It has since swapped (ie. bought) over $1T of MBS. See chart, from the EWT:

The purpose was to keep mortgage rates low, but "in buying up the mortgages, the Fed may have done something stupid." When shoring up the banks or hedge funds, the Fed could always refi those loans in such a way that would force the banking entity to sell the toxic assets to repay. Now it is stuck with the direct collateral, the very thing it was trying to avoid after TALF! If the Fed is stiffed with losses, the member banks will have to make good since banks are required to cover the Fed's losses. The banks will become more cautious, lending less, which is deflationary.

Congress is a Financial Weapon of Mass Destruction

Prechter lists a growing number of actions Congress is taking which all have the effect of reducing lending. If you read Karl Denninger, you know this is a good thing in general. History will look back and ask what sort of theoretical nonsense led us to try to borrow our way out of a credit bubble - are we that much in thrall to a long-dead economist?

Nonetheless, this good thing will be deflationary because it reduces debt. Let's step back. Many folk think that the Money Supply is the monetary base plus maybe a few other things like demand deposits and sweep accounts that can be rapidly turned into money via a check. The Austrian debate which money aggregate is real money, but this misses the larger problem: the inflationary or deflationary forces are based on the broadest view of money, which includes credit-money not just real-money. Credit can be turned into purchasing power, and because of fractional reserve banking, banks can lend well in excess of their reserves of real money. We have around $50T of credit on top of $2T of real money. It is the velocity of that $50T, and its rise and fall, that drives inflation or deflation. Hence anything which reduces the turnover or velocity of money, or reduces its stock, is deflationary.

Congress is finally facing up to fixing the financial crisis, not healthcare or global warming or other far off (or fake) crises. Their acts almost across the board will reduce lending and cause debt to be written off. The EWT has a long list which I won't repeat here. Suffice to say they deter the whole food chain of lending. The list shows how dysfunctional and ineffective Congressional acts have been so far. My favorite examples:

• The original $300B mortgage bailout, and the recent $75B Obama program, have only "helped" 1700 homeowners so far. To fix it, they want twice daily reports on progress from the banking workout teams! I am sure that will work ... the teams weren't that effective anyway dealing with  real problems, so why not pull them back to the office to fill out meaningless paperwork?
• The bailouts seemed destined to lose $30B on autos and another $30B on AIG. Such a deal!

The FHA Seems Doomed to Fail, Spectacularly

While attention has been focused on Fannie and Freddie, under Obama the FHA has become the lender of mass destruction last resort to housing. Even though 24% of its loans from 2007, and an astounding 20% of its loans from last year, are in default, the EWT notes with emphasis that it is "still writing mortgages at a frenetic pace", four times faster than in 2006 at the peak of the housing bubble! Down payments are as low as 3.5%, and the more distressed the area, the higher the FHA percent of the market. This is clearly madness. The FHA insures $675B of mortgages. These loans are packaged with others and run through Ginnie Mae.When this mess blows up, the taxpayer will be on the hook.  

Barney Frank justifies the horrifically high percent of bad loans as "policy" to keep housing from falling faster! Is he that big a fool? Maxine Waters recognizes that "without FHA, there would be no mortgage market right now."

Exactly right! So what to expect?

• Fed reduces QE, rates go up, housing goes back down, economy gets even more sluggish, FHA defaults get too high to bear, housing becomes a market of distressed sales and foreclosures.
• OptionARMs begin to "explode" and the second wave of defaults washes over the system.
• Congress passes even more frenetic acts to "fix" the problem. As history shows, when you regulate something, you get less of it. 
• As the mortgage problems accelerate, the Fed's balance sheet becomes suspect, and losses mount. It no longer can "save" the system.

Yikes! Then what do we do?

Maybe the demise in 2012 'predicted' by the Mayan calendar is of the Fed, not the Planet.

Equities and Bonds Fade the Fed - Is Santa Staying Home?

The Fed acted predictably and held steady. Stocks reacted predictably, albeit with less volatility than normal, by rising into the announcement and falling after. (You doubt it was predictable? Neely quite cleverly put out a bulletin this morning recommending to short the March e-mini five minutes after the FOMC release.) The 10-yr Treasury rose to 3.6%, the highest since August 2008 (!), and the TIPS jumped to over 2%, giving it an implied ten-year rate of 2.3%, also the highest since Aug08 (!!). 

The Fed modified their statement (click on markup, courtesy SeekingAlpha) to suggest their exit strategy is quickening, and QE may be through by the end of Q1. This may cause mortgage rates to rise by 35-50 bps above the 10-yr, which itself seems poised to rise. Good thing Bernanke refinanced his option ARM - which blew up on him - into a fixed 30-yr mortgage at 5%. 

You can find tea leaf readers looking closely at the changes in the statement above. It appears some pessimism has crept in regarding housing and employment. 

Stocks remain in a stall, but I still believe in Santa. Let me run though my Santa Rally Update with a series of charts.

This first chart from Jesse's Café Américain show the sideways action since Nov. Note the resistance at the green line around Sp1114. He makes no prediction of Santa, but notes that corporate bonds may be a trap about to spring shut, given the rate rise in Treasuries. 

  

This second chart from tonight's STU shows that in the Wilshire 5000 the sideways action goes back to October. They point to two sentiment indicators that signal caution: 

• Bernanke as Man Person of the Year on the cover of Time. News weeklies tend to highlight an event as the trend is near the point of exhaustion. Jeff Bezos made the cover in Dec 1999, for example. A great list of auspicious covers is provided by Mish. Other pundits today highlight a similar cover with Greenspan, Rubin and Summers, also in 1999. Paul Krugman will publish a column tomorrow with the same picture, saying "Be afraid. Be very afraid." The STU continues that usually the trend exhausts and reverses within a month - just as our Santa Rally predicts!
• Investors Intelligence Advisors Survey has gotten above a 75% bulls ratio, a ratio last seen in Oct 2007. Put more simply, the ratio of bulls:bears is above 3:1 at 3.13, within scratch of the 3.16 ratio at the all-time top. And with a Santa Rally, it might get even higher. Time to buy? Hmmm. 

 

Tony Caldero has modified his count to make the sideways move a flat instead of a triangle. His count says we have finished wave B of a zigzag up, and targets wave C to rise to around Sp1160. He believes in Santa! 

Given that in zigzags the A wave is typically the sharpest (whereas in flats it is the C wave), we should expect his wave C to somewhat meander upwards for at least the time of A (2 weeks) if not 1.6x of A (a little over 3 weeks, plus a few more days for all those holidays in between), which puts the end of C around the first week of January - or right where my Santa Rally should end! 

 

My take: the Santa Rally into the first week of January seems still on. The next couple of days get us to options expiration Friday, so volatility is to be expected, likely up tomorrow and down Friday. After that the historical data says watch the rally! I have recently posted a 37 year seasonal chart showing the Santa Rally. Here is a 110 year chart showing the same pattern, with the Santa Rally typically starting on Dec21 - next Monday! Ho ho ho!