Greece - Cognitive Restructuring

"Economic depression cannot be cured by legislative action or executive pronouncement. Economic wounds must be healed by the action of the cells of the economic body - the producers and consumers themselves." - Herbert Hoover

Like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. We have been therefore watching with interest the Greek saga and it's "Schedule Chicken" redux:

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

It is therefore not a surprise that, given our fondness for behavioral analogies, we decided this week to use as our title analogy "Cognitive Restructuring" with the on-going Greek debt odyssey taken by its new hero, Greek Finance Minister Yanis Varoufakis to alleviate Greece's €315bn Damocles sword. 

When it comes to our title, as a tongue in cheek to debt restructuring, it refers firstly to a psychotherapeutic process of learning to identify and dispute irrational or maladaptive thoughts known as cognitive distortions, such as "all-or-nothing" thinking (splitting), magical thinking, filtering, over-generalization, magnification, and emotional reasoning, which are commonly associated with many mental health disorders according to Wikipedia. Our title is even more appropriate when one realizes that  "Cognitive Restructuring" is used to help individuals experiencing a variety of psychiatric conditions, including "depression", substance abuse disorders (debt), anxiety disorders collectively, bulimia (more debt), social phobia, borderline personality disorder, attention deficit hyperactivity disorder (ADHD), and gambling, just to name a few.

In this week's conversation, we will visit Greece issues from an historical perspective and look at solutions as well for the long term.

Synopsis:

• Greece: a story of "unfinished business"
• Redistribution without efficient taxation cannot work on the long run
• How do you deal with a Mezzogiorno country like Greece?
• Will a GREXIT solve Greeks' woes?
• Keynesian solution to counter the fall in aggregate demand even with QE will fail

• Greece: a story of "unfinished business"

The on-going Greek Tragedy and its "Cognitive Restructuring is from an historical point of view a question of "unfinished business", in the creation of a modern state. On that subject we recommend reading "The Greek State: Its Past and Future" - An interview with Anastassios Anastassiadis from March 2012:

"Greece’s budget deficit and debt started growing rapidly in the eighties. At first, devaluations of the drachma and inflation softened the blow, but they were also bad for that Greek “frugality” that I mentioned a moment ago. In the second half of the 1990s, control of public finances was only ephemeral, and was quickly set aside by the euphoria elicited by the pharaoh-like projects that were planned for the 2004 Olympics. Furthermore, upon entering the euro, the Greek economy benefited from broad access to cheap credit. Within barely twenty years, frugality had given way to consumption, leading to a heavy dependence on credit. The Greeks borrowed from their banks, which borrowed from French and German banks. Why? To buy French and German goods." - Anastassios Anastassiadis.

On the subject of Greece, we read with interest the following comment from a reader of the Economist article "What emergency liquidity assistance means":

"Syriza seems determined to generate a payments crisis in Greece.
They have pledged (this weekend) extra spending:
- rehiring over 10,000 redundant civil servants
- increased pensions for lower income pensioners
- various schemes for providing free utilities & food to low income households
They have pledged (this weekend) to cut taxes:
- tax-free threshold for income increased to €12,000 (above median wage)
They have proposed no areas for spending cuts or raising tax revenue (beyond vague notions of tackling tax avoidance; some hopes that a higher minimum wage might boost tax revenue; alongside wishful consideration of fiscal multipliers and Laffer effects).
Against that background (a Greek payments crisis seems pretty certain, irrespective of whatever credit conditions Europe offers Greece), we should also recognize that a Greek begging bowl is offensive to the many poorer countries in the eurozone (Portugal, Slovakia, Slovenia, Estonia, Latvia, Lithuania).
Note:
- Greece has a basic state pension of €400/ month (which will be €5,200/ year when Syriza reintroduce the "13th month payment"), but most Greeks receive much more than this (state pension increases based on earnings). That is far more generous than, say, Lithuania's €236/ month (flat) state pension (only 12 months - they can count). Why should Lithuania pay for Greek profligacy? Compare public sector wage levels, government transparency, court performance, corruption, etc and there are many good reasons for most eurozone countries to grudge lending Greece a cent more than they already have.
If Syriza wants to rescue this, then they are going to have to come forward:
1) with sensible cashflow (revenue, expenditure) projections, and with proposed policy adjustments (moving forward) for accommodating any surprises. There must be a high degree of confidence that Greece can function without additional borrowing, without triggering a payments crisis in the near future.
2) with a credible programme of structural reforms, e.g. disempowering the oligarchs, taxing the church, forming a land registry and progressively taxing land, reforming courts, slashing military budgets, investing in education and R&D, making it *easy & quick* to register a business online and to begin doing business (without obtrusive or protracted licensing requirements), etc.
3) with a credible pledge to (by 2016) run a small primary fiscal surplus (perhaps a 1-2% of GDP target) and some domestic mechanism (auditing, legal review, etc) for generally pursuing this target (with some flex, but without bias towards deficit)

These three points are the absolute minimum - without these three points, there can be no further credit provisions for the Greek state. Syriza must somehow be brought to recognize this - based on their remarks over the past couple of days, they seem determined to default on pensions & wages, bankrupt the banks, wipe out business and broadly destroy the Greek economy entirely."

• Redistribution without efficient taxation cannot work on the long run:

We agree with the above analysis from a reader from The Economist and we reminded ourselves what we wrote back in August 2011 in our conversation "Liquidity? The IV Greek Credit Therapy":

"One thing Greece must address is tax cheats who represents 30 billion euros, or 12 per cent of GDP, every year. Another American solution to European woes would be, for Greece, to tax its citizens on their worldwide income, similar to the US. It would be a very efficient way to stabilise its ailing banking system and deposit outflows given one third of its funds withdrawn have gone abroad for fear of a crackdown on tax evasion. By imposing Greek citizens on their worldwide income like US citizens, and with the help of Luxembourg authorities, Cyprus, Switzerland and the United Kingdom, the outflow could be stemmed and vital tax receipts could rapidly help close the gap on the very acute budget deficit, but that's another story..."

There is nothing new about the Greek situation and the errors that have been made by its creditors, French and German banks initially (before being bailed out by European taxpayers) as written by French great writer Edmond About in 1858 as reported in Vox Europe in their article of February 2012 "Greece 1858 – plus ça change":

"Loans are only granted to governments that are well established. Loans are only granted to governments that are believed to honest enough to honour their commitments, and loans are only granted to governments that lenders want to maintain in office. Nowhere in the world does the opposition lend to the government. Finally, lenders can only grant loans when they have the necessary funds themselves." - Edmond About

But the issue with Greece, when it comes to "Cognitive Restructuring" and focusing on the process rather than the content (as any good behavioral psychologist would do), is the "unfinished creation" of a proper Greek state we would argue. It was further debilitated by the introduction of the Euro .It led the government access cheap credit and mis-allocation of European subsidies, mixed with corruption of the government, who used European funds to boost public spending on a grand scale. This "mis-allocation" of "capital" (funded by European banks) led to prices rising to inappropriate levels due to the inappropriate level of salaries in the increasing cohorts of public servants hired:

"The Greek system nonetheless suffered from three serious shortcomings: finances that were generated primarily by indirect consumption taxes; haphazard enforcement, which gave some professional groups better salaries simply because of their superior negotiating powers; and, finally, the use of public-sector employment and of advantages granted on the basis of “social criteria” as a cheap way of providing social insurance." - Anastassios Anastassiadis

Of course a fiscal policy based mostly on consumption taxes and the lack of a proper land registry (even after Europe poured €100 million euros for this specific purpose) meant that as soon as "austerity" measures were put in place by the Troika, revenues collapsed and misery increased on a grand scale. 

• How do you deal with a Mezzogiorno country like Greece?

As clearly highlighted by Dr Dambisa Moyo, in her book "Dead Aid" relating to the $1 trillion in development-related aid transferred to Africa, we believe Greek Finance Minister Yanis Varoufakis is right in the need for a sort of New-Deal for Greece.

Without the mis-allocation of a large part of European subsidies, sunk into Greece, and the completion of a Greek state there would not be such a difficult debt problem in the first place. Direct investments in infrastructures which human capital benefits from as well as productive capital, is the strategy currently followed by China, for instance in Africa. This is as well a subject tackled by Dr Dambisa Moyo in her most recent book "Winner take all".

• Will a GREXIT solve Greeks' woes?

Without "Cognitive Restructuring" and dealing with the "unfinished business" of creating a proper state with efficient records and taxation, Greece's exit from the Euro with a devaluation and a return to the Drachma, will not bring an end to its misery. This is clearly shown by Dr Constantin Gurdgiev's post from the 30th of January 2012 entitled "Fake Doctors Treating Fake Disease in Greece":

"There are many 'expert' voices in the media saying Greece should exit the Euro zone in order to return to growth. This, as I commented earlier today, is a gross oversimplification of the reality.
There is simply no evidence whatsoever that Greece can grow on its own any faster or more sustainably than it did within the Euro. In fact, the evidence presented below shows that the only period during the last 30 years in which Greece was able to somewhat marginally close the gap in growth between itself and the Advanced Economies group is the period immediately following its accession to the Euro.
It is a fallacy of 'alternative expectations' to believe Greece will be enabled to grow its economy under post-euro devaluation beyond achieving a 1-2 years-long 'bounce'. Analysts who expect Greece to recover on the back of exiting the euro & devaluing are deluding themselves for two major reasons:
1.Greece has no fundamentals for growth & its debt overhang will remain, unless it defaults hard. Even with a default, removing debt overhang is not going to deliver growth to Greece beyond simple mechanical post-depression bounce, as Greece lacks all fundamentals for growth - institutional, cultural and historical.
2.However, with a hard default option, post-Euro, Greece will not be able to borrow & absent Government spending Greece has no capacity to grow. This is clearly shown in the charts below which highlight that in 23 out of the last 29 years, Greece has managed to achieve growth only with accompanying fiscal imbalances.
In summary, Greece never once had any fundamentals to grow on its own without massive subsidies either via loose monetary policy or overinflated expectations relating to the country accession to the European common structures. Greece is not about to get real growth-driving fundamentals within or outside the euro area.
 In short, all those talking about 'Greece must exit euro zone to achieve growth' are nothing more than fake doctors treating a patient who himself is faking a disease. Greece's problem is not the Euro. It's problem is Greece itself." - Dr Constantin Gurdgiev - True Economics blog

There is no good decision for Greece between Grexit or No Grexit. Regardless of the path it chooses, the lack of completion of its state is the only way to put an end to the misery of its people.

• Keynesian solution to counter the fall in aggregate demand even with QE will fail

We already touched on debt deflation in our August 2011 conversation "AAA ratings - 10 little indians...and debt deflation (why Irving Fisher is right)":

"For Keynesians, the fall in aggregate demand caused by falling private debt can be compensated by growth in public debt, a government credit bubble. It isn't working."

When it comes to Greece in particular and Europe in general we reminded ourselves of the wise words as well of our good credit friend in 2012:

"When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.
But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.
This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

We keep reminding ourselves that credit dynamic is based on Growth. No growth or weak growth can lead to defaults and deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels.

The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments.

In Europe without debt mutualisation and fiscal transfers on a grand scale, deflation will not be avoided, QE or not.

From our August 2011, we indicated at the time that Irving Fisher's Forward Year Tax Receipts was indeed an interesting solution for the debt deflation situation plaguing the world (with the US in mind given the efficiency of the IRS and the fact that US citizens are taxed on their worldwide income):

"Recognizing that the federal government issues liabilities (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired." - source Debt deflation

Unfortunately, with most of the world implementing ZIRP, there will be no happy ending this time around rest assured:

"If you want to raise real GDP, you raise the real interest rate on government debt (which the federal reserve controls) and / or you lower the tax rate. This works well enough until you run a huge trade imbalance (like with China) that suppresses real interest rates or if you have a great depression type scenario where the inflation rate is severely negative (massive deflation). In the massive deflation scenario real GDP may show growth while nominal GDP would show contraction.
The way to get around both scenarios is to sell forward year tax receipts. A forward year tax receipt lowers the after tax cost of credit in the private sector while not depriving the bondholder of income (Friedman's permanent income hypothesis). This is the problem with monetary policy as it stands now. In a true great depression massive deflation type scenario even tax cuts don't have any traction because if nominal interest rates are 0, lowering the tax rate would have no effect on either money velocity or GDP." - source Debt deflation

On a final note we give you a revised Schedule Chicken" redux:

• "Wednesday February 11th – Likely t-bill auction to cover EUR 1.4bn maturity on 13th 
• Wednesday February 11th - potential emergency Eurogroup 
• Thursday February 12th – European Council of EU Leaders, Tsipras likely to meet Merkel on sidelines 
• Friday February 13th – Voting for new Greek President begins, EC Commissioner Avramopoulos most likely candidate, originating from New Democracy. Likely completed by second round on the following day requiring 151 MP majority
• Monday February 16th – Eurogroup where Greece likely to be top of agenda, conditions for extension of program to be made explicit by now 
• Wednesday February 18th-19th- - Bi-weekly ELA review Saturday February 28th – Current EFSF program expires" - source Deutsche Bank

As well as Greece debt profile as displayed in a recent CITI report:

- source CITI

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

Stay tuned! 

Credit - Perpetual Motion

"Oh ye seekers after perpetual motion, how many vain chimeras have you pursued? Go and take your place with the alchemists." - Leonardo da Vinci, 1494

Looking at the continuous new highs registered by the Dow Jones, we reminder ourselves of the quest of many scientists for perpetual motion when choosing this week's title:

"Perpetual motion is motion that continues indefinitely without any external source of energy. This is impossible in practice because of friction and other sources of energy loss. A perpetual motion machine is a hypothetical machine that can do work indefinitely without an energy source. This kind of machine is impossible, as it would violate the first or second law of thermodynamics." - source Wikipedia

Given that by now it is fairly evident that the Fed's balance sheet extension has had a significant impact on the performance in risky assets in general and the S&P 500 in particular as displayed in the below graph from Société Générale's recent report entitled "20 charts to understand the fragile equilibrium of US financial markets" published on the 15th of July, we wonder if indeed our "omnipotent" central bankers do not think they have indeed surpassed Leonardo da Vinci and invented "perpetual motion" in financial markets:

But we reminded ourselves of Adam Smith's quote in relation to real "price" formation:

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."

Despite the fact that successful perpetual motion devices are impossible in terms of the laws of physics, the pursuit of perpetual motion remains popular particularly in the US central banking space we think.

So we decided to "ramble" around the definition of perpetual motion in financial markets and the lack of "labor participation" in the current on-going Fed induced rally when carefully choosing our title and came up with this:

"The Fed's perpetual motion machine of the first kind produces "income" without the input of "labor". It thus violates the first law of "thermo economics": the law of conservation of labor." - Macronomics

In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level.

If a country has 100% debt to GDP, it means that this country has roughly bought growth at a 2% rate for 50 years which is the case for France given the last time the books were balanced was 1974. 

In this week's conversation we will discuss around the risks of "hyper-deflation" happening as well as looking at the potential trajectory during the summer for US yields.

As we have argued in our conversation the "Molotov Cocktail":

When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels. 

What we are of course concern in this much vaunted "Perpetual Motion" infatuation in financial markets is that we are still sitting tightly in the deflationary camp. In fact we expected further yield compression on US Treasuries as discussed in our conversation "the Vortex Ring" back in May this year:

"The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian)." - Macronomics

In our conversation"The Coffin Corner" we indicated the following:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."

So seeing the 1st quarter US GDP print shocker at -2.9% made us wonder about the control effectiveness of the Fed. We can relate to some of the interesting points developed by Shelby Henry Moore III in his Bell Curve Economics long post: 

"In a vicious feedback spiral, as the GDP shrinks, the private sector income shrinks and needs more debt (or government subsidies) to pay the interest on prior debt, but the additional government debt spending destroys more of the useful production and capital of the private sector. The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments. At this terminal phase, both increasing or decreasing M (debt), shrink the GDP, i.e. hyper-deflation." - Shelby Henry Moore III.

Of course this is why extended QE in the US and the launch of QE in Europe would be highly destructive we think and could potentially lead to "hyper-deflation". 

When it comes to deflationary pressures we have been tracking the events in the shipping industry with great interest and in particular the numerous prices increases in the Drewry Hong-Kong-Los Angeles Container Rates - graph source Bloomberg:

"Drewry publishes its weekly Hong Kong-Los Angeles 40-foot container rate benchmark on Wednesday mornings EST. The benchmark provides insight into the price to ship a container across one of the busiest trading lanes and is therefore used as a proxy for the market. It fluctuates with changes in liner supply-and-demand dynamics and rate surcharges." - source Bloomberg

Another shipping indicator we have been following is of course the Baltic Dry Index as oversupply of vessels keeps hire costs below break-even levels. The index dropped 29.4% on average in 2Q from 1Q and  is 69.8% lower than the 10-year historical 2Q average, yet is 8.8% higher than 2Q13 levels. Panamax vessels declined 40.1% on average sequentially, and were down 19.6% yoy in 2Q.- graph source Bloomberg:

"The Baltic Dry Index, which tracks the costs of moving dry bulk freight via 23 seaborne shipping routes, has averaged 32.5% higher yoy this year through July 16. The index is a barometer of the health of the dry-bulk industry, as well as the broader global economy. It has declined roughly 34.5% yoy and down 66.4% from the recent December peak. The index should begin to rebound as seasonal trends, such as grain exports out of South America, take hold." - source Bloomberg

For us shipping is a leading deflationary indicator as we have argued in March 2012: 

"He who rejects restructuring is the architect of default." - Macronomics.

As we have argued in our conversation  in September 2012 "Zemblanity" (being "The inexorable discovery of what we don't want to know"):

"By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate)."

 As a reminder:

Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

Credit growth is a stock variable and domestic demand is a flow variable. We always asked ourselves the following when it came to the Fed's policies:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Back in our September 2012 conversation we came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our past title analogy, namely "Zemblanity" and thought we had to share it at the time given we are at present discussing "Perpetual Motion" (which is impossible):

"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."

And of course the credit "japonification" process has clearly been set in motion.

When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.

The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.

However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

Capital gains in the form of exorbitant bond price? A game we have indeed played successfully given we have been learning a few tricks from our Keynesian magicians bankers as of late. We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great "magicians" and given our observation of "Perpetual Motion" machine we decided at the time to buy this French Perpetual issue. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:

Of course the main culprit behind our outsized gain is ZIRP (zero interest rate policy) given it has the effect of destroying capital. As the rate of interest is halved, the price of a long term bond is doubled.

Exorbitant government bond prices? The Core European bond market picture making new record lows such as the German bund 10 year yield at 1.14% and the French OAT 10 year at 1.56%, at the lowest level since 1746 - source Bloomberg:

"The continuing fall of interest rates in the 21st century, in the face of an unprecedented amount of Federal Reserve credit being created through bond purchases, is far from being illogical. Nor is the continuing bull market in bonds, now a third of a century old, is a conundrum to those of us who are not infected by the bug of Keynesianism. It is fully explained by the incentive to earn risk-free profits on a continuing basis, unconditionally offered to bond speculators by the policy of open market operations." - Antal Fekete, "Bonds Defy Dire Forecasts but they are not defying logic": 

In Europe of course, courtesy of our "Generous Gambler" aka Mario Draghi, ECB's president "whatever it takes" moment in July 2012 has indeed triggered the incentive to earn risk-free profits based on continuing "implicit" guarantees, a subject we discussed in our previous conversation last week.

Our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany. But what our "Generous Gambler" ignores is that generally hyper-deflation can lead to a deflationary spiral in which a deflationary environment leads to lower production, lower wages and demand, and thus lower price levels, which is continuing in Europe as far as we can see from the latest economic data releases.

Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience:

"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it 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.

But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

Of course, what the ECB has done as well is tame the speculators and prevented so far a deeper adjustment in the European banking space leading to an outperformance of financial bonds versus equities. But, as we pointed out last week, the continuous need to raise capital for the European banking sector is facing more margin calls, meaning more need to raise capital and the need for more sovereign supports to avoid a depreciation of the liabilities. This infernal "Perpetual Motion" is no doubt delaying a very painful adjustment which could lead the European sector to produce more than what is need just to make the interest payments of the ever rising debt burden!

Therefore it appears to us that deflationary environment in Europe is continuing leading to lower production, lower wages and lower demand, and thus lower price levels.

Moving on the trajectory of US yields during this summer lull, we agree to a certain extent with Nomura's recent take on US treasuries in their note from the 18th of July entitled "Bonds over-reacting or forward looking?":

"Summers aren't the time to burn carry and be short duration - wait for the Fall

We started out the year with a strategic call for lower rates and that has largely run its course. However, we have constantly said that investors should not expect a v-shape rise in rates just because the rally in duration wasn't expected. We have been slowly shifting our trading profile, and for now we have a tactical play on this bond rally to carve out a low this summer versus it just having a one-touch feel to it, where most have been hoping the May dip of 2.4% on 10s, for a brief second, was the low for year; we don't.

As seen in Figure 1, the market participants have been fighting the urge of getting dragged into the air pocket created last year post taper was let out of the bag. However, the path of least resistance and our call until the September FOMC (where there is a risk for more hawkish news around exits and growth/rate expectations) is for 10s to go towards 2.35% and 30s towards 3.10% during the balance of the summer. 

August traditionally is a seasonally strong bond rallying month, and Q2 data excitement can burn out soon (where we are watching if next week's CPI flares out and if at the end of the month wage inflation take off or not). Meanwhile, although investors are not as short, mentally most investors want higher rates and there are some groups underinvested.

Lastly as we mention in our mid-year update, once rates start to normalize, given the lower fixed income supply projections in the second half, bond markets will be supported even as Fed exits, in our view. In Figure 2 we highlight that the Fed has obviously been the biggest buyer during QE; however, in the past other investors would come in and fill the void. 

Recently there has been a focus on China buying USTs and how that was probably another force driving rates lower. However, bank buying in the US has been just as equal of a force while Japan hasn‟t been buying as strongly lately. So that can all change if yields back up and actors like GPIF allocate abroad." - source Nomura

On a final note and as we posited at the beginning of our conversation unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively. As reported by Anna-Louise Jackson and Anthony Feld in their Bloomberg article from the 22nd of July entitled "Higher Wages Signaled by More U.S. Employees Quitting", the jury is indeed still out there when it comes to confirming the "escape velocity" of the US economy:
"More than 2.5 million U.S. workers resigned in May, a 15 percent increase from a year earlier, based on seasonally adjusted data from the Labor Department. These employees represent about 56 percent of total separations, the highest since November.

Such departures serve as a proxy for consumer confidence because people are more likely to quit when they have a new position secured or are convinced that another is readily available, said Nicholas Colas, chief market strategist at ConvergEx Group, an institutional equity-trading broker in New York. The most-recent quits data were “very positive,” which suggests sentiment finally has turned a corner, he said. The report is one that Federal Reserve Chair Janet Yellen has said she uses to judge the strength of the labor market.
The share of Americans who say business conditions are “good” minus the share who say they are “bad” turned positive in June for the first time since January 2008: 0.2 percentage points, up from minus 3.5 points in May, based on data from the Conference Board, a New York research group.
Feeling Emboldened 

“Consumer confidence has been the last piece to come back in this recovery,” Colas said. This suggests wages also could go up because as employees feel more emboldened to switch seats, their bosses may be willing to offer higher compensation in an effort to prevent such turnover, he said.
People working in the private sector could see stronger salary gains ahead, according to Bloomberg BNA’s Wage Trend Indicator, designed to predict and interpret compensation trends. This forward-looking index rose to 99.12 in the second quarter from 98.92 in the first, marking the third consecutive increase and highest level since March 2009.
Pay for these employees could increase more than 2 percent by year-end, according to Kathryn Kobe, an economist at Economic Consulting Services LLC in Washington, who helped develop and maintains the indicator. Wages rose 1.7 percent in the three months ended March 31, near a post-recession low of 1.3 percent,data from the Labor Department show." - source Bloomberg

What of course could derail this very "fragile" recovery is a renewed jump in gasoline prices. The latest US core CPI climbed 1.9 percent from June 2013, after a 2 percent increase in the prior 12-month period. Gasoline costs jumped 3.3 percent, their biggest gain since June 2013, accounting for two-thirds of the increase in total prices, today’s report showed, something to watch closely we think.

"I can calculate the motion of heavenly bodies, but not the madness of people." - Isaac Newton

Stay tuned!