Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth

The illusion of Wealth:

We all know what happened during the financial crisis, a lot of Americans used their house as an ATM. Today the ATM is broken, following the dramatic impact of the crisis on households balance sheet and the collapse of the housing market. Thanks to QE2 and the rise in all asset prices, Ben Bernanke seems to be succeeding in creating the illusion of wealth. It is indeed the year of the rabbit and the magician is clearly Bernanke, pulling the wealth rabbit out of a hat.

http://www.quebecoislibre.org/05/050415-9.htm
THE ILLUSION OF HOUSEHOLD WEALTH - 15th April 2005 - Chris Leithner

"By borrowing against a home whose price is rising, sometimes substantially, households have been able to "extract equity" and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that has greatly exceeded the increase of household income. But all financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households' assets, particularly houses, can continue to rise much more quickly than income. A less immediate but ultimately much more significant risk is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future."

In this excellent article Chris also adds the following:

"Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households' net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household's portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are – and that savings are not – the route to higher net worth."

The Concept of Capital:
In his contribution, Chris Leithner discusses the critical concept of capital, quoting Peter Kasriel, chief economist at Northern Trust.

"Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods – and therefore that they should not be regarded as components of the capital stock."

This is probably one of the most important concept to understand. To some extent, it explains why there was a huge misallocation of capital during the financial crisis which validates the Austrian Business Cycle Theory.

Here is a reminder of the Austrian Business Cycle Theory:

"According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable."

Chris goes on an quotes Kesriel:
"Just because an existing house goes up in [price] does not necessarily mean that the more expensive house 'produces' more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour?
The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce".

The relationship between capital stock and household net worth is a very important one: the more households save the faster the capital stock subsequently grows:
"Two critical insights into the nature and causes of the growth of wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends heavily upon the composition of capital stock."

Chris concluded:
"Policies that encourage saving and investment – and do not sanctify spending and consumption – are required. But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially severe disorders have been bequeathed to the future."
This what Chris Leithner had to say in April 2005.

But back to today's macro environment.
In relation to the latest quarterly publication of the US GDP, it transpires that the reason why Personal Consumer Expenditure (PCE) rose Month to Month 0.7% in December, was because savings rate fell:
In the final quarter of last year, consumers spent more and saved less. Americans saved 5.4 percent of their disposable income, compared with 5.9 percent in the third quarter.

Truth is, continuous fall in home prices in the US will hurt both consumers and banks, counteracting the wealth effect generated by QE2 and the rise of assets prices.

Banks still face unexpected losses from their on-balance sheet mortgages, from commercial and residential mortgages. A slower growth in the US combined with a stable unemployment level could entice the FED to go for QE3.

Although western Central banks, namely the FED, Bank of England and the ECB will remain accomodative in 2011, you can expect further tightening in the emerging market space, due to inflationary pressures growing relentlessly on their economies.

The acceleration in the deterioration of Sovereign Credit - The impact of youth unemployment and the jobless recovery.

"As we peer into society's future, we -- you and I, and our government -- must avoid the impulse to live only for today, plundering for our own ease and convenience the precious resources of tomorrow. We cannot mortgage the material assets of our grandchildren without risking the loss also of their political and spiritual heritage. We want democracy to survive for all generations to come, not to become the insolvent phantom of tomorrow."
Dwight D. Eisenhower.
Farewell Adress - 17th of January 1961


Interesting Regression Analysis - as displayed by M&G Investments:

The issue is clear, youth unemployment is very high in peripheral countries in Europe. The danger being, the higher the rate of unemployment, the higher the risk for social unrest linked to the deterioration of Sovereign Credit, the slower the economic growth:

European map displaying Youth Unemployment Rates for 2009:

As the below graphs, shows, there is clearly a divide in Europe and the speed of the economic growth is impaired for many countries, such as Italy and France due to the very high level of unemployment for youths. Italy and France are in the danger zone clearly. They are already above the European average rate for youths unemployment rate. It does not bode well for the economic growth of the countries above the average. Structural reforms are urgently needed. Spain cannot delay any longer structural reforms of its very inefficient labor market.

The performance of labor markets generally reflects the performance of the economy as a whole.

Germany is powering ahead, with its very low youth unemployment level:

It is very important to look at the impact of youth unemployment in the light of recent events in Tunisia and now Egypt. There is a direct correlation to these events. It does not bode well for other countries facing similar youth unemployment levels, in the table below you can see the levels of the youth unemployment rates in 2001:

Youth unemployment clearly plays for a large part in the social unrest we have recently witnessed in Tunisia and now Egypt.

http://news.blogs.cnn.com/2011/01/28/young-educated-and-underemployed-the-face-of-the-arab-worlds-protesters/

"Muslim-majority countries in North Africa and the Middle East have the highest percentage of young people in the world, with 60 percent of the regions' people under 30, according to study by the Pew Forum on Religion and Public Life."

The arabic countries have a growing youth population:

CDS spreads for North African and Middle-East are widening due to the contagion from Tunisia (October 2010 until End of January 2011):

North African Middle-East CDS OCT10-JAN11 - Egypt, Lebanon, Tunisia, Morocco:

Sovereign Wideners for the 28th of January 2011 - CMA's Sovereign CDS data:

Egypt's cumulated probability of defaults now stands at 24%, above Spain which stands currently at 21% according to CMA.

Are young arabs satisfied with efforts to increase the number of quality jobs? (Gallup survey April 2009)

The jobless recovery:
During the recent crisis, youth unemployment has surged dramatically. The jobless recovery is a serious obstacle to the reduction of youth unemployment and rapid economic growth:

http://www.euractiv.com/en/socialeurope/eu-faces-jobless-recovery-admits-andor-news-501633


"EU Employment Commissioner László Andor has admitted that the EU is experiencing a "jobless recovery", amid warnings from the International Labour Organisation (ILO) that the situation might not improve this year."

"More than 23 million workers are currently registered as unemployed across the whole of the EU. This means that the number of job seekers has increased by 46% (some 7.3 million people) since March 2008.

Europe's young people are facing an especially difficult situation. Across the EU as a whole, the youth unemployment rate, for those under 25 years of age who are not in full-time education, is now at a record level of 21%."

"Young people in Spain face an especially difficult challenge in trying to find work, as more than 43% of young people under the age of 25 (not counting those in full-time education) are registered as unemployed."

"It is key that reforms are undertaken to reduce the rigidity that characterises many European labour markets. Flexibility is crucial in times of recovery in order to promote job creation," BusinessEurope declared.

For those of you who would like to go through the latest report on the Global Employment Trends for 2011, the International Labor Organization (ILO) report is available at the following address:

http://www.ilo.org/global/publications/ilo-bookstore/order-online/books/WCMS_150440/lang--en/index.htm


The jobless recovery is typical of a balance sheet recession.

In the US, unemployment among people under 25 with bachelor’s degrees reached 9.6% in December, up from 8.6% in November and 5.9% just two years earlier. A stagnant labor market means the USA cannot create enough jobs for the thousands of young people set to graduate in 2011.

Are we going to witness a major conflict between generations? We were warned by Dwight D. Eisenhower in his prescient Farewell Address delivered 50 years ago on the 17th of January 1961, a must read...

"Crises there will continue to be. In meeting them, whether foreign or domestic, great or small, there is a recurring temptation to feel that some spectacular and costly action could become the miraculous solution to all current difficulties."
What would Dwight D. Eisenhower have thought about Bernanke's QE2, about TARP, about Alan Greenspan?

In his great farewell speech Dwight D. Eisenhower also added:
"But each proposal must be weighed in the light of a broader consideration: the need to maintain balance in and among national programs, balance between the private and the public economy, balance between the cost and hoped for advantages, balance between the clearly necessary and the comfortably desirable, balance between our essential requirements as a nation and the duties imposed by the nation upon the individual, balance between actions of the moment and the national welfare of the future. Good judgment seeks balance and progress. Lack of it eventually finds imbalance and frustration. The record of many decades stands as proof that our people and their Government have, in the main, understood these truths and have responded to them well, in the face of threat and stress."

Dwight D. Eisenhower's wisdom was clearly not taken onboard. He would have been deeply shocked by the Financial Crisis Inquiry Report
and its conclusions but that's another matter...

Dumb and Dumber - QE2 and the risks linked to global rising Yields in 2011

The discussion around the debt ceiling could trigger a sell-off as high as 100bps in US Treasuries, like in 1996. You want to track the TBT ETF in 2011 as a caution (please see below).

Zerohedge goes into the detail of what could happen if we have a 1996 replay in relation to the debt ceiling discussions.

http://www.zerohedge.com/article/can-sovereign-debt-crisis-happen-here-case-study-1995-debt-ceiling-precipitated-government-s
"It is difficult to disentangle the full effect of the 1995-96 debt-ceiling crisis on bond yields since Fed expectations were also changing rapidly during that time. If there is any conclusion to be made, it is the market generally shrugged off the government shutdowns and instead focused on macro developments.

The government reached the debt ceiling in November, and Treasuries generally rallied over the next three months even as the situation in Washington continued to deteriorate. That said, the Fed was also easing monetary policy during this period, having lowered rates by 50bp to 5.25% between December 1995 and January 1996. Nonetheless, reviewing press reports from this period suggests that the market seemed to ignore the debate over the debt ceiling in the early stages, having assumed that politicians would never allow the US to go into default and that a resolution would be brought about quickly. The biggest move occurred in the final days of 1995 when the market was generally optimistic that a resolution would be achieved.

At the start of the New Year, the market realized that negotiations were falling apart with Treasury Secretary Rubin warning sending the 10-year yield 8bp higher. Around mid-February markets began to react negatively to any news related to the budget stand-off; that is until late March when the ceiling was lifted. Treasury yields increased about 80bps in less than a month during this period."

http://www.themarketfinancial.com/marc-faber-on-2011-barron%E2%80%99s-roundtable-why-everyone-will-be-a-billionaire-soon/122361

Marc Faber on 2011 Barron’s Roundtable: Why Everyone Will Be a Billionaire Soon:
Marc Faber and Bill Gross from Pimco had an interesting conversation relating to the state of the US economy and the risks.

Here what Bill Gross had to say:
"I don’t know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation. We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings. We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential. And, on the short end of the yield curve, we are looking at creditors receiving negative real interest rates for a long, long time. That, in effect, is a default. Ultimately creditors and investors are at the behest of a central bank and policymakers that will rob them of their money."

This a point Felix Zulauf made:

"There are two worlds—the industrialized world and the emerging world. The industrialized world continues to live in a fiction: that it can afford its current lifestyle by going further and further into debt. At some point, the bond markets will riot against that."

For the entire Barrons January 2011 Roundtable:
http://online.barrons.com/article/SB50001424052970204555504576075983972474462.html

Given current risks on a sell-off on US treasuries, it is important to track the following ETF as mentioned previously, namely the TBT: ProShares UltraShort 20+ Year Trea (ETF) (Public, NYSE:TBT):

ProShares UltraShort Lehman 20+ Year Treasury, seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond Index (the Index).

TBT is already up 9.49% in 3 months and 16.63% in just 3 months. Year to date so far: 5.64% up.

That's the result of a rise in inflation expectations in my book...

Rising global yields is a key issue for 2011.

The excellent Doug Noland in his latest Credit Market Bulletin share the same views:
http://www.atimes.com/atimes/Global_Economy/MA19Dj01.html

"The possibility for a surprising jump in Treasury bond yields is a major 2011 issue. On the one hand, Treasury is not interest-rate sensitive; the marketplace doesn't have to fear much of an issuance impact from a moderate rise in borrowing costs. On the other hand, this dynamic would imply that yields are poised to surprise on the upside when the markets eventually force borrowing restraint. It doesn't take a wild imagination to envisage a market problem leading to an economic problem, to additional "TARP" (the Trooubled Asset Relief Program bailout) more rescues and a jump in borrowing costs - all combining for a dramatic deterioration in our nation's debt position.

That borrowing restraint is being imposed upon US municipal finance is a major 2011 issue. The year has commenced with municipal bond yields adding to Q4's surprising jump. Today, state and local finance is our credit system's weak link."

Doug goes on:

"Here in the US, policymaking has turned simple: run massive deficits, keep rates at zero, and have the Fed monetize debt until the private sector can be trusted to do the heavy lifting. Well, don't hold your breath. So, for Issues 2011, we can assume the Fed stands pat on rates. And while they have little credibility, both congress and the Fed are talking tough against bailing out troubled states across the country. Whether they can stick to this rhetoric is an Issue 2011. The dollar continues to benefit from the capacity of policymakers to inflate credit, a dynamic that will compound our dilemma when the markets turn their sights on disciplining Washington.

I'll posit that each year of massive government marketable debt issuance reduces the likelihood that central bankers will be able to exit their market liquidity backstop operations. History has shown how systems become precariously addicted to inflationary measures and market interventions. The Fed's balance sheet will only move in one direction. And when push comes to shove, they may be forced to buy municipal debt or monetize more Treasuries to help finance bailouts.

For now, the most important issue of 2011 is that serious structural deficiencies ensure that the Federal Reserve errs on the side of liquidity creation. This would seem to ensure a year of even greater monetary disorder, with the risk of heightened instability throughout global fixed-income, currency, commodities and equities markets."

Dumb and Dumber...

Nightmare on Main Street - The impact of the rise of energy and food prices on US Households

Where is US M1 Velocity of Money heading in 2011? Is a double-dip on the horizon?

In past crisis when Velocity dropped significantly, recession occurred. We have to keep a close eye on the evolution of velocity in the US.

US Business Inventories are still rising:

US Inventories from 1992 to 2010:

But as the title of this post states, storms are gathering as indicated in the latest publication from David Rosenberg, Chief Economist at Gluskin Sheff.

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_011711.pdf

It is the fith time in modern history we have seen both food and energy prices rising in double-digits annual rate: 1979, 1980, 1996 and 2008.
In those five times we experienced two recessions, 2008 was a lead to a major recession. At this rate it is estimated that energy bill is going to amount to 60 billions USD for the US Household and the Food bill by 40 billions USD. Add to this end of debt service, it is another 100 billions USD headwind.
Bye bye Federal Fiscal stimulus...

Gasoline prices since last August in the US have gone from 2.65 USD per gallon to over 3.00 USD per gallon. 50 Billions USD hit for the already struggling US consumers.
John Mauldin (JohnMauldin@InvestorsInsight.com.) in his most recent message, provided the latest letter from Van Hoisington and Dr. Lacy Hunt from the Hoisington Fourth-Quarter Report. They tell us the following:
(Hoisington Investment Management Company: http://www.blogger.com/www.hoisingtonmgt.com)

"For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income. In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011."

Van Hoisington and Dr. Lacy Hunt go on:

"Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy."

Thank you Dr Ben Bernanke, QE2 is a complete failure.

Inception - Bernanke's QE2 experiment

Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game.

I agree with Cullen Roche from the excellent site Pragmatic Capitalist, that QE1 was not money printing and was necessary in order to alleviate the massive burden of toxic assets sitting on banks balance sheet.

http://pragcap.com/bernank-put

"Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems. When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy. In theory, this was intended to reduce the volatility of the business cycle. Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble. After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets. This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers. LTCM was the epitome of failed economic theory at work in markets. A group of brilliant economists believed they had discovered the path to minting money in financial markets. On paper their equations appeared flawless. In reality, they were a disaster waiting to happen. In one fell swoop this collection of geniuses proved that EMH was flawed. And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen. In the words of David Tepper, it was a “win win” market – or so they believed."

What if we had let LTCM fail in 1998? Would we have had a Lehman demise in 2008?

In his excellent post Cullen adds: "the modern day Fed has taken its role to an entirely new level. They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy"

The outrage and the condemnation stem from the moral hazard of the situation of QE1, where Main Street had to step in to bail out Wall Street.

Cullen concludes his excellent post with the following comment:

"What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets. Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability? Perhaps the Nasdaq never should have approached 5,000? Perhaps LTCM needed to fail? Perhaps housing was never intended to be a speculative asset? Perhaps these assets needed to be allowed to decline? The result has been a slow deterioration in the foundation of the system with each and every bailout."

Should the role of the Fed and its Central bankers be extended to preventing bubbles? Clearly some Central Bankers in other part of the world, think so. At least this is what the Central Bank of Canada has been following which meant that went the crisis occurred, they were in a better situation to face the financial carnage we witnessed. The Canadian Central Bank approach is highligthed in my previous post. Mark Carney, Governor of the Bank of Canada is right : "selected use of macro-prudential measures" are needed as a third line of defense in Central Banks policies, meaning deploying counter-cyclical capital buffers to lean against excess credit creation.

In the case of QE2, fear is justified, Bernanke has crossed the Rubicon.
When the Fed is starting to lend money to the US government, meaning no sterilization of the purchase of US treasuries, it is in fact money printing, let's be very clear about that. QE2 was not necessary and is very dangerous.

Paul Mortimer-Lee of BNP Paribas, in an article called "The night they killed Santa", commented in this article following Bernanke's television appearance that
"Until Tuesday, I believed QE2 was a monetary policy play designed to facilitate lower yields and avoid the threat of disinflation. Now it looks like the nice man with the white beard was just there to fund a fiscal expansion."

This is the greatest of moral hazard, when the central bank starts lending money to the US government. Is that what QE2 is all about?

Mortimer-Lee adds:
"Belief in the US as a pillar of stability has gone. We have written before about how the Fed's ultra-lax monetary policy is threatening the US dollar's role in the international monetary system. This week we saw any pretence of fiscal probity dumped."

He concluded his note with the following comment:
"Tuesday night was when I stopped believing in Ben Bernanke. I feel a bit foolish for having been gullible for so long, but a bit sad too."

"The night they killed Santa"

"One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing." Federal Reserve chairman Ben Bernanke, December 5, 2010.

In relation to Ben Bernanke's public intervention, the excellent Doug Noland commented in Asia Times in his weekly Credit Market Bulletin following Ben's intervention on television in December:

Bernanke was pilloried last week for his "we're not printing" comment from Sunday evening's 60 Minutes interview. I'll pile on, but from a different angle. It seems strange to me - perhaps disingenuous - for our Fed chairman to suddenly take such a narrow view of "money".

At US$917 billion, outstanding currency comprises just over 10% of the "M2" monetary aggregate (savings deposits are the largest component at $5.343 trillion). And I have argued over the years that "M2" is a much too narrow definition of "money" to provide a useful barometer of overall credit and liquidity conditions. Certainly, the expansion of paper currency has been inconsequential to the grand scheme of Washington stimulus.

In the "old days", the banking system dominated system credit creation. Bank lending was integral to credit growth, with new bank deposits created through the process of expanding bank loans. "M2" provided a good indication of bank lending - that was a decent indicator of overall credit conditions. As such, the Fed reigned supreme over the credit mechanism through its careful regulation of bank reserves. Rather mechanically, our central bank would add reserves - the fodder for new bank loans - when it sought a boost in lending. It would extract reserves when it preferred to lean against the wind. Bank deposits were the critical component of "money" supply, and our central bank judiciously monitored their expansion.

The financial world - certainly including monetary management - was turned upside down with the unleashing of (unconstrained) non-bank credit instruments. No longer did the banks dominate system credit creation. In a process that gained fateful momentum throughout the 1990s, the bank loan was relegated to second-class citizen in the age of the booming Wall Street securitization marketplace. Meanwhile, the Fed's entire process of manipulating bank reserves became moot. Fed policy immediately gravitated toward manipulating the securities markets, and Bernanke's predecessor at the Fed, Alan Greenspan - "The Maestro" - absolutely relished his new "activist" role.

I have defined contemporary "money" as the most precious of credit instruments. "Money" is as "money" does. The great Austrian economist Ludwig von Mises recognized the crucial monetary role played by "fiduciary media" that had the economic functionality of a more narrowly defined stock of money. Especially with the advent of non-bank credit, the definition of what might operate as "money" in the markets and real economy had to be broadened significantly. The greater the boom in marketable debt instruments the more paramount the role of market perceptions in determining the stability of our financial markets and real economy.

Over the years, I have explored the concept of the "moneyness of credit." Moneyness is driven by the marketplace's perception of safety and liquidity. Generally speaking, "money" is a debt instrument perceived as a highly liquid store of nominal value. Money has always enjoyed a special role and, hence, unique demand characteristics: folks simply can't get enough of it, which nurtures a propensity to create it in overabundance. Money operates with its own problematic supply and demand dynamics, and never has moneyness enjoyed such capacity to wreak global havoc as it does today. With all their good intentions, central bankers are nonetheless at the root of the problem.

The Fed may not be running the currency printing press around the clock, but Fed policies have certainly been instrumental to the unending expansion of Treasury borrowings. And, clearly, any meaningful definition of contemporary "money" must include government debt instruments. Indeed, with bank (and, more generally, private-sector) credit suffering from post-housing mania stagnation, never before has government debt so dominated system "money" and credit creation.

Importantly, the Federal Reserve's zero-rate policy and massive monetization program have been instrumental in maintaining the perception of "moneyness" in the face of unprecedented Treasury debt issuance. I can't envisage a more powerful bubble dynamic: the Fed intervenes and manipulates the Treasury market - the predominant debt market underpinning fixed income and securities markets more generally. Enormous fiscal stimulus then works to stabilize system incomes, corporate cash flows, state & local tax receipts, and asset prices more generally. In the final analysis, trillions of dollars of government-created purchasing power ensure that a structurally maladjusted US economy has, at the minimum, the appearance of viability - and the stock market booms.

The Fed may not be "printing", but its operations as "backstop bid" are fundamental to the US and global government finance bubbles. In a replay of how "backstop bid" of mortgage guarantors Fannie Mae and Freddie Mac, the Fed and the US Treasury created the "moneyness of credit" for mortgages and related securitizations, the Fed's quantitative easing program distorts market perceptions of various risks (credit, interest rate, liquidity and systemic) and promotes over-issuance. From this perspective, our central bank's operations are more dangerous than the traditional printing press.

"Moneyness" was fundamental to the doubling of mortgage debt in just about six years during the mortgage finance bubble. Over time, the expanding gulf between market perceptions of moneyness and the true underlying state of mortgage credit ensured a crisis of confidence. Moreover, the trillions of additional mortgage credit had played havoc with spending and investing patterns and, increasingly over time, the underlying economic structure. These days, the attribute of "moneyness" in Treasury debt is on track to ensure the doubling of federal borrowings in the neighborhood of four years. For this round, the "expanding gulf" is much more pernicious and the consequences of a crisis of confidence potentially more devastating.

Money has throughout history demonstrated its dangerous side. Abuse money and "moneyness" at your own peril - although this fundamental lesson is invariably unlearned given enough time (and the seductiveness of monetary booms). The fiascos are always a little different, inevitably created by clever new wrinkles in the many faces of "money" and credit.

We are in the midst of another sordid episode. John Law's experimentation with paper "money" in France ended with the spectacular bursting of the Mississippi Bubble in 1720. Today's backdrop is much more complex: the Fed and global central bankers are working diligently to control an experiment in electronic "money" and credit gone terribly awry.

If it were only the printing press, it would be easier to appreciate what was developing and how to administer some restraint. Instead, the Fed has banked everything on its capacity to inflate marketplace liquidity, sustain massive government debt issuance, and maintain market perceptions of moneyness."

Where Doug makes his point is the role played by the Fed in maintaining what he calls "moneyness". The Fed acts as a backstop bid as well as maintaining perception of value. In fact, what he means I think is that the game of the Fed is to maintain perception of value by inflating assets prices through QE, moneyness being the perception of safety.

The point he makes and we all know that, the Fed is great at creating bubbles after bubble and QE is already creating the seeds for another one. It will end up in tears.

Gold will therefore continue its meteoric rise, supported by the misguided QE2 policy. Oil got my attention when it was recently trading at 75 USD in October. I am not surprised we are getting closer again to the 100 USD level. I think we will reach 100 USD in early 2011.

Oil in 2010:

Also at the current level of VIX, buying insurance for a market correction is once again cheap, and as in April, before the May sell-off, I wrote it was the right time to buy some protection. Again this time around, I think it is a good time to start buying some protection for some downside risk in early 2011.

Facts on current vols levels:
-EuroStoxx 50 is at the lowest level in the last four years. One month Implicit Vol was on the 15th of December at 17.3%, the lowest point was 6th of April 2010 at 15.5%, we know what happened in May... Implicit Vol 1 year was at 22.8% on the 15th of December.
-V2X has never drop as fast as it did between the 5th and the 15th of December since 2004. 19.7% as of the 15th of December, lowest point in 2010 was 19.8% on the 26th of March 2010. This is the lowest point since 30th of May 2008. V2X was at 31.1% on the 30th of November 2010 as a reminder.

Merry Christmas to all!

Martin T.

PS: Happy Birthday to my blog, it has been more than a year now and it is well alive and kicking. I would like to thank all my friends who have provided me with reports and some Bloomberg specific graphs which have helped me to illustrate my point of view. Please don't hesitate to comment on the posts to make this blog more interactive.

The Endgame - Fin de partie

The current attitude of Central Banks and in particular the Fed is reminiscent of Samuel Beckett's Theatre of the Absurd play called Endgame, hence the title of this post.

Beckett's play, is also a reference to Chess Endgame. Beckett was an avid Chess player.

Endgames can be divided into three categories:


http://en.wikipedia.org/wiki/Chess_endgame

Theoretical endgames – positions where the correct line of play is generally known and well-analyzed, so the solution is a matter of technique.

Practical endgames – positions arising in actual games, where skillful play should transform it into a theoretical endgame position.

Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications

Martin Sibileau on the 12th of August published a very interesting post which I highly recommend reading. He goes through on how the game has changed dramatically recently and why the Fed has got it dangerously so wrong again. Martin Sibileau is currently a Director for the Loan Portfolio Management Team of a major Toronto headquartered financial institution.

http://mises.org/Community/blogs/tincho/archive/2010/08/12/a-view-from-the-trenches-august-12th-2010-quot-the-rules-of-the-game-have-changed-quot.aspx

"Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market. We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits. The street is watching…"

"One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity."

Like a broken record, I kept saying that the only results that will be generated from an extension of QE is inflation down the line. We are still in a deflationary environment but the EndGame will be Stagflation.
It is becoming more and more obvious we are heading towards stagflation. Martin Sibileau also comes to the same conclusion on his blog.

I also recommend you read the following post from David Goldman:

http://blog.atimes.net/?p=1532

"Bloomberg today reports that the first rise in CPI in four months has reduced fears of deflation. This is silly. Between 2000 and 2008, the Federal Reserve ignored the bubble in home prices because rents failed to rise, and CPI measures rent (or home rental equivalent) rather than home prices. Now that home prices have collapsed, and homeowners are being turned out of their dwellings, rents have stabilized, because fewer people can buy houses and must rent instead. This is the consequence of a 22% all in unemployment rate. The only thing that has reflated during the dead-cat bounce that earlier masqueraded as recovery was the corporate profit picture, achieved largely through cost-cutting (more unemployment) or financial manipulation by the Fed, which handed banks the steepest yield curve in history.

Asset markets, though, reflect considerable deflation risk. A preference for cash and fixed-income assets over brick and mortar is a statement that physical assets are more likely to be cheaper in the future. There is a huge demographic tailwind behind fixed income markets, as I mentioned on the Kudlow Report Wednesday evening. The population is aging rapidly: between 2005 and 2020, the proportion of Americans aged 60 and over will rise from 16.7% to 22.8%, according to UN data. For “more developed regions,” the increase will be from 20% to 28%. That generates a huge demand for savings instruments. And that is inherently deflationary: aging savers buy future goods (securities) rather than present goods."

David concludes his post from the 13th of August with the following comments:

"Absent a fiscal reform that provides incentives to entrepreneurs to shift into physical assets, the Japan scenario is likely. There’s no more striking sign of deflation than private equity and real estate funds turning money back to investors. If the fund managers can’t find projects worth buying (which pay them handsome fees), it’s likely that corporate managers can’t either."

Although David sits tightly in the deflationary camp, while like Martin Sibileau, I still believe in a Stagflation scenario due to the inefficiency of QE to generate growth(please see previous posts), David is also playing defence:

http://blog.atimes.net/?p=1523

"I own plenty of inflation-hedge equities (against the possibility that my core expectation of deflation turns out wrong), but I’m happy with the bulletproof tax exempts I bought at higher yields than are presently available"

"In short, the economy is going nowhere, and the stock market doesn’t have a second act after the heroic cost-cutting of last year."

From my point of view, we are still in a deflationary environment. This is due to the massive amount of deleveraging that still needs to go through. Banks are still busy using the steepest yield curve in history to repair their balance sheets, and many banks are effectively not lending due to risk aversion and lack of risk appetite due to heavier regulations as well as to very stringent credit standards.

But, given the propensity with which the Fed is likely to be using QE to tentatively boost the US economy, it will be inflationary down the line.

To conclude Andy Xie has very well written on the inflation coming in the near future, please see below link (Andy Xie is an independent economist based in Shanghai and was formerly Morgan Stanley’s chief economist for the Asia- Pacific region):

Inflation, Not Deflation, Mr. Bernanke
By Andy Xie 08.16.2010 18:12

http://english.caing.com/2010-08-16/100171139.html

"The globalization reality is that developed economies like Europe, Japan, and the U.S. will suffer slow growth and high unemployment. Stimulus is the wrong medicine for solving problems. Believing this will lead to excessive stimulus, which causes inflation and bubbles in emerging economies first and inflation in developed economies later. The wrong policy prescription pushes the global economy through unnecessary gyrations, stagflation and possibly another major financial crisis in the emerging economies. It's high time for Mr. Bernanke to wake up from his stimulus obsession."