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...

Fantasyland and the imaginary world of spending multipliers.

"The president still seems to believe in the imaginary world of spending multipliers — whereby each dollar of additional spending results in something in the order of $1.40 in additional output."

http://www.cato.org/pub_display.php?pub_id=11944

"Bury Keynesian Voodoo Before It Can Bury Us All"
by Kevin Hassett

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=av8oanNvkBwY

"Aug. 23 (Bloomberg) -- Initial claims for unemployment benefits surged to 500,000 in mid-August, a level more typical of a recession than a recovery. The bad news confirmed what conservative economists have been saying for some time: The biggest Keynesian stimulus in U.S. history was a bust."

"A 2002 study by economists Richard Hemming, Selma Mahfouz and Axel Schimmelpfennig of recessions in 27 developed economies from 1971 to 1998 found that increased spending by government had, in almost all cases, a barely noticeable impact, and sometimes a negative one. Heavily indebted countries that spent more in recessions grew about 0.5 percent less, relative to trend, than countries that didn’t, the study found."

It is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future, this is the very reason why the Keynesian inspired stimulus did not work. The theory of rational expectations can be used to support this:

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

"If the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment. This is a distinctly New Classical outcome."

The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations:

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

"If the government employed monetary expansion in order to increase output, agents would foresee the effects, and wage and price expectations would be revised upwards accordingly. Real wages and prices remain constant and therefore so does output, no money illusion occurs."

Marc Faber the author of the famous Gloom Boom & Doom Report also thinks QE will be interpreted as inflationay. Marc Faber sits in the Austrian camp and his latest comment is based on the theory of rational expectation. A self-fullfilling prophecy?

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a1TLO_pYLNHw

We have witnessed the impacts of a herd mentality and the effects on numerous occasions, such as bank runs. Also, people believing another recession is coming, and will be hoarding cash, which will trigger a deeper slump in consumption and another downturn.

The Macro picture is still very bleak and inflating air in a pierced balloon just doesn't work.

David Goldman on his excellent blog, accurately describe the terrible state of the US economy:

http://blog.atimes.net/?p=1550

"Pension funds will have umpty-zillion-dollar deficits once they recalculate their liabilities at a 3% rate of return rather than the fictional 8.5% return assumed by most of the defined-benefit plans during the 2000s. The equity risk premium will remain depressed for a generation. The banks can’t make money after the short-lived boom in distressed assets because demand for yield has flattened the curve to the point that their old trades are less economical. Hedge funds can’t make money because they are behind the banks in the queue for assets."

It is going extremely difficult going forward for pension funds to cover their liabilities. In conjunction with very severe headwinds with high unemployment and damaged balance sheets, you also have demographic issues in the coming years which will be painful to address.

Although Wall Street has been bailed out, Main Street is still ongoing the pain of unemployment and deleveraging. It is still very tough out there and balance sheets haven't been repaired.

Long term Macro views - as per Angus Maddison

To begin with, I highly recommend reading Angus Maddison's book Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History.

In most of my previous posts, I have been focusing on the risks of a double dip recession and the outstanding structural issues faced by most of the developed countries.

In all that doom and gloom Marc Faber's style, there are some bright spots of development in the world and in this post I will try to highlight the incredible tectonic shift we have been witnessing in the World Economy.

I will focus on this post on looking at historical trends and I will try to highlight what to expect in the coming decades in relation to Macro Economic growth in the World.

Let's start first by reviewing the evolution of the share of World GDP from 1-2003 AD (percent of world total) as per Angus Maddison's book (page 381):

According to Angus Maddison, the share of the World GDP for Western Europe has dropped between 1973 to 2003 from 22.8 % to 16.5 %.
Between 1870 and 1913, Western Europe'share of Global GDP was around 30.5 % during the industrial revolution, although it was only 20.5% in 1820.

For the USA the peak share of World GDP was 1950 at 27.3 %. Since then their share of World GDP has dropped to 22.1 % in 1973 and to 20.6 % in 2003.

The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This it where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:
Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.

Asia will therefore become the largest driving force in world trade. China will again become the world's biggest economy by 2018 according to Angus Maddison, with USA at number two and India at number three!



Western European countries faces the following massive headwinds:
Ageing population for a start.
Very high debt to GDP ratios which will weight very severly on maximum GDP growth attainable. Given current budget deficits, private growth will be hindered by higher taxation and larger weight of the public sector on the GDP.



When the average debt to GDP in percentage will be around 100% in 2014 in Europe, Emerging markets average debt to GDP will be in the region of 35 % in 2014.



This graph comes from the following interesting research document published by Deutsche Bank which can be obtained using the link provided below:

http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000255134.pdf

The authors of this very good research document conclude with the following statement:

"Should consolidation fail, policymakers in DMs and some EMs may be tempted to look for other ways to fix the fiscal damage. Either they could tolerate a substantial acceleration in CPI inflation to inflate public debt and/or they risk severe adjustments in the real effective exchange rate. Such adverse scenarios should not be
disregarded. The assumption that major macro issues cannot go wrong in the DM world (including EMU) has to be scrapped in the aftermath of the global crisis while this time EM, not DM, economies are the ones in the lead to keep public indebtedness sustainable.
Welcome to a new world!"

Emerging markets Debt is therefore the new investment grade and Western Europe Debt looks more and more like the new High Yield (or junk already for some countries...).
While most of western developed countries are busy trying to debase their currencies to generate inflation, Asian currencies will continue to outperform due to the very good situation of their economy, enjoying both trade balance surpluses and manageable debt to GDP levels.

http://www.marketwatch.com/story/asia-currencies-outperforming-stocks-on-fund-flows-2010-04-30?reflink=MW_news_stmp

In relation to Commodities and Gold in particular, I expect them to continue to rise in the near future. As I mentioned previously in this blog, this is the reason why so many hedge fund managers are heavily exposed to Gold (Paulson, Moore, Soros, etc). This is part of their macro strategy following the ongoing rebalancing of the World Economy we are experiencing. They are simply betting that our politicians will try to inflate their way out of the debt problem we are facing.

In terms of macro investments, Asian currencies will rise against the Euro, USD and GBP. Fixed Income Emerging Markets funds will do very well in this new environment given their lower probability of defaults depending on the country they are exposed to (South Korea, Singapore, Taiwan, Maylasia, Indonesia are attractive).

According to the Deutsche Bank research, we are in a new world, I will conclude this post, that it is more a return to the mean, as Angus Maddison is clearly illustrating in his research. Asian countries are returning to the level of world GDP shares they had 200 years ago and before.

Like Mark Twain said "History doesn't repeat itself, but it does rhyme."

Same apply to Macro Economy, it doesn't repeat itself but it eventually does rhyme.