"Arx tarpeia Capitoli proxima" or the recent US Downgrade threat and the Fed dual mandate issue

"Arx tarpeia Capitoli proxima"

The price of continued US lax fiscal policies has seriously risen with S&P putting the US economy under negative watch.

The Fed has now kept the benchmark at zero to 0.25 percent since December 2008 while proceeding to two rounds of Quantitative Easing.

Whereas in Europe, the ECB has started tightening. It is the first time ever the ECB has acted before the FED preemptively in relation to inflation concerns.

This is an important point, as it clearly shows the divide in policies between the US and Europe.

While Trichet and the ECB seems to be sitting in a more classical camp, Bernanke and the Fed, seems to believe in a Keynesian approach in resolving the difficulties faced by the US economy.

It is important to remind at that point the clear differences in mandates between the ECB and the FED. While the ECB's core mandate is of price stability, the FED has a dual mandate, price stability and maximum employment. Hence the current difficulties faced by the Fed. Targeting both unemployment levels and inflation levels is a near impossible task for the Fed currently. It has to promote both “maximum employment” and “stable prices. The Fed’s mandate was extended to "maximum employment" in 1978 as a way of forcing the central bank to "print money". This extension of the mandate made sure the Fed would always be under continuous pressure from the politicians. But, Paul Volcker initially in the early 80s did not play it that way. He clearly understood the risk in not taming the inflation beast. He knew he could not fight on two fronts and initially targeted inflation versus maximum employment. His policy of taming inflation with a rapid surge in interest rates led to a very severe recession but put back the US economy on track. The recession was short but indeed very painful which led Mr Volcker to be hated by both Republican politicians as well as Democrat politician.

One of the main reason of QE2, can be sourced to this ill-fated dual mandate.

The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game. I criticised the wealth effect policy in February 2011 (Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth).

It is important at this stage to link this post to a previous one I have written: "The Hurt Locker". In this previous post I published in September last year, I discussed the fundamental flaws in Washington’s stimulus policies, linked to the flawed dual mandate imposed on the Fed.

Also, I quoted Jacques Rueff and his analysis of the failings of Keynesian stimulus policies:

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

What we are seeing right now is a Fed creating price inflation during the current slump ensuring the "poor schmucks" real terms wages are going down.

This is what happened during the big Stagflation period of the 70s:

"Between 1974 and 1984, real wages fell as much as 30%."

In Homage to Jacques Rueff, Bill Bonner added the following:

"But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concluded:

"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

In May 2010, I wrote: Anterograde Amnesia or Retrograde Amnesia? Or both?:

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered." This seems to be the position of the classical ECB while the Fed seems to be suffering from Retrograde Amnesia. "Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

It is very important to understand the game played by politicians in relation to creation of the additional mandate of the Fed, namely maximum employment and its fallacy.

Joseph Schumpeter, one the greatest economist we ever had, clearly understood's the role politicians played; He presented in the quote below as "The Intellectual in reality our politicians. I initially referred to Schumpeter in December 2009 in the following post: "Blue pill or Red Pill?"

"Capitalism’s Greatest Enemy: The Intellectual

"The proper role of a healthily functioning economy is to destroy jobs and put labor to better use elsewhere. Despite this simple truth, layoffs and firings will still always sting, as if the invisible hand of free enterprise has slapped workers in the face. Unsettling by nature, capitalism’s churn gives rise to a labor movement designed to protect workers from job loss. That movement is fed emotionally by displaced workers and others who blame the capitalist system for their troubles, but it is led psychologically by a whole other type of person—the intellectual. Intellectuals—with little to do owing to the success of the capitalist economic system but with an intense desire to be seen as caretakers of society’s general well-being—anoint themselves as leaders of the labor movement. They object to capitalism on moralistic grounds and seek its destruction and replacement by another system—socialism—which places them center stage."

"You could replace "intellectuals" in the quote in today's economy by politicians and you would not be far from what is currently happening in many countries today" I argued back in 2009.

Creative Destruction as defined by Schumpeter, is at the core of Capitalism. Politicians for the sake of getting elected or re-elected cannot accept this core feature of capitalism. One could argue that Schumpeter's view of the evolution of Capitalism towards Socialism, is in fact quite accurate in the description of the process.

But I digress, let's go back to the Fed's dual mandate issue and the current situation.

The Fed is trapped in its dual mandate enforced by US politicians. QE2 will make it extremely much tougher for the Fed to eventually reduce its gigantic balance sheet, therefore risking higher inflation.

While the ECB's mandate make it more easier to react to inflationary pressures, regardless of unemployment levels:

Fed officials not attached to dual mandate - Reuters

"In a clean discussion of what the appropriate role for a central bank is, I can see some merit in looking at a narrower objective," Chicago Federal Reserve Bank President Charles Evans.

"It's interesting," he said in November. "The ECB (European Central Bank) has a price stability mandate ... The only thing a central bank can do in the long run is control the long run rate of inflation, so from that point of view it makes sense to have single mandate"

according to St. Louis Fed President James Bullard.

"With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for the American economy by focusing singularly on maintaining the value of the dollar and protecting the purchasing power of Americans,"

Mike Pence, No. 3 Republican in the House.

It looks like Mike Pence care about the "poor schmucks" Jacques Rueff mentioned, who are seeing their real terms wages are going down with the US dollar...

Former U.S. Treasury Department undersecretary John Taylor indicated as well is wish for an end to the dual mandate of the Fed in January 2011:

John Taylor Advocates Narrowing Fed Mandate - WSJ

“It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’”

Taylor told the House Financial Services Committee.

An excellent post from November 2007 on the blog published by Macro Man can be find below, relating to the subject of the dual mandate:

Does the Fed's dual mandate spell doom for the dollar? - Macro Man

"Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc."

Recently Dr Hussman, wrote an excellent article related to the trap the Fed has put itself in with QE2:

Charles Plosser and the 50% Contraction in the Fed's Balance Sheet (Hussman)

"A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% "starting in the not-too-distant-future," preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.3 trillion in the Fed's balance sheet, to a smaller monetary base of just under $1.2 trillion.

In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate is just about right (ten increments of 0.25 each, with an overall contraction approaching $1.3 trillion in the Fed's balance sheet). So Plosser's estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed's balance sheet to contract by more than 50%.

The problem, however, is that the required shift in the monetary base is not linear. It's heavily front-loaded. Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can't just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow.

The upshot is that Plosser's estimate of about $125 billion in asset sales for every 0.25% increase in yields is an accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.

In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I've called its "unstable limits." High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation."

Dr Hussman also added in this must read article:

"The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns."

In relation to today's market environment, the outcome is likely to be a very significant risk of unstability and sharp volatility increase. Given the potential for the economy to come to a stalling point in the upcoming quarters due to external inflation pressures (oil prices high prices) already creating serious headwinds on corporate profit margins as well as consumption, it is extremely important to be well aware of the consequences of unbalances which has been generated by a reckless Fed in launching QE2.

Another surge in Gold was clearly expected, I agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011: "Gold, the Fed, Ron Paul and Napoléon Bonaparte"

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."

The release of information related to the access to the discount window of the Fed, thanks to Bloomberg's tenacity in their lawsuit also underlines a very important point between the current relationship between the Fed and the ECB. Martin Sibileau in his post,goes further in the analysis of the access to the Discount Window of the Fed: loans to overseas banks including cross-currency swaps, and their implication in magnifying global leverage worldwide.

"These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.

In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs."

Like Martin Sibileau, I sit in the same camp, outcome will be stagflation.  We both believe in strong stagflationary forces being at play in the current environment.

What will happen when Asian countries as well as Oil rich countries, gorged with USD reserves and facing the rising threat of inflation, will decide it is not wise anymore to invest these reserves in US Treasuries, but to invest in gold, tangible assets and more yielding assets?

As I wrote previously you cannot expect China to bow to American pressure and start revaluating the Yuan versus the dollar. China has learnt the lessons from Japan: Revaluation of Japanese Yen, a historical lesson to draw: analysis - This is an article on the seventh page of People's Daily, September 23, by Pro. Jiang Ruiping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Chinese government officials have stepped up the rhetoric game with the USD stating they might have to diversify their USD 3 trillion of currency reserves away from U.S. dollars. Who would blame them, given the sinking value of the USD, therefore the sinking value of their chips in the game of marbles?

The dollar is 5% away from its all-time low, touched in March 2008, as tracked by the dollar index, which dates back to 1971.

The recent action led by S&P relating to its concern on the US economy, is a stark message sent to the US politicians, they need to put the US house in order and begin to show some long term fiscal discipline.

On the subject:

From Theory to Praxis - Sean Corrigan, Diapason Securities

"Only under the rules of what Jacques Rueff scathingly termed the 'childish game of marbles' by which the winners (the Chinese) return their spoils (the excess dollars) back to the American losers at the end of each round - by buying US Treasury and Agency bonds, in the main - and as a result of what the great Frenchman also dubbed the 'monetary sin of the West' - the fact that the dollar hegemony allows the US to go on mindlessly inflating and blaming others for its own lack of financial virtue - can the Chinese be held culpable for what is at work here."

Sean Corrigan also adds in his article:

"Emphatically, the only 'risks associated with deflation' are those which come from clinging too long in the naive faith that the value of one's money will be preserved by a central bank which can still talk about such an eventuality while the malign effects of its inflationary policies are everywhere increasingly undeniable."

"In a West already displaying symptoms of the extirpation of the middle class, in favour of the governing military-political elite and at the cost of buying off its feckless urban proletariat with a higher dole and more spectacular circuses, the more the state expands in this way, the more success it will enjoy in the only one of its wars on abstract nouns which it wages unremittingly and a outrance - its War on Capital."

The Dollar Standard which succeeded Bretton Woods in 1971, following its collapse, has allowed the deficit countries like US, to consume more than they produce. Whereas surplus countries, such as China, Singapore and others, have been able under the new system to produce more than they consume, therefore accumulating vast USD reserves accordingly.

Between January 2004 and the beginning of 2008, worldwide international reserve assets more than doubled. Asian countries have boosted their reserves by acquiring export dollars. These dollars then moved back to the US, where they funded most of the excesses: subprime mortgages, leveraged buy-out, structured credit markets and so on.

QE2's wealth effect, it can be argued, cannot be branded as a success. The surge of US stock prices has been a mere reflection of the decline of the US dollar, hence the rise in Gold in the process.

The excellent David Goldman clearly illustrates the point:

If the economy is weak, why are stocks up?

"The last two weekly unemployment claims prints above 400,000 show how weak the labor market is. I’ve been saying for two years (pardon the broken record) that an entrepreneurial economy can’t do that well as long as there are no entrepreneurs in the picture. If that’s the case, why are stocks doing so well?

Part of the answer is that stock prices reflect the declining dollar: overseas profits increase when translated back into dollars, and American cash flows look cheaper to foreign investors."

Trade Weighted Dollar vs. S&P 500, April 20, 2008 to April 20, 2011

In relation to the current situation, the recent warning shot fired towards the USA by S&P, is an important inflection point as we moved towards what I have previously called relating to Chess, "The Endgame - Fin de partie":

An endgame is when there are only a few pieces left. We are close to the point.

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

This is the situation the Fed is currently in.

"You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect for those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."

George Bernard Shaw

 

The Hurt Locker

Definition: noun. a period of immense, inescapable physical or emotional pain.



The Hurt Locker and the problem of the liquidity trap.

Paul Krugman's definition of the liquidity trap, the Keynesian view:

[a] liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible price, full-employment economy; and although any reasonable model of the United States in the 1930s or Japan in the 1990s must invoke some form of price stickiness, one can think of the unemployment and output slump that occurs under such circumstances as what happens when an economy is trying to have deflation — a deflationary tendency that monetary expansion is powerless to prevent.[29]


Excellent comment this week by R. Glenn Hubbard, dean of the Columbia Business School and former Chairman of the Council of Economic Advisers under President George W. Bush, and Peter Navarro, a professor of economics at the Merage School of Business at the University of California-Irvine:

http://blogs.reuters.com/great-debate/2010/09/10/desperate-times-do-not-always-call-for-desperate-measures/

"The fundamental flaw in Washington’s stimulus logic is the incorrect assumption that America’s current economic woes began with the 2007 recession. In fact, the roots of our slow-growth problem date back at least a full decade.

From 1946 to 1999, GDP grew annually at 3.2 percent, but since then, we’ve only averaged about 2.5%. On a cumulative basis, this seemingly small difference adds up to about 10 million jobs we failed to create.

What these statistics add up to is not a short term cyclical downturn, but rather longer-term trouble driven by four major structural imbalances in America’s GDP “growth driver equation.”


Overconsumption:

From 1946 to 1999, consumption averaged 64 percent of GDP but over the last decade, that share jumped to 70 percent. This increase was fueled not by rising wages, but rather by a housing bubble and a mortgage refinancing wave that turned American homes into ATM machines. This overconsumption has been mirrored in a low saving rate and a second major structural imbalance – underinvestment.

Underinvestment:

Business investment in research and development, technological innovation, and the new productive capacity required for the job creation process has been the single most important missing ingredient in our economic recovery – and for renewed long-term prosperity. Yet the current administration seeks only to raise the regulatory and tax burdens of business.

Chronic trade deficits:

These have been equally destructive. During the 2000s, our current account deficit more than doubled and likely reduced our annual GDP growth rate by a half a percent or more.

Excessive government spending:

This spending has provided some short-term stimulus. However, an overfed Uncle Sam represents the ultimate seed of destruction through upward pressure on taxes and interest rates and a stark future of sharp cuts in defense, education, and infrastructure spending."

"Over the long — and short — term, in implementing any stimulus, we should favor tax cuts to stimulate business investment as the best way to stimulate job creation. Reducing the fiscal burden of entitlement programs is also essential to restoring prosperity."

Federal Government Debt: Total Public Debt



In relation to the raging inflation/deflation debate, Bill Gross at PIMCO has decided to put a wager on it. A 8.1 billion USD wager...quite meaningful (notional value of derivatives position tied to the Consumer Price Index).
They bought inflation floors in size...

"Inflation floors, structured as options on the consumer price index for all urban consumers, are similar to insurance. The buyer of the contract pays a premium at the outset in return for the right to receive a payment after 10 years should the CPI decline during this period."

The bet is that the USA will not be like Japan and are not on a verge of entering a similar lost decade as Japan did.

As I previously discussed in relation to the heated deflation/inflation debate, we are going through a deleveraging period, which meant deflation in some asset prices (real estate, etc.) but inflation in other items, such as food items (up 16% since 2009). In a previous post I argued you could have both deflation and inflation at the same time as currency values are being debased. The latest new record of Gold is of no suprise and the trend is up and up, given we can expect a second round of QE in November in the US.

The rise in food prices are strong inflationary forces at play which is probably creating a lot of headaches for the Bank of England given its inflation target of 2%. You can therefore expect the UK to rise interest rates sooner than expected which will coud increase the risk for a double-dip recession due to the current constraints in household balance sheets. I hope Mervyn King still has plenty of ink in his pen, as he will definitely have more letters to write to the chancellor in the coming months...


http://noir.bloomberg.com/apps/news?pid=20601087&sid=aqqEDrWMDO3w&pos=3

“We think the possibility that the U.S. goes 10 years with stagnant or falling prices is remote,” Mihir Worah, the head of Pimco’s real return portfolio management team, said in an e- mailed response to questions. “The options were priced at rich levels to the underlying” risk, added Worah, whose funds invest in Treasury inflation protected securities."

"Pimco Chief Executive Officer Mohamed El-Erian said last month the chance of deflation in the U.S. is around 25 percent."

Deflation then inflation is still the ongoing theme, which might lead us to Stagflation 70s style.

The latest inflation figure in the UK is of no surprise: August's consumer price inflation came in at 3.1 %. QE is working just fine...I kept saying the results of QE would be more inflation down the line, in April, in March...



http://www.telegraph.co.uk/finance/economics/8003750/UK-inflation-is-uncomfortably-high-says-Bank-of-England-rate-setter-David-Miles.html

"Inflation has been above the central bank's 2pc target since December 2009 although policymakers have argued that it is largely down to one-off factors and should subside over time."

Can the policymakers please specify the time frame? They won't...

High UK inflation no conspiracy:
By James Mackintosh

http://www.ft.com/cms/s/0/81dacaae-c038-11df-b77d-00144feab49a.html?ftcamp=rss



Jacques Rueff, a great French economist clearly saw the strategy behind Keynes General Theory of Employment which is currently being used in the UK with QE:

http://www.moneyweek.com/news-and-charts/economics/homage-to-jacques-rueff-88380.aspx

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

Bill Bonner also adds in his hommage to Jacques Rueff the following:

"Rueff died in 1978. Had he lived, he probably would have been as surprised as we have been by the stamina of the monetary horses. Except for a brief rest while Paul Volcker was managing the stables, they have run from bubble to bubble... delivering more liquidity wherever it would do the most damage. All the while, inflation continued to cut the price of labour. Between 1974 and 1984, real wages fell as much as 30%. Then, more moderate levels of inflation held them down for the next 24 years.

But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concludes:
"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

http://www.thedailybell.com/1114/Britain-to-See-Inflation-Risk.html

"Until the 1970s, classic Keynesian economists seem to have believed that it was impossible to have a stagnant economy along with an aggressive monetary stimulus program. In slumps, central banks should print money, and more money, to stimulate via government spending and bank lending. Of course, while such Keynesian solutions may not stimulate the economy much (not with real jobs anyway), they do lead to inflation, and then price inflation, especially in severe slumps. Hence, stagflation..."

http://www.marketoracle.co.uk/Article21501.html

"Krugman's monetary solution to a liquidity trap is sustained inflation, where the central bank reverses fears of future deflation by instead causing an increase in the price level through massive monetary pumping (Krugman estimates this to be in the area of $10 trillion, borrowing the figure from a prior study conducted by Goldman Sachs)."

Housing in the US is still in the hurt locker:

More pain to come unfortunately. There is a huge shadow inventory that needs to be worked through. Banks reposession runs unabated. Housing starts at rock bottom still.

http://www.cnbc.com/id/39175282

"RealtyTrac, an online foreclosure sale site, will release its monthly numbers on Thursday, but sources there confirm the number of repossessions will come in just shy of 100,000 for the month.
That is the highest since the site began tracking in 2005. July's repossession number was the second highest on record. The last highest was 93,777 in May of 2010."

U.S. Home Prices Face Three-Year Drop as Supply Gains:

http://noir.bloomberg.com/apps/news?pid=20601109&sid=aPjDFWbLAdd8&pos=10

“Whether it’s the sidelined, shadow or current inventory, the issue is there’s more supply than demand,” said Oliver Chang, a U.S. housing strategist with Morgan Stanley in San Francisco. “Once you reach a bottom, it will take three or four years for prices to begin to rise 1 or 2 percent a year.”

Gains Versus Inflation

"If the market doesn’t fall to its natural bottom, price gains in the next five to 10 years won’t keep pace with inflation as the difference is made up “on the backend,” said Barry Ritholtz, chief executive officer of FusionIQ, a New York research company. Price increases that fail to at least match inflation are the same as reductions in value, Ritholtz said."

"The Obama administration’s effort to help mortgage holders, the Home Affordable Modification Program, or HAMP, is another source of future inventory as owners with new loan terms re- default, Ritholtz said. About half of the modifications done in 2009 were behind in payments by the first quarter of 2010, according to the Treasury Department."

‘Day of Reckoning’

“The belief has been: if we stimulate sales with a tax credit and delay foreclosures with modifications, the market would stabilize,” said Ritholtz, author of “Bailout Nation.” “We’re just putting off the day of reckoning and drawing out the pain by not letting the housing market hit its bottom.”

Insanity: doing the same thing over and over again and expecting different results. Albert Einstein.

Just the facts on housing in the US:

"Owners of about 11 million homes, or 23 percent of households with a mortgage, owed more than their property was worth as of June 30, according to CoreLogic. Another 2.4 million borrowers had less than 5 percent equity in their houses and probably would lose money on a sale after paying broker fees and closing costs, CoreLogic said Aug 25."

Deep sea fishing: Housing starts still at rock bottom



From the excellent Calculated Risk blog:

http://www.calculatedriskblog.com/2010/09/two-key-housing-problems.html

"The excess supply is keeping pressure on residential investment, and therefore on employment and economic growth. As new households are formed, the excess supply will be absorbed - but this is happening very slowly."

"It takes jobs to create households, and usually housing is the key driver for employment growth in the early stages of a recovery. So this is a trap: the excess supply means weak employment growth, leading to few new households, so the excess supply is absorbed slowly - putting off more robust employment growth.







The excess supply is also pushing down house prices (prices are just starting to fall again). Lower prices will eventually help clear the market, however lower prices will push more homeowners into negative equity."

"Negative equity frequently leads to distressed sales (short sales or foreclosures), and losses for lenders."

It will take a long time to clear the mess in US housing. A long, painful process to clear the excesses of the housing bubble.

Anterograde Amnesia or Retrograde Amnesia? Or both?

Definitions:

Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

"To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

David Einhorn, President of Greenlight Capital, in John Mauldin' "Outside the box" on the 26th of October 2009

The market moved dramatically tighter following the announcement of the 750 billion euros package and bank share rallied massively in double digits on the Monday.

"Monday, in fact, saw the biggest one-day change in the history of the Markit iTraxx Europe index – tightening from 142bp to 102bp."

http://ftalphaville.ft.com/blog/2010/05/14/232156/cds-report-volte-face/

Well, the euphoria did not last very long...

Itraxx Main CDS 5 year has move again at around 110 bps. Corporate default risk as measured by the Itraxx index is on the rise again after a strong respite:

"The Markit iTraxx Financial Index of swaps on the senior debt of 25 banks and insurers jumped 15 basis points to 147 and the subordinated index rose 19 to 215, JPMorgan prices show."

http://www.businessweek.com/news/2010-05-14/greece-leads-surge-in-credit-risk-as-ackermann-doubts-debt-plan.html

It is very interesting to see that the Itraxx Financial index senior is trading wider than the Itraxx Main Europe as historically, it should trade tighter. Corparate debt is seen safer than bank debt for the time being.

You just can't get rid of a problem by throwing money at it and Deutsche Bank chief Josef Ackermann did not help our politicians by raising doubt on Greek debts currently being snapped up on the secondary markets by European Central banks in a concerted effort.
As a result the Euro currency took another massive beating Rocky Balboa style and broke through a very important support at 1.2450 against USD from March 09 lows:



Euro did fell to lowest level since Lehman Brothers collapse as finally people envisage the probability of a Euro break up:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aqquuYOAN_sE&pos=2

Sounds familiar does it? Be nice, please rewind...

I discussed this exact subject on the 9th of December last year in my post The importance of being earnest, about the Eurozone in general and the Euro in particular.

http://macronomy.blogspot.com/2009/12/importance-of-being-earnest-about.html

I stated at the time:

"The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro."

Looks like Volcker shares my views...

http://www.bloomberg.com/apps/news?pid=20601010&sid=a8CjGqGASv9E

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

Quizz time:
In the above quote, Paul Volcker was thinking about which country?
A. Greece
B. France
C. Spain
D. Portugal
E. Italy
F. All of the above


In this previous post as well I indicated the possibility of a Euro break up. You will find the links to the analysis which had already been made by Nouriel Roubini and Macro Research house Gavekal.

But back to this week price action.

By tearing up the sacred rule book and resorting to the Nuclear Option of Quantitative Easing (the politically correct definition for what really means "screwing your currency"), the Euro could only go down from there. There was the same result for the GBP when the Bank of England resorted to "Quantitative Easing" (I hate these two words).

VIX is now much higher than in my previous post on the 10th of April:



And Gold? New record high as well. The only way is up now that the US, UK and now Europe are all equal in the "Debasing Currency Club".



On the employment front in the US you have the following:

Source Creditsights.com:

https://www.creditsights.com

"There are a total of 10 million claimants receiving some type of unemployment benefits. Furthermore, there are a growing number of individuals (referred to as ‘99ers” in some circles) who have exhausted all 99 weeks of benefits and are waiting for tier 5."

290,000 increase in NFP (Non Farm Payrolls) for April.

But unemployment is still rising and you have, as Creditsights mentioned a growing number of 99ers.



Clearly deleveraging is still in full play which means further headwinds for employment levels in the near future in the US

So much for the "anticipated" V recovery...

Update on the bond vigilantes: FLIGHT TO QUALITY (at least perceived quality...)

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3uJ_8cLNk.A&pos=3

"U.S. two-year notes had their first three-week winning streak since January as demand for the safest assets rose on speculation Europe’s sovereign-debt crisis will damp growth and lead to disintegration of the euro."

BONDS PRICE YIELD (Bloomberg)
10-Year UK 108.13 3.75 yield
10-Year German 101.20 2.86 yield
10-Year French 103.23 3.12 yield
10-Year Italian 101.12 3.90 yield

Bund is the safe haven in Europe.

Spreads of German 10 year Bund versus other European countries 10 years government bonds is on the rise:

Spread BUND VS French OAT 10 year (Bloomberg):



Spread BUND VS Italian BTP 10 year (Bloomberg):



Spread BUND VS Spain 10 year (Bloomberg):



Spread BUND VS Greek 10 year (Bloomberg):



And good old TED spread is moving up as well:

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

"The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt. The TED spread is an indicator of perceived credit risk in the general economy."
"
When the TED spread increases, it is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills."



No need to panic yet given long term average of TED is around 30 bps but definitely something to watch.

The theme is still the same deflation then inflation down the road as we are still ongoing the painful deleveraging process which goes with the reduction of public spending and tackling the debt burden. GDP growth will be slow, and slightly positive to negative in some European countries.

Blue pill or Red Pill?

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.

The Matrix movie - 1999

There we are year end coming fast and everyone is expecting the recovery in 2010, following the surge in the many green shots seen in the economy.

Too many people have taken the blue pill.

The facts unfortunately doesn't support the idea of a strong recovery.

In my last post Greece Sovereign CDS was trading around 230 bps for 5year. Another downgrade from S&P came along and there we are with Credit-default swaps linked to Greek debt rising another 30 basis points to 260, according to CMA DataVision, the highest since March.

Everyone is expecting Greece to do the right thing, cutting on spending and reducing their abyssmal budget deficit before it is too late. Will a Greek socialist government be as aggressive as the Irish in tackling their issues?
The answer is definitely no.

Standard Bank has definitely turned negative on both Ireland and Greece:

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3SIOdqSGOtE&pos=5

As per my previous post, there is a probability that Greece could at some point exit the Euro.

Prime Minister George Papandreou announced he was taxing greek bankers at the rate of90% of their bonus and a the same time he announced that civil servants making less than 2,000 euros a month would get pay rises above inflation.

How does the Prime Minister of Greece expect to fund the salary of his public servants? By issuing bonds that no one will want?

http://www.ft.com/cms/s/0/b0d436c0-ea90-11de-a9f5-00144feab49a.html

Get ready for another bumpy ride in 2010...

Also in the news, one of Austria's largest bank (ranked 6th) had to be rescued by the Austrian Government:

http://www.ft.com/cms/s/0/ebfa6b22-e890-11de-9c1f-00144feab49a.html

Hypo Group Alpe Adria hit the wall. Another one bites the dust.

"Under the terms of the deal, Austria will take over 100 per cent of HGAA and the shareholders surrender their stakes and inject about €1bn ($1.5bn) in capital."

"Meanwhile, Austrian banks could face another €10bn in writedowns over the next two years, Austria’s central bank warned on Monday. Austrian banks have about €200bn of exposure to central and eastern Europe and have written down €15bn since the start of the crisis."

Problems have not been resolved by the governements and the deleveraging is still an ongoing process globally.

Defaults are still rising and unemployment levels are still going up.

(Bloomberg) -- Homeowners with mortgages of more than $1 million are defaulting at almost twice the U.S. rate and some are turning to so-called short sales to unload properties as stock-market losses and pay cuts squeeze wealthy borrowers.

http://www.bloomberg.com/apps/news?pid=20603037&sid=aQED_96QBBkk


It started with subprime mortgages going sour, then the ALT-As and ARMS, now the prime and jumbo loans are getting hit hard as well.

What we can expect is that the FED will maintain the interest rates low for a long period. We cannot expect them to raise rates in 2010. By maintaining them artificially low, they are trying to ensure banks can offset somehow the tidal wave of defaults and provisions they are facing, ensuring they make some very good profits on the spread banks are borrowing at and lending at.

The recession will really be over when small businesses which are the motor of an economy will start to hire as they did last time we had a valid recovery.

Here is the Red Pill for all of you who want to see how deep is the rabbit-hole we are:

From David Goldman's excellent blog (the link is indicated in this blog as well)

"Structurally, a very large percentage of job losses during recessions reflect creative destruction: big companies who lay off workers in recessions downsize permanently. The jobs are not replaced at the same companies; the old jobs go away forever, and new jobs are created at the grass roots of the economy.

That’s why we have to look to small business for continued job growth, and why the prospects are grimmer than the market seems to believe."

http://blog.atimes.net/?p=1274

No matter how much liquidity the US administration injects, no matter how Obama would like bank to increase lending (for some who have the capacity to do so...), the recovery is not around the corner but at least a couple of years down the line.

This is the awful truth.

The governments are preventing creative destruction to take place by trying to prop up some dying parts of their economies: GM, some banks, etc.
I mean by creative destruction the emergence of a new economy based on new technology or new industries.

As Joseph Schumpeter mentioned creative destruction hurts a lot in the short term and this goes again governments and short term views for short term political gains.

Volcker, arguably the best president the FED ever had, killed stagflation in the US in the late 70s. Soon we will be entering a new phase of Stagflation and you can expect inflation to start creeping up at some point and commodities prices to reach new highs.

As per a Wikipedia article around Creative Destruction:
"Layoffs of workers with obsolete working skills can be one price of new innovations valued by consumers. Though a continually innovating economy generates new opportunities for workers to participate in more creative and productive enterprises (provided they can acquire the necessary skills), creative destruction can cause severe hardship in the short term, and in the long term for those who cannot acquire the skills and work experience."

Joseph Schumpeter was a visionnary, and probably on of the first takers of the "red pill".

For those of view who would like to extend on Schumpeter's economic views which are very accurate, I recommend reading his book: Capitalism, Socialism and Democracy.

Here is a link to Wikipedia's review on this major book.
http://en.wikipedia.org/wiki/Capitalism,_Socialism_and_Democracy

So which countries to look for to invest? Follow where innovation is taking place at a fast pace, where education levels are strong and where there are plenty of skilled workers: Asia. India and China will continue to grow strong in 2010, they have the skills and the ressources to navigate these treacherous waters much better than most developped countries.
Canada as well will do well thanks to their natural ressources and their solid financial sector which was not damaged by the financial crisis.

I will conclude this post by a quote from Joseph Schumpeter:

"Capitalism’s Greatest Enemy: The Intellectual
The proper role of a healthily functioning economy is to destroy jobs and put labor to better use elsewhere. Despite this simple truth, layoffs and firings will still always sting, as if the invisible hand of free enterprise has slapped workers in the face. Unsettling by nature, capitalism’s churn gives rise to a labor movement designed to protect workers from job loss. That movement is fed emotionally by displaced workers and others who blame the capitalist system for their troubles, but it is led psychologically by a whole other type of person—the intellectual. Intellectuals—with little to do owing to the success of the capitalist economic system but with an intense desire to be seen as caretakers of society’s general well-being—anoint themselves as leaders of the labor movement. They object to capitalism on moralistic grounds and seek its destruction and replacement by another system—socialism—which places them center stage."

You could replace "intellectuals" in the quote in today's economy by politicians and you would not be far from what is currently happening in many countries today.