Archive - Jan 16, 2011

"If there's one institution in the US that consistently and repeatedly messes up everything, the Federal Reserve is that institution." So says famed investor Marc Faber in an interview he gave to ChrisMartenson.com this week. In it, Chris and he dive deep into the Fed activity (encouraged by Washington and Wall Street) responsible for the current severe health of our economic system. Both feel that once you understand the nature of the critical role the Fed now plays, you have much better clarity into what the most probable outcomes for our economy and financial markets will be.

Lately there has been a lot of chatter among the supposedly smarter-than-mainstream media that even should the debt ceiling not be raised, it would not mean the bankruptcy of America as interest payments would still be satisfied. While that technicality is absolutely true, it is even more absolutely irrelevant. What propagators of such theories forget is that lately there are just two exponential curve trendlines that are worth noting: that of the cumulative debt issuance, and of the US cumulative deficit (see chart below). Each month, the US issues around $50 billion more debt than is needed to just fund the deficit. This is debt that is on top of the debt that is needed to plug the different between revenues and expenditures. As Zero Hedge has pointed out repeatedly before, that ratio is already roughly 1 to 2, meaning for every dollar in revenue the US government issues more than one dollar of debt just to fund the deficit. And then some. As the chart below shows, in December alone the government issued $84.4 billion on top of the budget funding shortfall ($80 billion deficit and $164.4 billion in debt issuance)! So yes, while the Treasury can fund interest expense at record low interest levels, that is completely irrelevant. Unable to fund incremental expenses to the tune of hundreds of billions per month, the US government will shut down (a point when nobody will accept US government IOUs, not Social Security which passed the point of being self sustaining last year, and certainly not Medicare and Medicaid, and most certainly not private sector Defense Vendors) just like it did in 1995. Below, we present the key charts and the full report from a must read SocGen report on the sovereign debt crisis, titled Can It Happen Here? We urge all those who pretend to have an educated opinion on the US funding crisis to read this report before they open their mouths in public and once again validate their critics.

The more the market becomes close to the tipping point the more we can expect the cartel of bullion banks to make bear raids as we have seen this last week because they desperately need to cover their short positions. However, in the case of silver and soon to be the case with gold a negatively correlated open interest to price relationship means that lower prices lead to higher open interest; in other words there is no way to cover at lower prices; the only way to cover is at higher prices. As this becomes increasingly obvious to the cartel the severity of the bear raids will decrease, particularly when the premiums in the physical market are showing that the bear raids are stimulating massive physical offtake making the predicament of the cartel ever more precarious. This makes the brouhaha about the CFTC imposing position limits on the Comex a complete joke because, as always, the regulators are going to be too late. Just like all the other nefarious financial engineering schemes that are falling like houses of cards, the scam of selling precious metals that do not exist is fast approaching a rendezvous with its day of reckoning.

Over the past week, one of the less noticed and more notable developments, was that the 2s10s quietly climbed back to just short of all time record wides: at 273 bps, the curve is just 13 basis point away from the all time record 286 bps achieved on February 2, 2010. For those who still don't understand how this most recent gift to the banks by the Fed and the government works, the math is that for every 100 bps in spread widening, banks make profits by borrowing free at the 2 Year and lending out at the 10 Year spread (on a Price x Volume basis, although as we will discuss momentarily while the price (i.e. spread) may be there the volume is missing), even as home prices decline by about 12% for each percentage point. In other words, in the past year the entire double dip in home prices can be attributed to the spike in long-term rates, which have in turn caused mortgage rates to jump to year highs. All of this has been predicated by increasing concerns that the Fed will allow runaway inflation, as a result pushing 10 and 30 Year spreads (and gold) ever higher. And while traditionally, a steep curve implies substantial bank profits, this time it is really is different, as demand for mortgages, by far the biggest bank product beneficiary from rising LT interest rates, is non-existent - recent new and refinancing mortgage applications are plumbing 15 year lows, meaning that even if banks make exorbitant profits on a spread basis, there is just not enough of them to go around, which in turn means that banks once again have to rely on accounting gimmicks such as declining reserve provisions to pad their books. And unfortunately for the banks, every incremental basis point increase from here on out only means accelerating home price deflation (regardless of how many days in a row cotton, wheat and whiskey closes limit up), which will wreak havoc on myth of any "recovery." This is in fact the most salient point of Scott Minerd's of Guggenheim latest letter: while the bulk of his latest thoughts is focused on Europe, we believe that the critical part if really that dealing with US interest rates. As he concludes: "The story in housing remains a compelling reason yields on the 10-year note above 4 percent are simply not sustainable at this juncture." We complete agree, which also means that the strawman of higher bank earnings due to the yield curve is now dead and buried. Alas for all the bank bulls, from this point on the only direction the curve can go is down... Unless of course the Fed really loses control of the long end in which case all bets are off and QE3 is sure include purchases of MBS.

Not shares of AAPL, not freeze dried MREs, not shotguns shells, not even €45 million European pieces of linen in a suitcase... Gold. And one wonders why all the physical silver and gold is slowly but surely disappearing from the distributors: someone should really check the cargo hold of Lloyd's, Jamie's and Vikram's G-6 planes...and of course the extra cargo holds in the private helicopter squadron of that "other" Ben, elsewhere now known lovingly with the adjective of Blackhawk (f/k/a Helicopter).

The key macro meme over the past 3 months, starting with Goldman's "thematic" validation for the surge in the market (which was purely QE2 driven) leading to the firm's 180 degree shift in outlook from pessimistic to optimistic, had to do with the passage of various recent fiscal US-centered stimulus programs, which were explained by the punditry as a means for America to avoid the fate of the global capital markets (most of which are now if not declining (Shanghai), then in slow down mode (Europe)) through "reverse decoupling" whereby the US takes the global economic growth baton from China. While we can only laugh at the assumption that the US can compensate for a Chinese clampdown on liquidity, that is not the issue. A far greater question is just how can US stocks ride to previous records without the rest of the world's participation. Nicholas Colas explains the quandary: by isolating the Dow Jones Industrial Average, and specifically the 13 stocks that account for two thirds of the index, the BNY strategist looks at what are the gating items preventing the DJIA to hit 13,000...and 14,000 in the next year. And while Colas comes to the conclusion that valuation in itself is not a great stretch (13K is a 13.2x multiple of projected 2012 earnings estimates, while 14K is 14.2x), not major outliers to historical forward earnings multiples, what is unique about the current situation is that the "average company on the Dow heavy hitter list has only 43% of its revenues originating in North America." Colas concludes: "A better U.S. economy, without uptake from other parts of the world, is not enough to give stocks the earnings power they need to reach Dow 13,000 or 14,000." Without the benefit of a suddenly fiscally austere Europe, and a suddenly monetarily shy China (and Japan which is more focused on rescuing the EUR than its own market), more than half of the projected growth in the DJIA earnings will be based on nothing but hopium.

The growth of state power demonstrates beyond all doubt the trend away from representation and toward centralization. At the time of its founding, the combined civil and military employment of the United States’ then-federal government was perhaps 2,500 peoplevii, or roughly one federal worker for every 1,600 citizens, while its now-central government employs some 14.6 million people, or more than one central worker for every 21 of the nation’s present population. Amounting to a growth rate of nearly 7,600%, it is little wonder, then, that Americans’ tax burden has grown even more. For while the average U.S. citizen paid a paltry $20 a year in federal taxes at the time of the nation’s founding, today the average citizen pays over $10,000 a year in inflation-adjusted terms, amounting to a growth rate of fully 50,000%.

Pervasive bullishness combined with current market fundamentals, the need for QE2 to continue (amid hints of QE3 and beyond), and the mass outbreak of riots over runaway inflation, leaves us rather reluctant to start waving our market rally pompoms.

The Cravens' Brothers summary:

Slow Growth Period: Debt payments consume disproportionate amount of consumer income.

Accordion-­Shaped Markets”: Markets that go up and down in dramatic fits and starts. Currently, markets are in a positive trend due to government stimulus.  However, we still believe that stocks are in a long-­term secular bear trend.

Risk of Global Debt Reset: There is a distinct possibility that countries and banks will have to take “haircuts” on their foreign debt holdings, leading to bank failures and a second financial crisis."

A look at the week ahead, which is expected to be more of the same. Per Goldman: "The Econfin meeting on Monday will keep the focus on the Eurozone periphery and the governments' ability to enhance the framework already in place. Inflation data out of Malaysia, UK, New Zealand and of course China will keep the issue of inflationary pressures on the agenda. Of these prints, the most critical is China’s CPI and the question of China tightening. We do expect inflation to have softened in December to 4.2%, but rising food prices through January so far suggest this softness will be short lived. We expect the Central Banks of Poland and Brazil to hike rates by 25 and 50bps respectively in response to inflationary pressures. Rates are likely to be kept on hold in Canada, Mexico and South Africa. The Turkish central bank is expected to cut rates by 25bps. The November TIC data will be dissected to determine foreign appetite for US assets."

A few days ago Robert Lenzner of Forbes had a column discussing what he termed "phantom income" created by $1.4 trillion of delinquent mortgages, based on an analysis from TrimTabs' Madeline Schnapp. As usual, we decided to bypass the messenger and go straight to the source. Below is Madeline's clarification on the issue. As we expected, it is not so much an issue of bank mortgage fraud and cash flow deficiency (which by now everyone knows is pervasive, and everyone knows is being backstopped each and every quarter by the GSEs to the tune of tens of billions of dollars every three months like clockwork). Incidentally, a topic we are surprised nobody in the media has picked up on, is that indeed banker bonuses appear to be running well below last year's levels for many institutions. The reason: while accounting gimmickry allows banks to pad their bottom line, it does little to actually stimulate the cash flow statement. And since investment bankers prefer to be paid with cash and not out of accounts payable, the truth is that banks are actually hurting when it comes to actual cash retention: a big red flag to cut through all the FASB accounting fraud. But back to Schnapp's point: a far more important observation, and one which we have been claiming since 2009 is the primary reason for the consumer "renaissance", is that the "phantom stimulus" which allows consumers not to pay their mortgages (with the banks' and the GSEs' blessing) is equivalents to about $84 billion annually, or 0.5% of GDP. Add to that the $120 billion in payroll tax cuts and $60 billion in "Make Work Pay" tax credit, and one can easily see how that government's fiscal largess immediately accounts for more than half of the projected 2011 GDP growth, the other half being more than accounted for through (now years of) inventory restocking.

It was just under a year ago that we first learned that Greece had been cleverly scheming to fool the EU, EuroStat, and investors, foreign and domestic, about the true nature of its fiscal deficit courtesy of various currency swaps constructed by none other than Goldman Sachs: a process which would end up being the first time the "Greeks" were butchered by Goldman. The whole purpose of Goldman's innovative "revenue scheme" was to allow the Greek government to skirt the 3% fiscal deficit limit imposed by the EU on peripheral countries, in essence making Greece appear far stronger for years than it really was. It is this deceit that laid the seeds for the current Eurozone insolvency which requires a virtually daily bailout. Amusingly, yesterday we also learned that it was the US Federal Reserve which knew about this willfully fraudulent misrepresentation as long ago as March 2005, as disclosed in the most recent Fed minutes: "CHAIRMAN GREENSPAN. Can we borrow from the Greeks? [Laughter] MR. KOS. It’s interesting, since they are at about double the 3 percent limit. So the markets are not punishing anybody for not complying." Of course, nobody is laughing now that the markets are certainly punishing those for not complying with a vengeance. Had the Fed brought attention to this, the outcome for the now doomed Eurozone and the EUR would have been different. Now it's too late. And in this vein, on Friday it was once again Goldman which put the last nail in the coffin of the "Greeks" only this time not so much the insolvent nation, as the much-suffering letters α and β. The reason for this is that also on Friday, the WSJ ran a great article which basically blasted hedge fund groupthink, confirming that the only so-called strategies that work now are those that copycat the whale asset managers (courtesy of much delayed 13F/G filings). David Kostin, fearing that his groupthink-promoting authority is being challenged (not to mention his recent promotion to partner at Goldman), immediately came to the rescue of the hedge fund hotel habituals, in essence saying that beta is really alpha, and only fools don't do what the big boys are doing. In traditional Goldman fashion, ruin follows about 5 years later to all who follow the firm's advice (long after the commissions have been converted to gold stores in various non-extradition countries). This time we are confident the event horizon will be far shorter.

HO HO HO! Santa Claus rally did happen (again!!!). Perhaps, this seasonal phenomenon is really worth playing. Following the previous analysis in November, technically the markets were carving out bullish structure across the board with the fundamental backdrop of QE2 – therefore a few conditional (bullish/reversal candles at key levels) calls were made, which went down successfully. However, at this juncture probability increases for sizeable pullbacks and corrections in risk assets.

Counter trade the flood?

Nothing moves a subject forward like exploring open problems. Think of this as a first (actually second) entry in a collection of puzzles, hopefully added by more than just myself. In the tradition of the Scottish Book, each entry will include an attribution/dedication, a problem statement, data that provide some motivation, and associated hypotheses, and conjectures.