Archive - Aug 2012

We are often asked for glossaries or background posts to help in the comprehension of how-we-got-here?, where-here-is?, and where-we-are-going? We hope that our posts, while diverse in nature, build upon one another and provide an educational platform for all levels of market/economy participant (active traders, passive investors, and working / non-working citizens alike) but as far as a succinct primer on how broken the status quo is and the 'euphoric' economy that very few could see through their Keynesian "debt doesn't matter" blinders, Steve Keen's introductory lecture at UWS is perhaps the most complete soup-to-nuts discussion we have seen recently. From the OECD's total ignorance to Bernanke's 'Great Moderation' miss; from economic 'religion' to science; and from Keynes to Minksy, Keen explains, in language even Chuck Schumer could understand, how more debt doesn't solve too much debt, how stability breeds instability, and why the US won't be finished deleveraging until 2025 (at this rate).

Miseseans choose to reach their conclusions not from data, but instead from praxeology; pure deduction and logic. This is quite unlike the early Austrians like Menger who mainly used a mixture of deductionism and data. Like all sciences, economics should be driven by data. For if we are not driven by data than we are just daydreaming. As Menger — the Father of Austrianism, who favoured a mixture of deductive and empirical methods — noted:

The merits of a theory always depends on the extent to which it succeeds in determining the true factors (those that correspond to real life) constituting the economic phenomena and the laws according to which the complex phenomena of political economy result from the simple elements.

Praxeology is leading Austrian economics down a dead end. Austrianism would do well to return to its root — Menger, not Mises.

November 16, 2011 was a historic date: that's when the US officially surpassed $15 trillion in debt for the first time since World War 2. We celebrated it by cheering $15,OOO,OOO,OOO,OOOBAMA. Today, August 28, 2012, is when we can unofficially celebrate again, because 286 days after the last major milestone was surpassed with disturbing ease, total US debt following today's $35 billion auction of 2 Year bonds is, well, in a word: $16,OOO,OOO,OOO,OOOBAMA! 

Will Steve Keen be proven 'early' and correct? We suspect so; and the following infographic from DebtConsolidation.com.au provides some more compelling evidence of the growth of the Aussie housing bubble and its geographical diversity (and should you consider a trade on the back of this - Australian bank CDS are trading near 12-month tights).

Over the weekend, we pointed out that the old mechanism for the People’s Bank of China to expand its balance sheet and create base money has been broken by new funds flow pattern, and it will sooner or later require some sort of large scale asset purchases programme a.k.a. quantitative easing to offset the impact of the broken mechanism (after other tools such as cutting RRR reach their limits). However, we also mentioned that as the private sector is currently quite overstretched and will start the deleveraging process (if they have not already started), and that would render traditional monetary tools useless, and quantitative easing ineffective. And that would necessitate deficit spending at both local and central government levels. If we have read the social mood correctly that China might be more pro-austerity than pro-Keynesian, and if policymakers indeed share that view, then the consequence in the near term could be rather grim. The delay in stimulus as well as the small size of it so far has already done damage, if you like. The economy is already on course to a hard landing.

Going nowhere fast was the theme today as equities managed to end practically unchanged (SPX/Dow down, NDX up) but intraday saw some very gappy behavior (though admittedly in a very small range). VIX is the story of the day in our view - realized volatility has dropped to near-record lows (which had, until a week ago, been a big driver of front-end implied vol compression) and yet VIX pushed higher (with implied vol now at almost a three-month high premium to realized). The point being - protection is bid, and a VIX of 16.5% is much more concerning given its premium than some would believe. Volume was above its very recent and dismal average but still around 15-20 percentage points below normal summer doldrums levels. Risk assets in general trod water today with modest outperformance by Treasuries (yields lower 1-2bps) and negligible moves in FX carry trades - even as the USD is down 0.35% since Friday (mirroring Silver's 0.35% gain). With Consumer confidence dismal, somewhat strangely both Consumer Staples and Discretionary outperformed on the day. Very low average trade size, a low high-low range, and a general inability to pull away from VWAP (+/-3pts only) suggested everyone is on hold (or buying protection as we noted above); but the small flush into the close was not very encouraging.

The causal relationship between scarcity, demand, and price is intuitive.  Whatever is scarce and in demand will rise in price; whatever is abundant and in low demand will decline in price to its cost basis. The corollary is somewhat less intuitive, but still solidly sensible: the cure for high prices is high prices, meaning that as the price of a commodity or service reaches a threshold of affordability/pain, suppliers and consumers will seek out alternatives or modify their behaviors to lower consumption. Much of the supposedly inelastic demand for goods is based on the presumptive value of ownership. For many workers, there simply won’t be enough income to indulge in the ownership model.  The cost in cash and opportunity are too high. This leads to a profound conclusion:  What will be scarce is income, not commodities.

China’s credit risk is rising, probably much more rapidly than the official non-performing loan (NPL) statistics indicate. SocGen is concerned as they think we are only seeing the beginning of the end of this NPL cycle. While they do not anticipate an outright banking crisis, as the government will certainly keep intervening at each turn on the way to avoid such an outcome, this is no reason to feel relieved. The reason being a major structural element in China's NPL cycle as many industries have massive excess capacity - after years of aggressive expansion that ran way ahead of demand growth - which eventually has to be eliminated. This process will take some time, during which faster depreciation in the form of deleveraging and consolidation will be unavoidable; and while expectations of an imminent hard landing may be overdone, the landing will nevertheless be multi-year and bumpy in their view.

When Ben Bernanke launched QE 2 in 2010 he outlined a third mandate for the Federal Reserve - the boosting of consumer confidence. He stated that the goal of QE 2 was to boost asset prices in order to spur consumer confidence through the "wealth effect" which should translate into economic growth. In 2010 he was right, and QE 2 not only boosted asset prices sharply, but kept the economy from slipping into a recessionary spat. As Friday's speech from the economic summit in "Jackson Hole" draws near - Bernanke should be taking a clue from today's release of consumer confidence in considering his next move. 

Regimes are shifting. Can you feel it? While at the surface, indices tumble along in small ranges and AAPL does its thing, asset-class movements and sector-rotations suggest something is afoot. Since the peak in the S&P 500 last week, we have seen a clear rotation from cyclicals to non-cyclicals, a major rotation from stocks into bonds, and a significant regime change in the relationship between Gold, the USD, and Treasury prices. One thing is clear - the heads-I-win, tails-you-lose high-beta strategy (on the ECB/Fed 'has your back' thesis) appears to be weakening a little (though in 100 milliseconds from now - who knows?)

A week ago everyone was convinced that in three days, Bernanke would reveal the second coming or whatever the equivalent biblical event is these days that would send the Dow to 36,000 in a heartbeat. We laughed at such naive suggestions. Then over the past five days the market has seen a profound transformation with what was initially a seed of doubt that the Chairman may in fact disappoint his stock buying disciples, having sprouted into a full blown weed of outright denial, fear and loathing. Which makes sense: in a world in which everything is jawboning, everyone's hope is always on the event just over the event horizon, but never on the one that is imminent: that way when the inevitable disappointment happens one can just say it was all premeditated and is coming "next time." However, in case the market has finally had enough of being led by the nose, lied to, and does throw a temper tantrum, there are way to take advantage of this. One bank that suggests just a way to do this without trading in that insane asset class known as stocks, where up is down, down is purple, and the triangle-square-square-circle killer combo sequence now works in reverse, is Credit Suisse, which suggests to put on a short bond position in anticipation of a major selloff which should inevitably accompany a disappointment from the Fed. Their suggestion: put on a $50K DV01 short at 1.64% and expect a steep selloff when the Fed disappoints, with a 1.75% target. If all works out according to plan, everyone involved should be $500,000 richer at market close on Friday with Bollingers all around.

Complicity reigns supreme as everyone benefiting from a scam keeps quiet about everyone else's skim lest their own share of the spoils fall under the harsh light of inquiry. Can an economy that has become dependent on lies, misrepresentation, "fudging" of numbers, fraud, embezzlement and a multitude of skimming and scamming operations escape the moral and financial black hole it has created? The self-evident answer is "no."

Droughts tend to produce vast yield variations. This week's ProFramer crop tour reaffirmed this tendency and as UBS notes, conditions declined with the expectations of low yields compounded by the harsher reality of poor quality - likely to be a major issue for corn feeders. Interestingly, Soybeans looked good from the road but up close (pod formation and beans/pod) were well below normal; and UBS adds to forget the CME for the moment - the cash market is now the attention grabber as they expect it to lead this rally in Ags higher - especially the July 2013s, raising an interesting question of if (or when) the US will restrict exports? Especially with no let-up in the drought conditions.

Moments ago the US Treasury auctioned off the latest monthly batch of 2 Year bonds, this time $35 billion, or toward the higher end of the issuance range, which was a bit of a dud. Pricing at 0.273%, this was a brisk move from July's record low 0.22%, a weakness which was substantiated by the expected pricing of 0.266% even though the When Issued traded at 0.275% coming into the auction, so technically there was no tail. That said, a very modest 9.01% was allotted at the high yield, implying the bulk of the action in the Dutch Auction was below the closing yield. Beneath the headline, the internals were not pretty either, with just 22.3% of the total bond taken down by Indirect bidders, well below the 32.78% TTM average, demanding an increase in both the Direct and Primary take downs, the former taking down 16.08% while the Dealers having to push 54.66% of the entire auction promptly into the tri-party repo market in exchange for cash to be used for much wiser purposes, such as buying Las Vegas REO real estate and converting it into rentals. Was the weakness of the auction a harbinger of disappointment from Jackson Hole - stay tuned for an opinion from Credit Suisse which says precisely this. And while the auction itself may have been unspectacular, there is a very historic aspect to this particular $35 billion bond issue, which we will reveal after market close.