Archive - Jul 2, 2012 - Story

There is a saying that it is better to remain silent and be thought a fool than to speak out and remove all doubt. Today, the San Fran Fed's John Williams, and by proxy the Federal Reserve in general, spoke out, and once again removed all doubt that they have no idea how modern money and inflation interact. In a speech titled, appropriately enough, "Monetary Policy, Money, and Inflation", essentially made the case that this time is different and that no matter how much printing the Fed engages in, there will be no inflation. To wit: "In a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid. Over the past four years, the Federal Reserve has more than tripled the monetary base, a key determinant of money supply. Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman.Despite these dire predictions, inflation in the United States has been the dog that didn’t bark." He then proceeds to add some pretty (if completely irrelevant) charts of the money multipliers which as we all know have plummeted and concludes by saying "Recent developments make a compelling case that traditional textbook views of the connections between monetary policy, money, and inflation are outdated and need to be revised." And actually, he is correct: the way most people approach monetary policy is 100% wrong. The problem is that the Fed is the biggest culprit, and while others merely conceive of gibberish in the form of three letter economic theories, which usually has the words Modern, or Revised (and why note Super or Turbo), to make them sound more credible, they ultimately harm nobody. The Fed's power to impair, however, is endless, and as such it bears analyzing just how and why the Fed is absolutely wrong.

The long-term importance of the dependency ratio (which at its most base represents the ratio of economically inactive compared to economically active individuals) is at the heart of many of our fiscal problems (and policy decisions). Not only have they and will they become a larger and larger burden on the tax-paying public but as a voting block will be more and more likely to vote the more socialist wealth-transfer-friendly way in any election (just as we see extreme examples in Europe). The following chart provides some significant food for thought along these lines as by 2016, for the first time ever, developed world economies will have a higher dependency ratio than emerging economies and it rises dramatically. How this will affect budget deficits (food stamps) and/or civil unrest is anyone's guess but for sure, it seems given all the bluster, that we are far from prepared for this shift.

Ah Moldova… the poorest country in Europe, which just so happens to have had a Communist party majority in its parliament since 1998. These two points are not unrelated. Despite having achieved its independence from the Soviet Union over 20 years ago, the state is still a major part of the Moldovan economy…from setting prices and wages to media, healthcare, agricultural production, air transport, and electricity. Under such management, it’s no wonder, for example, that Moldova has to import 75% of its electricity. It is the exact opposite of self-sustaining. The government does a reasonable job of chasing away foreigners as well. Agriculture is the mainstay of Moldova’s economy… and while on one hand they say “we welcome foreign investment in agriculture,” on the other they say “foreign investors cannot own agricultural property.” It’s genius.

The colossal size (and growth) of the US government's budget deficit is a problem that seems to remain on the sidelines all the time the Fed is buying and maintaining interest rates at an acceptable level. As we noted last night, nothing points to investor concern (yet) aside from an increasing diversification from the USD as a trade currency. Many have suggested raising taxes on the rich to cover the difference between what the government collected in revenue and what it spent. Professor Antony Davies takes on this thorny issue and demonstrates that taxing-the-rich will not be sufficient tyo make the budget deficit disappear as he notes: "the budget deficit is so large that there simply aren't enough rich people to tax to raise enough to balance the budget"; instead we should work on legitimate solutions like cutting spending.

The broad theme of buying stocks because they are cheap - as evidenced by the dividend yield's premium to US Treasury yields - seems to fall apart a little once one look at a long-run history of the behavior of these two apples-to-unicorns yield indications. Forget the risky vs risk-free comparisons, forget the huge mismatch in mark-to-market volatility, and forget the huge differences in max draw-downs that we have discussed in the past; prior to WWII, the average S&P 500 dividend yield was 136bps over the 10Y Treasury yield and while today's 'equity valuation' is its 'cheapest' since the 1950s relative to Bernanke's ZIRP-driven bond market; the 'old' normal suggests that this time is no different at all and merely a reversion to more conservative times - leaving stocks far from cheap.

In line with our views on Europe's endgame, Marc Faber opined on Bloomberg TV this morning that if he "was running Germany, [he] would have abandoned the eurozone last week". We suspect that given the lack of real steps forward and no additional exposure (as yet) for Germany that they can hang on a little longer before they reach the final phase of the game-theoretically optimal exit (that Credit Suisse and us share) of a mercantilist GERxit occurring sooner than many think (benefiting from deposit inflows and low-EUR-based high profitability from exports for as long as possible and not a moment longer). The "cosmetic fix" of this latest summit, as Faber calls it, simply does not solve the fundamental problem of over-investment in the euro-zone. He is bottom-fishing in some European equities (though avoiding banks) and is not long the Euro here as he sees the modest rally in risk assets in Europe as merely a reflection of illiquidity and a grossly oversold market reverting on 'not a total disaster' though he reminds us early on that "pooling 100 sick banks does not make them healthy."

There is a perverse macro-level outcome from over-zealous central-planning. We have talked in the past about the greater risk of huge tail events in a controlled/normalized/planned/smoothed world, but as SocGen's Dylan Grice in an analogy to driving: "traffic lights and road signs are well intentioned, but by subtly encouraging us to lower our guard they subtly alter the fundamental algorithm dictating micro-level driving behavior." In other words, we drop our guard. With the plethora of financial market traffic light and road signs (Basel III, Solvency II, Bernanke Put) the fear is that this illusion of capital or safety has made markets more lethal (think AAA-rated bonds for a simple example). "We should be able to understand that the world isn’t risk free, can never be made risk free and that regulations which trick people into thinking it is risk free serve only to make it more dangerous." But instead, following the rule-of-Iksil (baffling with bullshit), regulators have gone the traditional route - but this time to an exponential place of craziness with Dodd-Frank - layering complexity upon complexity to give an out to those who abuse it most. Perhaps, as Grice notes, instead of focusing on 'fixing' the "crisis of capitalism", it would be more pragmatic to focus on the "crisis of dumb counterproductive intervention"?

The chart below, via Stone McCarthy, shows the months with Fed intervention since December 2008. That in the past 42 or so months, less than one third have been intervention-free, should close any open questions about whether the stock "market" is anything but a policy vehicle used by the Fed to perpetuate a broke(n) status quo now entirely dependent on every market up (and down) tick. We dread to think what would happen to those record low US bond yields if the market were to be left on its own without the backstop of guaranteed Fed intervention in the interest rate market... ironically something which Barclays is in boiling hot water for right about now.

Judging by the market's response to the latest European bailout, the one associated with Germany supposedly 'folding' on austerity and being beaten down by her broke neighbors, and which according to the chart below had a half-life of one full day; the market has already priced in all the news and is now praying for more monetary morphine from the ECB and BOE this week. It will almost certainly get those. Then what: a half life of 12 hours? 6 hours? Or zero (and will Torres come on with 45 minutes to the close to save the day?)

With the end of Operation Twist and a dismal multi-year low print in ISM, it seems Treasuries are a little less sanguine at the hope for a week-/month-/quarter-start bid for risk than equities. 10Y rates are back near Friday's lows while S&P 500 e-mini futures are 40-45 points higher. Does Operation Twist+ have that much impact? Is 'bad' good once again for QE hopes?

Replacing old impaired debt with new impaired debt does not generate growth. Borrowing more money will not reverse financial death spirals. Sorry, Bucko--Europe is still in a financial death spiral. Friday's "fix" changed nothing except the names of entities holding impaired debt. We can lay out the death spiral dynamics thusly:

What goes down, must come up. In this case crude, which is soaring on news out of FARS that Iranian lawmakers have drafted a bill proposing a blockade of the Straits of Hormuz for oil tankers heading to sanctions supporters, i.e., embargo countries. Naturally, if implemented, this would mean an almost inevitable military retaliation on behalf of the "western world." Then again, this is not the first time Iran has postured with a blockade. If indeed willing to follow through, it surely mean Iran has at least implicit whisper support of Russian and Chinese support when the situation inevitably escalates.

And so we have recoupling, with the ISM printing below 50 (i.e. contraction) at 49.7 for the first time since July 2009. Expectations of a 52.5 print were obviously blown away, as the final number came well below the lowest Wall Street forecast of 50.5. Prices plunge to 37 on expectation of 57 and there go your corporate margins; Employment down from 56.9 to 56.6, and New Orders implode from 60.1 to 47.8. Epic disaster which proves that no, decoupling, does not exist and now puts the Fed back in play, which however, with the S&P just shy of 2012 highs, can do didley squat.

Some time ago we said that in a world in which virtually every risk and liquidity benchmark is manipulated by either private banks (thank your Liebor) or central banks, if one needs to know the true state of events in Europe, the only real remaining, unmanipulated benchmark remain Swiss nominal bond yields. And at -23.5 bps for the 2 Year it is telling us that nothing is fixed. As usual. Also judging by the SNB's new head Jordan statements which just hit the tape, in which he says that he would not rule out capital controls or negative rates if the crisis worsens, the SNB gets it. Or does it? Jordan also said that the SNB is ready to defend the FX market with unlimited market purchases if necessary. However, as the note below from JPM shows, the SNB may simply be faking it, hoping it too can get away with simple jawboning, instead of actually putting its money where its mouth is. As it turns out the SNB has indeed been intervening in huge size in the month of May to keep the EURCHF peg. The previously undisclosed news is that it has also been sterilizing its purchases. As JPM further notes: "This is highly significant and undermines the credibility of the SNB’s claim that it is willing to do whatever it takes to hold EUR/CHF 1.20. For the floor to be credible the SNB needs to surrender control over the Swiss monetary based, i.e. it has to be willing to deliver both unlimited and unsterilised FX intervention. The intervention in May was certainly unlimited; it most definitely was not unsterilised." How long until the FX vigilantes decide to test just how far the SNB is truly willing to go in defending the peg? And what happens when Swiss nominal yields hit record negative numbers once again?

The spread between HSBC's and China's version of Manufacturing PMI increased a little over the weekend when the headline of China's data point managed to cling perilously above the 50-line of expansion over contraction (while HSBC's drifts lower and lower under 50). The headline print - still its lowest since Nov 11 - however, hides a much less sanguine truth in the sub-indices with the new orders index fell once again staying in the contractionary territory under 50. What is more worrisome for China (and implicitly the rest of the world) is that while transport equipment and electrical machinery improved (explicitly thanks to government funded infrastructure projects) there has been no multiplier effect of a broad-based investment rebound. As Credit Suisse notes: "The stimuli launched in middle of May seems to have failed to jump-start the overall economy, yet the moderation in PMI is not severe enough to justify a much more aggressive rescue package."