Output Gap

Goldman's Francesco Garzarelli throws some numbers at its Bond Sudoku model, spins around its Wavefront Growth equity basket, and the magic firm's 8-ball spits out the following: "we presently show a 3.25% level in US 10-yr rates at the end of Q1:11. In light of the strength of the data, this now looks too low, and we would now lift the forecast to 3.5%. Our end-2011 and end-2012 projections are 3.8% and 4.3%, respectively, and we stick to these." In other words, if the market moves, we will adjust our "forecasts" accordingly. If China hike 3 more times as is expected and the 10 Year falls off a cliff, well then, we will no longer "stick to those."

Following China's Christmas day hike, Roubini Global Economics has put together a brief (and not so brief for clients) summary on the firm's views of what the Chinese post-liquidity stimulus hangover will look like. Here is how Nouriel's firm summarizes its near-term views on China: "Three interest rate increases after the hike on December 25 will leave real deposit rates negative for most of 2011, which will require additional macroprudential measures to prevent a further increase in property prices. A modest slowdown in growth, as we forecast in our recently published 2011 Outlook, is a likely side effect. Some of the interest rate hikes in 2011 probably will be asymmetrical to increase the role of price signals in credit decisions. This will be a gradual process, however, since moving too fast to remove the subsidized net-interest margin of the state-owned banking sector would put it at risk of insolvency." In the meantime, as China does everything to prevent an unpegging of the CNY from the USD which means an increasing tightening across all other verticals (especially with higher rates attracting excess global capital), virtually anything the US does to reliquify stocks will have a diminishing effect on risk asset values, and much more of a price shock on commodity input costs, as the specs move away from China and attack the US, that last bastion of infinite liquidity, full bore. Which is why we believe that WTI of $100+ is just a matter of weeks.

Here's a hint: it's all great. Just like the 10 Year hitting 0% was great for stocks, Jim explains why its round trip bacl to 5% is even gooder. In fact, it may be one of the goodest things to ever happen to the gnome underpants business that Goldman suddenly believes the US economy is: "I would guess that GDP growth could be above 3 pct, and it would not surprise me if some start forecasting close to 4 pct soon...checking my simple stats with Jan Hatzius this weekend, the US stock market would “only” need to rise by around 19 pct in order for the 168 bps rise in government bond yields to be entirely neutralized...Are 5 pct US 10-year yields and an S+P of 1475 possible in 2011? We shall see. In my opinion, a 19 pct rise in the US stock market seems quite likely. As for 5 pct bond yields, I think they are much less likely, but not impossible. If they did occur, it certainly wouldn’t have to be for negative reasons." That's all fine and great even if it is totally and utterly insane. The real win here, and it may be hidden at first, is that we now have not a phrase, but an entire essay to challenge that all time dumbest thing ever uttered: "If it weren't for my horse, I wouldn't have spent that year in college"...

The administration's support for Bernanke's "weak dollar" policy is evident in the way that Obama keeps reiterating his promise to double exports in 5 years. This simply can't be done without ripping the dollar to shreds, which appears to be Obama's intention.

Substantially more sanguine than their two key strategists Albert Edwards and Dylan Grice, SocGen's Cross Asset research has come out with a report looking at the future of the world, and the various scenarios that may end up taking us there (although the actual reality will of course be something unforeseeable). So while we play predictive games, here is how SocGen believes the upside/neutral/downside cases could look like across asset classes, and across the globe.

This isn’t about jobs at all. It’s about power. It’s about who is going to dictate policy to the rest of the world. Bernanke wants emerging markets to bear the costs of a financial crisis that originated on Wall Street and was nurtured every step of the way by the easy money policies of the Federal Reserve.

Yesterday we highlighted that Goldman had closed out its long China trade in anticipation of reactionary measures to what the Beijing politburo decided to telegraph as high inflation (after all there is no such thing as Chinese "economic data": it is whatever the central committee agrees on). The news sparked a fresh wave of selling in the SHCOMP resulting in the biggest two-day selloff for the index in months. Today, Goldman pours more fuel on the fire, by raising its 2011 Chinese CPI expectations from 1.3% to 4.3%, which guarantees that the State Counsil will have to hike rates as it is obvious that the CNYUSD currency peg will not be removed as long as it is being used as a political scapegoat by Washington. Furthermore, ongoing insanity by the Fed guarantees that surging commodity prices will generate even more inflation in China, which in turn will eventually lead to higher prices in the US, leading to greater margin contractions, leading to more layoffs, leading to the need for what the Chairman will see as even more QE, thereby compounding the most virtuous cycle in the global economy that nobody talks about, as more and more money sloshes around the global system, and finds packets of least resistance. However that is a topic for Q1 2011.

Update summary added.

Just a headline on Reuters, citing Medley Global Advisors:

• FED WOULD CURTAIL ASSET BUYING IF COMPELLING EVIDENCE OUTPUT GAP CLOSING QUICKER THAN EXPECTED

Is the Warsh-Hoenig-Plosser-Fisher-Kocherlakota mutiny about to go nuclear? We will bring you the report if we see it.

As usual, those who want the truth behind the cheery, and misleading, headlines don't have many options. David Rosenberg continues to be one of the best options. Here is his take on today's NFP, recent market action, impact of D.C. gridlock (bad for fiscal policy, no impact, we believe on monetary - all hail emperor Ben), and why $5 trillion in total QE means Goldman's estimate for $1,650 gold may need to soon add an extra zero to it.

In a word - skeptical: "There is a growing hope that the Tea Party has tapped a raw nerve and will serve as a lightning rod for change. And change is needed in a really big way when one considers the financial strains that mandatory entitlements, such as Social Security, will pose as the demographics, in terms of an ever-higher dependency ratio, ascends further. These mounting “locked in” fiscal costs have to be addressed as do the $3.5 trillion of actuarially unfunded state/local government pension plans. Social contracts will have to be re-written — perhaps with implications for contracts with bondholders. But hope is never a good strategy. Results are what matter. It took two full years for the Reagan rally to really take hold. An economy growing at a 7% clip in the aftermath of the 1980-82 malaise and an unemployment rate that came crashing down more 300 basis points from the highs certainly helped. So, while there is hope that the stage is being set for meaningful political change in 2012 (where the Republicans stand a very good chance of reclaiming BOTH the House and the Senate) the near-term outlook is muddled. Investors should not lose sight of the fact that the recovery is so listless that we are only one negative shock away from tilting the economy back into contraction mode." David Rosenberg

In September 2008 the US came to a fork in the road. The Public Policy decision to not seize the banks, to not place them in bankruptcy court with the government acting as the Debtor-in-Possession (DIP), to not split them up by selling off the assets to successful and solvent entities, set the world on the path to global currency wars. By lowering interest rates and effectively guaranteeing a weak dollar through undisciplined fiscal policy, the US ignited an almost riskless global US$ Carry Trade and triggered an uncontrolled Currency War with the mercantilist, export driven Asian economies. We are now debasing the US dollar with reckless spending and money printing with the policies of Quantitative Easing (QE) and the expectations of QE II. Both are nothing more than effectively defaulting on our obligations to sound money policy and a “strong US$”. Meanwhile with a straight face we deny that this is our intention. It’s called debase, default and deny.

With just over a week left to the QE2 announcement, discussion over the amount, implications and effectiveness of QE2 are almost as prevalent (and moot) as those over the imminent collapse of the MBS system. Although whereas the latter is exclusively the provenance of legal interpretation of various contractual terms, and as such most who opine either way will soon be proven wrong to quite wrong, as in America contracts no longer are enforced (did nobody learn anything from the GM/Chrysler fiasco for pete's sake), when it comes to printing money the ultimate outcome will certainly have an impact. And the more the printing, the better. One of the amusing debates on the topic has been how much debt will the Fed print. Those who continue to refuse to acknowledge that the economy is in a near-comatose state, of course, hold on to the hope that the amount will be negligible: something like $500 billion (there was a time when half a trillion was a lot of money). A month ago we stated that the full amount will be much larger, and that the Fed will be a marginal buyer of up to $3 trillion. Turns out, even we were optimistic. A brand new analysis by Jan Hatzius, which performs a top down look at how much monetary stimulus is needed to fill the estimated 300 bps hole between the -7% Taylor Implied Funds Rate (of which, Hatzius believes, various other Federal interventions have already filled roughly 400 bps of differential) and the existing 0.2% FF rate. Using some back of the envelope math, the Goldman strategist concludes that every $1 trillion in new LSAP (large scale asset purchases) is the equivalent of a 75 bps rate cut (much less than comparable estimates by Dudley, 100-150bps, and Rudebusch, 130bps). In other words: the Fed will need to print $4 trillion in new money to close the Taylor gap. And here we were thinking the economy is in shambles. Incidentally, $4 trillion in crisp new dollar bills (stored in bank excess reserve vaults) will create just a tad of buying interest in commodities such as gold and oil...

We highlighted the following report from St. Louis Fed's Daniel Thornton in today's Frontrunning, but it may bear repeating as it is the first written salvo in the internal Fed trench warfare over QE2. The report is no surprise: as St Louis is the bastion of Daniel Bullard, one of the biggest non-voting hawks at the Fed, a group which is increasingly getting more vocal with such others as Philly's Plosser and Dallas' Fisher, not to mention Atlanta's Hoenig, the paper titled "Would QE2 Have a Significant Effect on Economic Growth, Employment, or Inflation?" is merely an attempt by the sensible undercurrent at the Fed to distance itself from the policies enacted by the supreme madman in charge of it all. While the report says nothing notably new, it does repeat what all QE2 skeptics know all too well: "It is possible – perhaps even likely – that almost all of any increase in the supply of credit associated with QE2 simply would be held by banks as excess reserves. If so, the effect of QE2 on interest rates could be small and limited to an announcement effect – the effect associated with the FOMC’s announcement – independent of the effect of the FOMC’s actions on the credit supply." Which begs the question - why is this report coming out now? Is this the red herring to the lack of a QE2 announcement on November 3? With everyone certain monetization is imminent and inevitable, is everyone about to end up on the wrong side of the trade? And if so, just how far will the market crash, now that at least 150 S&P points worth of QE2 are priced in...

Jan Hatzius pretty much slams the door on any possibility for a liquidity moderation (let alone exit): "We found that under our own economic forecasts it might take until 2015 or longer before a rate hike became appropriate." In other words, the US economy will very likely just go down in flames, as the Fed makes sure that each and every American is infinitely "rich" courtesy of zero cost debt denominated in worthless dollars. The only salvation from this outcome is for the rest of the world to stage a Fed intervention before it all burns down.

From the Fed's Evans: "If we were to do more large scale asset purchases, namely Treasurys, that would have a beneficial effect. There would be some reduction in long-term yields. That would be of some help. But given the nature of the outlook, much more accommodation than that is probably what’s called for. We have to think a little more carefully about the potential tools that we have available to us."

$10 gallon gas is one step ever so closer. The administration is committing suicide by pursuing a hyperinflationary path. Never too late to the party, spot gold just passed $1,340 for the first time ever.