Recession

Stephen Roach, chairman of Morgan Stanley Asia, has penned one of the most unapologetic letters bashing the central banking climate we have ever read from an institutional insider (he is still technically part of MS). And Roach should know: From 1972 until 1979, Roach served on the research staff of the Federal Reserve Board in Washington, D.C., where he supervised the preparation of the official Federal Reserve projections of the U.S. economy. As a result he is all too aware of the quality and caliber of Fed individuals. Which serves as the groundwork for this stunning speech presented on October 12 before the World Knowledge Forum in Seoul. The topics covered include the creation of, and asset bubble "resolution" authority , the collapse of America into a Japanese deflation death spiral, the general destructive worthlessness of the Fed, and other such pleasant issues. Most importantly, Roach speaks out in all too clear terms against another "hyper stimulus" round: "Whether it’s the latest round of quantitative easing now under way by major central banks or the polarizing tax cut debate in the US, there is a limited likelihood these measures will achieve meaningful traction in the real economy. The authorities would be much better off not wasting the next stimulus on policies that won’t work and better disposed toward taking actions that are  directed at providing support to the true victims of this recession— namely, the structurally unemployed and underemployed." Roach's dire warning: "I fear that unless regulatory reform is accompanied by a rethinking of monetary policy, another crisis is far more likely than not."

One of the more devious consequences of QE2, is that it carries the seeds of its own destruction with it. Namely, if after flooding bank basements with another $2 trillion in excess reserves, and if bank lending picks up, suddenly the amount of currency in circulation will explode by over 300% from under $1 trillion to around $4 trillion. And while a comparable increase in wages is certainly not guaranteed to occur concurrently, what this explosion in the free money will do is lead to a very rapid and drastic destabilization in the concept of a dollar-based reserve currency. The only thing that could prevent this are the Fed's mechanisms to extract liquidity from the system. Alas, the IOER process is very much unproven, and should animal spirits kindle at the peak of the biggest liquidity tsunami in history, that money will inevitably make its way to Main Street, not Liberty 33. All this has made Goldman's Ed McKelvey warn that should increased bank lending be the end result of QE2 (and ultimately that is precisely what it should be, as that would be indicative of a healthy economy), then, to put it so everyone will get it, "this would cause too much money to chase too few goods." And, as liquidity extraction then would likely be impossible, it would be the beginning of the end: "The obvious risk to this last point is if inflation expectations surge. In a stronger growth environment than now prevails, such a surge could prove difficult to control. It would require Fed officials to remove the liquidity quickly, which is why they will concentrate on purchases of Treasuries (easier to sell back into the market) and remind us continually of the tools they have developed to withdraw the liquidity (by periodically using them in small size)." Too bad the Fed will soon be forced to buy MBS (again), REITs, ETFs and pretty much everything else.

On the wires:

• Fed's Lockhart says leaning in favour of more monetary stimulus, decision not clear cut

Somehow this will lead to even more QE "pricing in", even though by now it is "priced in" about 150%. Of course, this is no surprise as Lockhart has long been in the opposing camp of an ever increasing group of hawkish Fed presidents such as Hoenig, Bullard, Kocherlakota and to some extent, Fisher. That only one of them is a voting member is irrelevant. After all at the end of the day, only one madman has the launch codes.

The next big focus in the foreign exchange markets will be a strengthening US economy and another slow down in Europe. After one last gasp, that could take the euro as high as $1.45, and a great shorting opportunity will set up that could take it as low as $1.10-$1.15 next year. The US elections will remove much uncertainty from the dollar just when American growth is reasserting itself, opening the way for another down leg in the European currency. (FXE)

In plain terms, corporate insiders, the folks who know their business and its prospects better than anyone are dumping shares as fast as humanly possible. They are literally putting their money where their mouths are when they say the US economy is AWFUL and business prospects are on par with those of February 2009 (before Bernanke even thought up that stupid “green shoots” nonsense).

Despite every commodity opening limit up virtually every day for the past two weeks on expectations of a free money tsunami about to be unleashed (and a 14th weekly increase in M2 which we will describe shortly), David Rosenberg still adheres to the belief that deflation is not only here to stay but get worse. And, frankly, we don't disagree. It has long been our contention that the sublimation from deflation to hyperinflation will not pass through the inflation phase at all (or it may, but will last for exactly one millisecond as $3 trillion, by then, excess reserves are released and send every price up by a few quadrillion percent). In the meantime, the input cost-price mechanism is still broken, which leads Rosie to believe that the fact that the 30 Year just closed at an increasing inflection point with the rest of the curve going tighter, is to be ignored. Alas, with corporate margins approaching zero (and if you are Amazon, probably already there) companies face one of three choices: become banks, and borrow at ZIRP, and lend money to their customers via private label credit cards (unlikely), shut down, or raise prices. The last one is what will happen, and will finally put an end to the ridiculous consumer disrectionary rally that has perplexed humans (but not robots) for quarters on end. Furthermore, as to Rosie claims: "For all the talk of how higher Chinese wages were going to be transmitted to higher prices of these imported items, it does not seem to be happening" we will shortly post some thoughts which confirm that this is precisely what is happening.

Here is Jan Hatzius' initial read on Bernanke speech. In a nutshell, Hatzius seems to believe that reading between the lines may mean Bernanke will not do QE2, and preserve some of the Fed's mystique, so that all those massive bond managers who get the Fed's data early appear to have a competitive advantage. Alas, they don't. And all those who believe the Fed at this point, now that fiscal stimulus is no longer an option and all out FX war has broken out, has any other option but to buy anything not nailed down, well, we would like to point them to the 9 upcoming POMO monetizations over the next 4 weeks. What is most troubling is that the market has now priced in not only that, excluding some intraday volatility especially on OpEx days, but the expansion of Fed proxy buying of AAPL to $25 billion a week. Hatzius better hope that his attempt to restore some credibility to the Phantom of the Fed is grounded in reality. Because in the off chance he is right, buying a boatload of far OTM broad market puts on November 2 may well end up being the most profitable trade of the year, if not decade.

More broken gospel from the Central Bank of faith and hope, as gold surges, despite what anti-gold bugs out there preach day in and out:

• Fed's Bernanke says sees case for further action with too low inflation
• Fed's Bernanke says Fed could buy assets, alter statement
• Fed's Bernanke says hard to determine pace, size of any purchases, must weigh costs, benefits in deciding how aggressive to be
• Fed's Bernanke says Fed has tools to ease when rates near zero, earlier bond-buying was successful in lowering long-term rates
• Fed's Bernanke says risk deflation is higher than desirable, unemployment clearly too high
• Fed's Bernanke says at current rates of inflation, short-term real interest rates are too high
• Fed's Bernanke says unemployment to decline slowly, prolonged high unemployment would pose risk to sustainability of recovery

In this day and age, nothing is sacred, unless of course you believe in fairy tales...

Interview with Vitaliy Katsenelson on the challenges facing China and Japan and the implications to the rest of the world.

After a tumultuous 2009, oil has been one of the least volatile assets of 2010. It now appears that this crucial commodity is stretching its muscles, limbering up, and getting ready for a serious move. The net effect of the BP oil spill will be a cut of one million barrels a day of Gulf production, about 5% of US consumption. A serious run on the dollar is adding fuel to the fire. (USO), (XOM), (CVX), (OXY), (RSX)

Oh shit, it is on again like white on rice, stink on shit, and Black on Scholes (and for you quants, just know that Brownian motion has more than one meaning), as a flurry of blue chip companies beat earnings guesses and pushed the market higher. With the 50 day moving average now rising above the 200 day moving average the S&P has hit the fabled Golden Cross (which is kind of like the Hindenburg Omen only less fiery, with fewer McClellan Oscillators, and the exact opposite), which means technicians are expecting to be showered with returns.

It is clear that companies just aren't ramping up hiring fast enough to reduce the unemployment rate, now 9.6 percent. So where will the U.S. find jobs? Contrary to President Obama's belief, an analysis of the Industry Life Cycle and Supply Chain will show that green tech and manufacturing are unlikely the answers to unemployment.

Ben Bernanke should be relieved of his post. I say this in response to Jon Hilsenrath's latest article in the Wall Street Journal on the Fed, "Fed Chief Gets Set to Apply Lessons of Japan's History." I would re-entitle the article, "Fed Chief Gets Set to Repeat Mistakes of Japan's History."

What is to stop U.S. banks and their customers from creating $1 trillion, $10 trillion or even $50 trillion on their computer keyboards to buy up all the bonds and stocks in the world, along with all the land and other assets for sale, in the hope of making capital gains and pocketing the arbitrage spreads by debt leveraging at less than 1% interest cost? This is the game that is being played today.