Budget Deficit

In the 1940s, the Fed adopted pegging operations to protect the financial system against rising interest rates and to ensure the smooth financing of the war effort. In effect, the Fed became part of the Treasury’s debt management team; as the budget deficit hit 25% of GDP in WW2, it capped 1Y notes at 87.5bps and 30Y bonds at 2.5%. From the massive bond holdings of its domestic banks to its exploding public debt, Japan today faces a situation very similar to the US in the 1940s. When the long-term rate climbs above 2%, the BoJ will probably adopt outright measures to underpin JGB prices to prevent turmoil in the financial system and a fiscal crisis - and just as Kyle Bass noted yesterday, they are going to need a bigger boat as direct financial repression in Japan is unavoidable.

What may come as a surprise to most, is that as of this week's H.4.1 update, the amount of ten-year equivalents held by the Fed increased to $1.583 trillion from $1.576 trillion in the prior week, which reduces the amount available to the private sector to $3.637 trillion from $3.668 trillion in the prior week. And also, thanks to maturities, and purchase by the Fed from the secondary market, there were $5.219 trillion ten-year equivalents outstanding, down from $5.244 trillion in the prior week. What this means simply is that as of this moment, the Fed has, in its possession, a record 30.32% of all outstanding ten year equivalents, or said in plain English: duration-adjusted government bonds. It also means that the amount of bonds left in the hands of the private sector has dropped to a record low 69.68% from 69.95% in the prior week. Finally, the above means that with every passing week, the Fed's creeping takeover of the US bond market absorbs just under 0.3% of all TSY bonds outstanding: a pace which means the Fed will own 45% of all in 2014, 60% in 2015, 75% in 2016 and 90% or so by the end of 2017 (and ifthe US budget deficit is indeed contracting, these targets will be hit far sooner). By the end of 2018 there would be no privately held US treasury paper.

Preview of tomorrow's Bernanke testimony and FOMC minutes.

My guess is that in 2-3 years most folks in the country are going to hate Obamacare, but it it will be impossible to get rid of by then.

On one hand we have bad Hilsenrath sending mixed messages saying the Fed may taper sooner (with good Hilsenrath chiming in days later, adding it may be later after all), depending on whether HY bonds hit 4% YTM by EOD or mid next week at the latest. On the other, even resolute Fed doves are whispering that a tapering may occur as soon the summer, so in a few months, and halt QE by year end. Bottom line - confusion. So who better to arbitrate than the firm that runs it all, Goldman Sachs, and its chief economist Jan Hatzius, who issues the following Q&A on "tapering." His view: "not yet." Then again, Goldman is the consummate (ab)user of dodecatuple reverse psychology, so if Goldman says "all clear" the natural response should be just as clear.

• Once a beacon, Obama under fire over civil liberties (Reuters)
• Eurozone in longest recession since birth of currency bloc (FT)
• EU Oil Manipulation Probe Shines Light on Platts Pricing Window (BBG)
• BMWs Cheaper Than Hyundais in Korea as Tariffs Crumble (BBG)
• Stock Boom Isn't a Bubble, Says BOJ's Kuroda (WSJ)
• Struggling France strives to shake off economic gloom (FT)
• JPMorgan investors take heat off Dimon (FT)
• Private-Equity Firms Build Instead of Buy (WSJ)
• Bloomberg Saga Highlights Clash Between Two Worlds (WSJ)
• Bank documents portray Cyprus as Russia's favorite haven (Reuters)
• HSBC Signals 14,000 Jobs Cuts in $3 Billion Savings Plan (BBG)
• Argentines Hold More Than $50 Billion in U.S. Currency (BBG)

Or how a forecasted surplus turned out to be a $1+ trillion deficit in three short years...

While every other hedge fund manager is bashing Bernanke, we finally found one who loves the Chairman, unabashedly. The last time the outspoken hedge fund manager appeared on CNBC it was to pump financials into his asset sale in Europe (and here). Today he could not have been more upbeat about the US economy, US banks, and US manufacturing as he is "overwhelmingly bullish," adding that "the numbers are truly amazing". Sure enough the 'Tepper rally' market responded with its ubiquitous lemming like surge as the Appaloosa manager (with $17.9bn AUM) says: The Economy is getting better; he is bullish On Japan; does not worry about Fed tapering - but does not like bonds (adding that the end of QE2 was bullish (though if you care about facts, it wasn't); his biggest holding is Citigroup; sees a great US manufacturing renaissance; and while the Middle East is a concern, expects only a 5% drop if there is war. If that's not enough for you to back up the truck, he believes the US budget deficit will shrink "massively' and housing will rise. The only thing he is not buying with both hands and feet - Apple. As he said - the numbers are truly amazing, though we suspect we are looking at different numbers.

While German finance minister Schaeuble 'blessed' the French two-year grace-period for 'missing the deficit targets', adding that "he trusts France.. and is aware of its duties and responsibilities," it is his fellow countryman that is making headlines. Though the pains to which the politicians are going to convince an increasingly gullible public that the Franco-German divide is strong, German central bank head Jens Weidmann has strongly criticized French efforts to reduce its budget deficit warning that French delays could damage the credibility of euro-zone rules. The real money man exclaimed, "you can't call that savings, as far as I am concerned," adding that France (as a 'core' member of Europe) must strive to set a positive example, and not "damage their credibility by taking advantage of the built-in flexibility." We have been vehement (here and here) that France is on the cusp of a very serious depression and this 'verbal' pressure from Weidmann will not go down well with France's Moscovici who begged, "we don't want excessive consolidation for our country, we don't want austerity beyond what is necessary," but the broad fear is that France is setting a bad example, "only a question of time before other highly-indebted countries demand concessions."

Last month we laid out the reasons why France was On The Brink Of A Secondary Depression - in short, due to a deadly collision of French politics with Frankensteinian monetary union. Unfortunately, subsequent data confirms the bleak trajectory. Even Francois Hollande is beginning to wake up to just how destructive and anti-business the French agenda is. France will enter a recession at a time when spending and debt levels are quite high and Hollande’s recent attempts to assist entrepreneurs are too little, too late. France has been slower to cut taxes than other EU members and a secondary depression will push the French budget deficit to new dangerous heights as the government's 'forecast' of the primary balance is farcical. Even if borrowing costs remain low, debt ratios will still explode. Knowing this, why then are French rates so low? The usual explanations (purchases by the Swiss National Bank and Mrs. Watanabe buying) have some merit, but other factors may also be at play. In any case, in a bond market, one should look at two things: the return ON capital and the return OF capital. The return ON capital is pitiful and the return OF capital is far from certain. Sell the financials in Europe - and in France especially. Really, the euro is on its last legs. France is in play.

On the third year anniversary of the flash crash, and in a week in which earnings season unwinds and in which there is very little macro news, the bulk of the newsflow happened overnight, starting with a drop in the Chinese Service PMI, which tumbled from 54.3 to 51.1, the lowest in two years, then we got Australian retail sales which dropped -0.1% on expectations of 0.4% gain, indicating that the Chinese slowdown is dragging down the entire Asia-Pac region further.  Afterwards, we got a barrage of European non-manufacturing PMI data starting with Spain, at 44.4, down from 45.3, the lowest since December (although one wonder if Spain has finally opened a branch of the BLS, reporting that unemployment actually dipped by 46.1k, on expectations of just a 2k decline, and down from 5k the prior month: how curious the timing of the "end of austerity" and the immediate "improvement" in the economy), then Italy Service PMI printing at 47.0, up from 45.5, on expectations of a 45.8 print, the highest since August 2011, French Services PMI rising modestly from 44.1 to 44.3, Germany's up from 49.2 to 49.6, on expectations of an unchanged print, all of which leading to a combined Eurozone PMI at 47.0, up from 46.6, and beating expectations of a 46.6 print.

Financial markets operate on a number of implied assumptions about growth, policy direction and other factors. Experience tells us that these assumptions often turn out to be erroneous. A modern economy is an incredibly complex entity that involves millions of transactions every day. The notion that this vast and largely self-governing system can be controlled through tools such as government spending and/or an increase in the quantity of money is - to say the least - bizarre. A flood is rarely a cure-all solution to a drought; it just creates new problems for an already suffering population. From 2002 to 2007, we witnessed a massive attempt by central banks to manipulate interest rates and currency exchange rates. The consequences of this action came due in 2008-2009. Criminal psychologists have long known that villains frequently return to the scene of their crime—in the case of western policymakers, they seem to be looking to finish off a caper that went badly wrong at the first attempt. The end result for the broader community is unlikely to be pretty.

The next Great Depression is already happening - it just hasn't reached the United States yet.  Things in Europe just continue to get worse and worse, and yet most people in the United States still don't get it.  We have been warning that the next major wave of the ongoing economic collapse would begin in Europe, and that is exactly what is happening.  In fact, both Greece and Spain already have levels of unemployment that are greater than anything the U.S. experienced during the Great Depression of the 1930s. Pay close attention to what is happening over there, because it is coming here too.  A full-blown economic depression is raging across southern Europe and it is rapidly spreading into northern Europe.  Eventually it will spread to the rest of the globe as well. The U.S. economy has become a miserable junkie that is completely and totally addicted to reckless money printing and gigantic mountains of debt. If we stop printing money and going into unprecedented amounts of debt we are finished. If we continue printing money and going into unprecedented amounts of debt we are finished. Either way, this is all going to end very, very badly.

The Baltic States are unique in Europe in that they went through an austerity crash program a while ago already (beginning right after the 2008 crisis) and have in the meantime recovered strongly. Der Spiegel has an interesting interview with Lithuanian president Dalia Grybauskaite, in which she explains her views on the topic. It can obviously be done successfully. And while we are aware that every case is unique - the problems are not the same in every country, and due to cultural norms and traditions, it may be easier to enact reform in certain countries than others; it seems that no matter how many times Paul Krugman insists that no Baltic nation can possibly be held up as an example, the fact remains that they have imposed fiscal austerity and implemented wide-ranging reform measures and have succeeded.

Macro perspective of this week's events.  Hint:  the ECB meeting may be the most interesting.