Sunday, February 28, 2010

Inflation’s Sweet Spot Augur For A Gold Breakout And Global Equity Market Rally

``When the government and the banking system begin inflating, the public will usually aid them unwittingly in this task. The public, not cognizant of the true nature of the process, believes that the rise in prices is transient and that prices will soon re­turn to “normal.” As we have noted above, people will there­fore hoard more money, i.e., keep a greater proportion of their income in the form of cash balances. The social demand for money, in short, increases. As a result, prices tend to increase less than proportionately to the increase in the quantity of money. The government obtains more real resources from the public than it had expected, since the public’s demand for these resources has declined. Eventually, the public begins to realize what is taking place. It seems that the government is attempting to use inflation as a permanent form of taxation. But the public has a weapon to combat this depredation. Once people realize that the govern­ment will continue to inflate, and therefore that prices will con­tinue to rise, they will step up their purchases of goods. For they will realize that they are gaining by buying now, instead of wait­ing until a future date when the value of the monetary unit will be lower and prices higher. In other words, the social demand for money falls, and prices now begin to rise more rapidly than the increase in the supply of money."-Murray N. Rothbard,The Economics of Violent Intervention in the Market

Speaking of benign inflation, the “sweet spot” of the inflation is the seductive phase where the financial and economic ambiance is characterized by an episode of rising asset prices which reinforces the perception of the strengthening of the economy’s recovery and vice versa.

This actually plays out in the manner introduced by market savant George Soros as the reflexivity theory- a self-reinforcing feedback loop mechanism where people interpret prices as signifying real events, and where real events reinforce these price signals.

In short, from our perspective, the sweet spot of inflation represents as a boom scenario for markets resulting from easy money policies.

However, since the interplay of perceptions which have been enhanced by price signals and statistical information on the real economy has been manipulated by the official policies, most people don’t recognize that price signals are manifestations of the deepening scale of malinvestments into the system. And as the boom phase draws in more of the crowd, the trend becomes entrenched until they become unsustainable...but we seem to be getting way too far.

A Global Rally Ahead?

Last week we said that equities are likely to be a “buy” once gold breaks above the 1,120-1,125 area[1]. And perhaps the sweetspot of inflation will become more conducive once it is supported by the concomitant rise of US and Chinese markets.

The reason we opted to use gold as a major key indicator for markets is because gold has not only decoupled from the US dollar and is likely to seek its own path overtime, but importantly gold has served as a significant lead indicator for equity and commodity prices. This is because Gold apparently reflects on the state of the global liquidity.

For now, even as gold hasn’t broken above the important threshold, the ancillary conditions appear to be suggestive of an upcoming breach (see figure 4)

Figure 4: Sweet spot of Inflation?

US equities as signified by the S & P 500 (SPX), while down for the week, has brushed off the recent accounts of the volatility from the ‘Greek tragedy’ and appears to be in an uptrend.

We also see China’s Shanghai index (SSEC) as striving to move higher (see middle minor window). China’s major bellwether have been in consolidation over the past two months, after being hammered repeatedly by the formal and informal arm twisting by her government in an attempt to squeeze bubbles out of her system late last year.

Next we have the JP Morgan Emerging Markets Debt fund (JEMDX) or a bond fund which is invested in sundry emerging market sovereign debt, as sharply moving higher. These could be signs that foreign money flows could be gathering steam into Emerging Markets anew.

Combined, these market signals could presage a vigorous resurgence of global equities out of “loose monetary conditions” and the reflexivity theory ahead.

And this is likely to also be reflected in gold’s next moves.

Gold’s ‘Fundamental Change In Sentiment’

Another reason why gold should be a good benchmark is that the varying interests of global central banks appear to have created a “neutral” zone for gold.

By neutral zone, we mean that gold is likely to reflect on market forces with reduced odds of manipulation. Many emerging market governments have been increasingly playing the role of “buyer” while former sellers seem to be downscaling sales activities.

Asian Investors quotes the World Gold Council on this noteworthy shift, ``After net-selling an average of 444 tonnes of gold in the five years to 2008, central banks only offloaded a net 44 tonnes last year. In fact, after 62 tonnes of net selling in the first quarter of 2009, central banks posted three quarters of net buying. This shift may signal a "fundamental change in sentiment", says the London-based World Gold Council (WGC).” (bold highlight mine)

In other words, the “fundamental change in sentiment” has transformed central bank officials’ view of gold from a “barbaric metal” to insurance, as previously discussed.[2]

I’d like to further add that gold prices have recently been weighed by the IMF’s proposed sale of the remaining 191.3 tons to the market.

While after a week of announcement, no nation has officially taken up the IMF’s offer, there are reports that India may suit up for IMF’s last batch of gold sales. This should stir up the gold market anew.

Many have expected China to take the counterpart of the IMF’s offer. But this may not happen. China’s gold procurement has been marked by inconspicuous domestic acquisitions since. As example, in April of last year, China surprised the market with the declaration that it had raised its gold reserves by “33.89 million ounces by the end of April” of 2009 since December 2002.

And since China is now the world’s largest gold producer, she isn’t likely to be pressured on overtly buying into IMF’s gold.

Albeit, we are quite sure that China’s interest in the precious metal remains unabated. Her huge sovereign wealth fund, China Investment Corporation (CID) had reportedly acquired an equivalent of 4.5 tonnes of SPDR Gold Trust ETF just recently, making the fund the largest holder, alongside with investing legends as John Paulson and George Soros.

Finally, should gold opt to somewhat mimic on the Euro’s moves anew, the prospects of a sharp rebound in a severely oversold Euro could also give the metallic money a boost (see figure 5)

Figure 5: Mineweb: Extremely Overbought US dollar and Severely Oversold Euro

Here we quote Mineweb’s Rhona O'Connell: (bold emphasis mine)

``The instrument shown here is the US Dollar Index position reported by the "I.C.E.", or IntercontinentalExchange, which turns over very heavy dollar trading, although the net speculative positions are comparatively low when compared with those in the euro on the CME or gold on COMEX. Nonetheless they reflect sentiment. The reported positions relate to contracts of $1,000 each, meaning that the largest recent net dollar short position, at 12,521 contracts, was equivalent to $12.5 million. The swing since then has been equivalent to $53.4 million to the long side and the latest position, a net long of $40.9 million, is almost 150 times the average since 2004.

``Meanwhile the net euro position on the CME is even more extreme. Taken over the same period, the net speculative euro position on the Chicago Mercantile Exchange has averaged a long of $4.8 billion euros. In mid-February the position was a net short of 8 billion euros; the outright long is at 71% of the average for the period, but the short is twice its average.”

So the forces which heightens the odds for an upside breakout for gold prices looks firming up, and we should gold’s breakout to likely be accompanied by auspicious sentiment for the asset markets.

Positive Foreign Trade For The Philippine Stock Exchange

I’d like to conclude with a chart of the foreign flows into the Philippine Stock Exchange (PSE) (see figure 6)

Figure 6: PSE: Net Foreign Trades

Despite the marked selling in early February, we are generally seeing net foreign inflows into the PSE on a year to date basis.

This squares with our earlier observation that despite the diminishing share of foreign trade in the markets (about 37.7%), foreign trade has accounted for a net inflow to the tune of 5.2 billion pesos (about $110 million) for 2010.

Inflationism in developed economies is likely to spur more foreign fund inflows, which should support the domestic asset markets, particularly, the equity market, the real estate sector, corporate and sovereign bonds and the Philippine Peso.

[1] See Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

[2] See Is Gold In A Bubble?

Saturday, February 27, 2010

8 Reasons Why Canadian Banks Have Been Crisis Resilient

Professor Mark Perry enumerates 8 reasons why Canadian banks has proven to be repeatedly resilient during crisis times and has outperformed its US contemporaries.

The scoreboard:

Number of bank failures during the 1930s:
United States: 9,000, Canada: 0

Number of Bank Failures during S&L crisis (1980s-90s) United States: Almost 3,000, Canada: 2

Number of Bank Failures during the Great Recession (2007-2010) United States: 196, Canada: 0

Delinquency Rate for Home Mortgages in December 2009 United States: 9.47%, Canada: 0.45%

The 8 Reasons:

1. Full Recourse Mortgages in Canada.
2. Shorter-Term Fixed Rates in Canada
3. Mortgage Insurance Is More Common in Canada than in the United States.
4. No Tax Deductibility of Mortgage Interest in Canada.
5. Higher Prepayment Penalties in Canada.
6. Public Policy Differences for Low-Income Housing.
7. Differences in Canada’s Bank Concentration and Greater Diversification.
8. A Few Other Differences that Contribute to Bank Safety in Canada.

Bottom Line: Taken together, the features and regulations of banks in Canada outlined above create a healthy and sound “pro-lender” environment absent of political motivations for outcomes like greater homeownership, compared to the often politically motivated “pro-borrower” and “pro-homeowner” policies of the United States. While Canada’s banking system has promoted responsible borrowing and prudent lending and underwriting practices with little politically motivated interference, the U.S. banking system seems to have encouraged excessive lending to risky borrowers because of the political obsession with homeownership.(emphasis added)

Read the rest here

Friday, February 26, 2010

Philippine Election Myth: "I Am Not A Thief!"

"Delusions are states of refuge. The mind, unable to comprehend realities or to deal with them, finds its ease in superstitions, beliefs and modes of irrational procedure. It is easier to believe than to think." Garet Garrett

Elections operate on a spectrum of irrationality. That’s because voters tend to cling on to absurd mushy beliefs while candidates reinforce this by peddling drivels.

In the Philippines, corruption appears to be the single most crucial issue that could determine the outcome of the next political leadership. And it’s been the primary focus of the campaign trail.

And it’s why most of the political missives I’ve seen (through email messages) have been fixated on innuendo or character assassinations (ad hominem). And it also why leading protagonists have engaged in an outlandish squabble over slogans like “I am not a thief!”

Yet common sense tells us that NONE of these leading candidates are likely to cleanse the mythological Augean stables.

We can even see this from just one aspect: Election spending.

Measured in ad spending alone the top 6 candidates have already spent an estimated “real ads spending” of 2.1 billion pesos and counting!

Unless these candidates are doing it for charity, elementary inference tells us that these are “investments” will eventually extrapolate to “investment returns” by the winning party.

With the salary of Philippine President pegged at 300,000 per year (Wikipedia). You’d wonder why so much moolah is being put to risks for the top spot (by the candidates, sponsors, friends, alliances

But the perspective changes when one realizes that the Office of the President’s budget is at an estimated Php 4.259 billion annually.

In addition, with 1.54 trillion ($327 billion) pesos earmarked for government spending in 2010, then one would reckon that there’s simply tons of money to be made with by the winning team through “political endowment” or “privileges”- political concessions, monopoly, behest loans, subsidies, silent partnership in public-private programs, undeclared fees etc...

This is otherwise known as crony capitalism.

As Murray Rothbard describes on why political leaders needs an elite group...

"the chief task of the rulers is always to secure the active or resigned acceptance of the majority of the citizens. Of course, one method of securing support is through the creation of vested economic interests. Therefore, the King [President] alone cannot rule; he must have a sizable group of followers who enjoy the prerequisites of rule, for example, the members of the State apparatus, such as the full-time bureaucracy or the established nobility. But this still secures only a minority of eager supporters, and even the essential purchasing of support by subsidies and other grants of privilege still does not obtain the consent of the majority.

In short, political privileges endowed to core groups are key to the preservation of power by the political leadership. Or simply said, keeping certain interests groups happy, who will work to control or contain the majority, ensures the tenure of power by the political leadership.

Hence, election spending alone is a great indication that none of the campaign promises (on corruption) will likely be met.

Though the ideal is to vote for candidates with little spending and or with a small political baggage. But this isn’t likely to happen, because democracy is a popularity contest!

Yet for voters earnestly believing that their choice of candidates will represent “change”, regardless of such facts, I’d quote Professor Bryan Caplan’s views on why he thinks voters are irrational, ``Even when his views are completely wrong, he gets the psychological benefit of emotionally appealing political beliefs at a bargain price.”

As an old saw goes, the more things change, the more they stay the same....

Thursday, February 25, 2010

Available Bias, US Consumer Industries and Homebuilders

The recent stock market actions in the US should serve as fundamental example of how the "available bias" plagues mainstream reporting.

The other day, as consumer confidence hit a 10-month low , the report apparently coincided with a fall in US stockmarkets. And media hastily promoted a causal effect: market actions had been driven by current news.

Chart from Northern Trust

Bespoke Invest, for the second day, has assiduously rebutted the issue and showed that the broadbased decline had consumer discretionary and consumer staples as the least affected sectors (see here)

In contrast, materials, finance and energy had been smacked the most.

Bespoke Invest extends the rejoinder by illustrating the outperformance of US retail stocks relative to the key benchmark the S&P 500 and called on today's advances as "new bull market high"

In addition Bespoke makes a dissection of the breadth and observes that consumer sectors have, not only outclassed the key index, but also all the other sectors.

They write, (bold highlights mine)

``Consumer Discretionary and Consumer Staples are currently trading the farthest above their 50-day moving averages of the ten sectors. The other two sectors currently above their 50-days are Industrials and Financials...We provide the year-to-date change, % from 50-DMA, dividend yield, P/E ratio, price to sales ratio, and price to book ratio for the various sectors. Across the board, we use red to green as the color code from lowest to highest, but obviously for ratios, the lower the better.

``While it used to have one of the highest yields, the Financial sector currently has the second lowest yield at 1.15%. It also has the highest P/E ratio at 66.44, but it has the lowest price to book at 1.14. Consumer Staples, Consumer Discretionary, and Telecom have the lowest price to sales ratios, while Technology has the highest. Technology also has the highest price to book."

Chart from Businessinsider

If the US consumer industry's outperformance is an indication of the upcoming real activities, even amidst a fall in commercial and industrial loans at commercial banks, this suggest to us that any lagged but positive response to the steep yield curve is likely to even bolster the recent retail activities [see previous discussion Changing Dynamics In Central Bank Management, Quasi Boom Policies]
Finally as we addressed earlier, homebuilder stocks seem to be laying foundations to another bubble cycle. Bloomberg's chart of the day notes that the industry group have also bested the market, according to Bloomberg,

``As the CHART OF THE DAY shows, the Standard & Poor’s 500 Homebuilding Index -- composed of D.R. Horton Inc., Lennar Corp. and Pulte Homes Inc. -- ended last week with a 21 percent gain for the year. The advance compares with a 0.5 percent loss for the S&P 500.

``Homebuilders were the year’s third-best performers among 134 industry groups in the S&P 500, according to data compiled by Bloomberg. The groups that did better each had one member: Eastman Kodak Co. for photo products and Harman International Industries Inc. for consumer electronics."

Well it would appear that market conditions have only been responding to "bubble policies" which is likely regenerate the same cyclical conditions: A boom today for a bust tomorrow.

Tuesday, February 23, 2010

Cartoon Of The Day: Crowding Out

My 6 year old computer finally expired. So I spent the whole day yesterday with my children looking for an alternative.

Now, I'm having a difficult time adjusting to this new substitute.

Worst, my chart programs can't even seem to run. So the familiarization process could affect my posting.

Anyway, my test post will begin with this great caricature on what is known as the "crowding out effect." (reference: Cafe Hayek)

It's basically about government versus private spending.

As Murray N. Rothbard explains, ``The annual government deficit, plus the annual interest payment that keeps rising as the total debt accumulates, increasingly channels scarce and precious private savings into wasteful government boondoggles, which "crowd out" productive investments."

This shouldn't be seen as only a US phenomenon but universally applicable.

Sunday, February 21, 2010

Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

``There is room for investors to start celebrating ‘neither too hot nor too cold’ again, when they stop fretting about tightening and before they start worrying about bubbles again…All roads still point to an asset bubble in China, most particularly if the currency’s appreciation continues to be suppressed.”-Christopher Wood, CLSA (Bloomberg)

The recent Fed’s action had not been well taken by Asian markets.

Although Asia’s markets had been up for the week, they have immensely underperformed their regional and emerging market counterparts.

It looks as if Asian markets may have overestimated on the impact of the US discount rate hikes and may equally underestimated the Fed’s future actions.

Figure 4: Discount Rate Troubles?

The fall of Asian markets, including the Philippine Phisix (main window), Japan’s Nikkei (Nikk) and Dow Jones Asia ex-Japan (DJP2) seem to coincide with the Fed’s ‘surprising’ announcement.

Perhaps it maybe just an excuse to retrench or perhaps there could be other factors involved. The week long absence of China’s market, which celebrated her Lunar New Year of the Tiger, may have also been a factor.

Nonetheless, surging commodities prices appears to have turned the tide for the Baltic Dry Index (BDI) an index which tracks shipping prices for dry goods. As for the latter’s sustainability, this has yet to be confirmed over the coming sessions.

Our guess is that if China’s markets have indeed bottomed as we suspect it has [see last week’s A China Bubble Bust Is Unlikely Yet], then the BDI index we suspect will rise in congruence to rising key stockmarkets worldwide.

Since China’s markets has recently shrugged off the recent second round of increase in reserve requirements for her banks, her markets may have begun to digest the “exit” strategies employed by their local central bank.

For us, Asia and emerging markets are likely to be more receptive to the incentives brought about by the steep yield curve to keep asset prices afloat than to developed economies.

So it seems a bizarre reaction that we read from a local official of our domestic central bank, the Bangko Sentral ng Pilipinas, to extol on the Fed’s increase of its discount rate as helping out local policies by “narrowing of the [interest rate] spread”, “this gives us [BSP] additional space before we implement our own exit plan” said BSP Deputy Governor Diwa Guinigundo.

Figure 5: Asian Bonds Online: Steep Yield Curves

Mr. Guinigundo doesn’t seem to realize that local inflation will likely speed ahead of the US given the domestic market’s likelihood to respond better to low interest (see figure 6), the El Nino problem which will likely aggravate the looming shortages of our agricultural produce already hampered by last year’s Typhoon Ketsana nickname Ondoy and Typhoon Parma nickname Pepeng, and compounded by rising oil prices in the global market.

These factors, which weigh heavily on our local CPI, would likely pivot up the domestic interest rates ahead of the US, perhaps as soon as the local elections are concluded in May.

The basic flaw is to read Fed’s policies as oversimplistically linear, as the case is with most of the practicing aggregatists which tend to pick on select variables to highlight on their desired outcome.

We can’t entirely blame Mr. Guinigundo since as one of the leading technocrat for the banking sector, media publicity demands for “simplistic” replies.

By looking at the internal dynamics of the Phisix as potential measure of capital flows, the past two weeks has seen some substantial inflows from foreign funds. These inflows have been coincidental with the dramatic surge of the Phisix following the “Greek and China” myth induced meltdown during the prior weeks.

Yet compared to the 2003-2007 boom, where foreign funds constituted the bulk of the trades, today’s market attribute reveals the opposite local investors dominate trade.

But given the inflationist approach by major economies in dealing with their local predicament, it isn’t far fetched that the “widening” spreads [and “devaluing” foreign currencies] from which our domestic central bankers seems concerned of may come to fruition (see figure 6).

Figure 6: Money Week Asia [UBS]/ Wall Street Journal: Who Wins In A Liquidity Bubble/Private Capital Inflows

And considering the underdeveloped and relatively small state of the Philippine Stock Exchange, a larger than usual foreign inflow can virtually exaggerate returns that could turn the Phisix into a full blown bubble as it had during the 1987-1994 chart (left window).

Phisix 10,000? That should be peanuts compared to the returns then (the Philippines and Indonesia had nearly 1,000% gains while Thailand had 800%. Argentina and Mexico had even an astounding 1,400% gains-all in US dollar terms.)

It isn’t likely that past performance would exactly repeat, but as shown in the right window, foreign capital flows into emerging markets appear to be accelerating anew and they may contribute to enhanced returns based on global policy arbitrages.

And it is also why the IMF has reverted to its interventionist tendencies and has recently prescribed capital controls for emerging markets, ironically aimed at curtailing inflows. This is in sharp contrast to the past where it recommended capital controls to prevent outflows.

Times have indeed changed.

So while many seem to fear for a reprise of 2008, a dynamic which we see as a remote possibility since most of these fears appear to be predicated on Posttraumatic Stress Disorder (PTSD) [see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?], we see that excess reserves and the inflationist proclivities of developed economies in dealing with their fiscal woes as risking a supersized global inflation or serial bubble blowing in Asia and or in emerging markets.

In short, while many fear a meltdown, I am concerned of a meltup.

Finally, if gold surpasses its resistance at 1,120-1,125, it is likely that global markets will continue moving against a wall of worry or continually move uphill. This ascent will especially be stronger if both the US and China’s markets chimes in.

Why The Hike In The Fed’s Discount Rate Is Another Policy Bluff

``Certainly not without justification, the markets came to the recognition that yesterday’s increase in the discount rate did not signal any imminent tightening of financial conditions. It will be interesting to see if the markets eventually end up calling a bluff on Fed “exit” policies more generally.”-Doug Noland, The Beginning of Tightening?

The US Federal Reserve surprisingly raised its discount rate or its overnight lending rates to banks!

However, it maintained the Fed Fund rates, or the interest rates banks charge to each other, while it also shortened the maturity for primary credit on the discount window.

The widening of the spread of the Discount rate and the Fed Fund rate, according to the Federal Reserve Board, ``will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds.”

Figure 1: FT Advisors and Northern Trust: Spread of Discount and Fed Rates and Reserve Bank Credit

The fact of the matter is that the Federal Reserve has been reacting to the meaningful current improvements of market conditions, where access to the emergency credit window of the Federal Reserve has apparently been on a decline (see figure 1 right window).

The Federal Reserve has also been in the process of withdrawing other emergency programs prior to this week’s surprise. According to the Businessweek, the central bank has ``closed its emergency aid programs to money markets, bond dealers and foreign central banks.”

Since the cost of borrowing from using the Federal Reserve’s discount window would be higher than the interest rates of banks charge to each other, then the present policy adjustments incentivizes the banking system to wean from dependence on the central bank funding.

Nonetheless, the Fed’s action could be read as ex-post reaction of the little used programs which Asha Banglore of Northern Trust aptly labels as programs “dying a natural death”.

Markets Reaction To The Federal Reserve Policy Changes

We said that the Fed’s action had been a surprise, that’s because while everyone knew it was coming, no one exactly knew of the timing.

Nevertheless, Fed officials immediately rushed into “calming” of the markets such as Federal Reserve Bank of Atlanta President Dennis Lockhart who was quoted by Bloomberg, “I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent,” Lockhart said. “Rather, this action should be viewed as a normalization step.” (italics mine)

It’s the same with Federal Reserve Bank of New York President William Dudley who called the adjustment “technical” in nature. The Wall Street Journal blog quotes Mr. Dudley, “We made a very small technical change” by raising the discount rate, Dudley said. “The action yesterday was really an action about the improvement in banks,” and reflected the fact these institutions no longer need this emergency source of cheap funding the way they did during the depths of the financial crisis, the official said.

``The discount rate increase “is not at all a signal of any imminent tightening” in monetary policy, and the Fed’s commitment to keep rates very low for an extended period “is still very much in place,” Dudley said.” (italics mine)

First Trust’s Brian Wesbury and Robert Stein noted that Ben Bernanke appeared to have telegraphed this action during his congressional testimony last week.

Mr. Wesbury and Mr. Stein quotes Mr. Bernanke: ``(B)efore long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes…should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they…should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC.” (italics mine)

But of course not everyone is pleased.

David Kotok of Cumber Advisors thinks that the “surprise” factor more than the policy action itself constituted as uncertainty.

He sardonically writes, ``By using this surprise the Fed has introduced some confusion into markets. It doesn’t mean rates are going up tomorrow or next month or by mid-summer. But it does mean that an additional uncertainty has been introduced into market pricing. Interest rates will now reflect this uncertainty. The dollar strengthened immediately as one would expect it to do. Currency exchange rates are now the first thing to react to changes in policy. And this was a change in policy event though the Fed says it is not so…

``But the Fed has now added an uncertainty premium and markets are adjusting to it. That means somewhere, some mortgage will not get refinanced. And somewhere, some bond financing will cost more to accomplish. And somewhere, some US manufacturer who exports will face a headwind because the dollar is stronger and his foreign competitor can sell more cheaply than yesterday. And somewhere, some person is not going to get hired because this uncertainty has raised the risk of hiring to the employer. That, friends, is a tightening.”

In my view, the market’s reaction to unexpected information matters most. It’s simply people reacting by voting with their wallets!

Figure 2: Financial Markets Shrugs Off Discount Rate Hike

While the US dollar had an intraday spike following the “surprise” announcement, which subsequently faltered, the rising US dollar or the new policy action failed to contain the gains of the US broad based equity index the S & P 500, which incidentally rose 3% over the week! (I heard somebody uttered the US dollar carry trade?? Where???)

Importantly, major commodities as gold (+3.8%), silver (+4.96%), copper (+8.9%), oil (WTIC-7.5%) and the CRB (3.7%) index soared!

The advances of gold prices had even been subdued due to the IMF announcement of its second batch of on-market phase gold sales program, which amounted to 191.3 metric tons out of the original 403.3 metric tons, a day ahead of the Fed action.

What the markets appear to be saying is that the newly adapted policies by the Fed could likely be even more inflationary!

Are the markets suggesting that US interbank lending is likely to improve thereby venting its effect currently on the markets which would extrapolate to a spillover effect into the real economy?

In other words, markets appear to have reacted in stark defiance to mainstream expectations.

Yet despite the Fed’s purported efforts to rollback its influences, in my opinion, they still contribute immensely to the direction of the marketplace.

Figure 3: Federal Reserve Bank of Atlanta: Federal Reserve Assets

The Fed continues to balloon its balance sheet with purchases of agency debt and agency backed mortgaged back securities (MBS) which according to the Federal Reserve of Atlanta has reached 96% and 95% of respective Quantitative Easing (QE) quotas (see figure 3).

So while some mischievous minds could be entertaining the thought of the Fed or the US government could have been tweaking the markets, a generalized manipulation of sundry markets seems improbable.

Of course a day or a week doesn’t a trend make, which means we are likely to ascertain the sustainability of the market’s reaction over the coming sessions.

Although if the present momentum continues at its present pace then deflation advocates are likely in for a big a surprise!

The Philosopher’s Stone As The Dominant Policy

Notice further that the Fed’s campaign to pacify the markets had been directed at the assurance that the said adjustments in policies had not been aimed at tightening. Said differently, the promise is that the environment of cheap funding will remain intact.

In addition, the gingerly approach by Fed officials simply reveals what we’ve been saying all along…policymakers are so highly sensitive to the direction of asset prices as to concentrate their verbal signaling on maintaining current monetary conditions.

From these premises, should we believe that the Federal Reserve will meaningfully withdraw, even factoring in its present actuations?

My answer is NO.


Because aside from the entrenched economic ideology that has been institutionalized in the technocratic bureaucracy [as discussed in Getting Ahead Of The Curve], the path of the Fed’s policies are seemingly being telegraphed in terms of ‘political pressure’ from what is projected as ‘political consensus’.

The vast tentacles of the US Federal Reserve in the academia, Wall Street and related political institutions could be working to paint the impression that there is a popular clamor to use inflation as the most effective tool to resolve the current economic predicaments.


In a morbid fear of deflation, these networks of experts have been pushing hard for policies that would inflate away the debt in the system which they believe could simultaneously buoy nominal economic growth rates.

For instance, IMF’s chief economist Oliver Blanchard recently asked central banks to consider a higher rate of inflation. Basing his recommendations from a study by his IMF economist underlings, Mr. Blanchard recommends an annualized target of 4% to deal with the present predicament.

According to the Wall Street Journal, ``In a new paper with two other IMF economists, Giovanni Dell'Ariccia and Paolo Mauro, Mr. Blanchard says policy makers need to consider radically different approaches to deal with major banking crises, pandemics or terrorist attacks. In particular, the IMF paper suggests shooting for a higher-level inflation in "normal time in order to increase the room for monetary policy to react to such shocks." Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

``At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.”

Morgan Stanley’s Spyros Andreopoulos sees an average inflation rate of 4-6% to stabilize public debt.

Bloomberg’s Caroline Baum cites Harvard luminaries asking for nearly the same levels of inflation, ``Last May Harvard University economists Ken Rogoff and Greg Mankiw joined a chorus advocating higher inflation. Rogoff lobbied “for at least 6 percent for a couple of years” to help the deleveraging process while Mankiw saw inflation as a better alternative to more stimulus packages and higher national debt.”

One must be reminded that Ken Rogoff was the chief economist for the IMF (2001-2004) and Greg Mankiw was chairman of the Council of Economic Advisers for ex-President George Bush.

But why stop at 4-6%?

Ms. Baum mockingly remarks, ``if 4 percent is good, 8 percent should be better and 10 percent better yet!”

As Ludwig von Mises had warned, `` In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.” All these are simply manifestations of the political elite chronic addiction to inflationism.

Yet for the mainstream what matters is a band-aid approach in dealing with structural problems, with little concerns on the long term repercussions. As Cato’s Jerry O'Driscoll comments on an article, ``A little bit of inflation is like being a little bit pregnant. Once the process has begun, it is ended at only great cost.”

To consider, with the Fed’s quantitative easing program nearing completion and considering that the US mortgage market has been dependent on [where 9 out of 10 mortgages have been estimated to have been owned or guaranteed by], the US government, an abrupt retreat from the markets is a scenario that would likely be unacceptable to politicians and the bureaucrats. Besides, whatever short term political gains accrued today could be perceived as being negated by a sudden withdrawal.

Hence, the support for the housing market via the mortgage markets will likely be sustained, although the difference would be in the manner of how funding will be obtained. Most possibly this will be through the extension of quantitative easing by the Federal Reserve or through the US treasury by issuing sovereign liabilities (the latter could also be tacitly financed by the Fed) to cover the deficits or losses.

At the end of the day, mortgage investors are likely to be subsidized by the US government at the cost of the US taxpayers [Dr. John Hussman calls this “How to spend (up to) $1.5 trillion without Congressional approval”]. These are the kind of redistributive policies that will eventually erode the comparative advantages of the US relative to the world.

To add, as mentioned in Poker Bluffing Booby Traps: PIMCO And The PIIGS, there are many prominent personalities who superficially use “economic” analysis to masquerade as political propaganda.

The typical or identifiable approach by political propagandists would be for them to issue “analysis” that limns on a dire environment, where the helplessness of the situation would necessitate for more government intervention, via inflationism, as the only feasible solution.

As Professor Bryan Caplan aptly conveys, ``This pessimistic bias is a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.” (bold highlight mine)

So I’d be leery of heeding ‘doomsday’ analysis from the progressive camp. They signify no less than self fulfilling propaganda predicated on the addiction to inflationism.

The bizarre part is that even if these experts know how baneful the after effects of inflation can be, they refuse to acknowledge that the path of any form of addiction is self-destruction.

They are inclined to believe in the alchemy of the philosopher’s stone where they can turn lead into gold or attain the elixir of life by the miracle of converting stones into bread.

Meanwhile, markets are likely to continue manifesting incremental signs of inflation, which will persist to seep through markets, consumer prices and into the economic system, both in the US and around the world.

This is not only because of the impact of past policies but also of the direction of prospective political policies.

As we said at the start of the year, Poker Bluff: The Exit Strategy Theme For 2010, we are likely to be faced with policy bluffs until authorities are faced with the true menace.

Changing Dynamics In Central Bank Management, Quasi Boom Policies

``With the economic improvement and steepening yield curve that our US team expects, commercial banks may find it a good risk/return decision to move these funds into the real economy rather than simply earn an interest rate in the neighborhood of the risk-free IOR. The risk therefore is that these methods of draining reserves simply postpone the macro problem of burgeoning excess reserves.”-Manoj Pradhan ER, RR, IOR and RRR

It’s a simple fact that the world constantly changes.

Even the management of central banks given today’s monetary conditions has been exhibiting such changes. Traditional tools don’t seem to have the same measured ‘efficacy’ due to the drastic stimulus-response feedback loop mechanism applied by authorities in response to the rapidly changing environment. I would posit that the past successes had not been out of bureaucratic skills but out of happenstance; the emergence of globalization had engendered the era of the “great moderation”.

For instance, in an effort to curb the incidences of bank failures during the latest crisis, central banks have rapidly deployed the unorthodox (nuclear option) means of providing emergency loans against ‘dubious’ forms of collateral and importantly the purchasing of specific types of bubble ‘tainted’ assets directly from the market.

The proceeds from the central bank loans or sales have led to the intensive ballooning of excess reserves (ER) of banks, which until today, has been warehoused in the central bank. Considering the extent of balance sheet impairments of the US banking system, the temporary measures have not yet adequately resolved the chronic woes, nor has these excess reserves been converted into end user or consumer loans. Not yet anyway.

Hence, the huge buildup of excess reserves has apparently altered the scalability of the tools required to deal with balance sheet management of the central bank.

Morgan Stanley’s Manoj Pradhan describes the transition, ``The traditional way of draining reserves was to sell T-Bills to commercial banks. This would mean that commercial banks would replace cash on the asset side of their balance sheet with the T-Bill of an equivalent quantity. However, ER held by the Fed now stand at US$1.1 trillion and the size makes it difficult for reserves to be drained in the traditional way.” (emphasis mine)

In other words, the change in the discount rates or possibly even the Fed Fund rate may seem more symbolic than functional. And perhaps this may be one reason why the markets appear to have discounted the recent actions by the Federal Reserve.

The Federal Reserve has thus been tinkering with experimental tools such as reverse repo, term deposit facilities and interest rates on reserves.

So while the Fed desires to see ample liquidity in the system, withdrawing the huge stack of bank reserves underlines the apparently emerging distinct objectives- the task of liquidity and interest rate management.

Reviving The Credit Process By Fueling Bubbles

On our part, we understand the fact the Fed is dabbling with generally untested tools relative to the new circumstances it is faced with brings about greater risks than what the mainstream expects.

For one, it is becoming clearer that credit demand hasn’t been the underlying problem as alleged by many, instead it looks more likely to be a ‘supply’ problem, where tight lending from banks have stifled the credit process.

As proof, many in the US, have turned to local ‘scrip’ currencies in the face of money shortages to conduct business or trade [see Emerging Local Currencies In The US Disproves The 'Liquidity Trap']. There are as many as 100 local currencies operating in the US today.

Next, banks that have benefited from government’s bailout have reportedly been averse at lending to small business.

According to CNN Small Business,

``Small business loans continue to dry up at the nation's biggest banks. Eleven top TARP recipients -- including Wells Fargo, by far the nation's largest lender to small companies -- cut their collective small business loan balance by more than $2.3 billion in December, according to a Treasury report released late Tuesday.

``The drop marked the eighth consecutive month of declines for the 11 banks. In that time, their total loan balance has fallen 7%, to $169.4 billion. Seven of the reporting banks have cut their small business loan balance every single month.

``"Credit is still tight for many small businesses," the Treasury acknowledged in a Feb. 10 report.

Another, government interventions in the housing market through a recent tax credit subsidy program compounded by low interest rates could spark the process of inflating yet another property bubble.

But this time bubble signs appear to have surfaced in homebuilder lots, according to Doug French of the Mises Institute, (bold highlights mine)

``Last November, President Obama signed the Worker, Homeownership, and Business Assistance Act of 2009, which, as many people know, extended unemployment benefits and the first-time-homebuyer tax-credit program. But quietly included in this legislative lasagna was a provision allowing big businesses to offset the losses of 2008 and 2009 against profits made as far back as 2004. This provision will generate corporate tax refunds of $33 billion, the New York Times reports. Previously, only small companies could offset losses against past years' profits.

``Big home builders are the prime beneficiaries. After racking up monster profits during the housing boom, the industry has booked huge losses in the bust, accentuated by write-downs of their land positions totaling $28.5 billion for the 14 largest publically traded homebuilders. Now these large homebuilders are recapturing some of what Uncle Sam took away during the boom years. According to the Times, Pulte Homes has a refund of $450 million coming, Hovnanian Enterprises will get back $250–275 million, while Standard Pacific and Beazer Homes will recoup $80 million and $50 million of their profits respectively.

``And while returning taxes to businesses is a wonderful thing, home builders are reading the distorted economic tea leaves. These seem to say that low interest rates and tax credits will eventually bring buyers back to their subdivisions, while many of the big builders' smaller competitors were washed away for good by the housing tsunami — so ramp up the higher-stage and durable-production process by investing capital in building lots…

While it is true that there are still enormous housing inventories to reckon with as to successfully reignite a bubble, improving trends in the sales of homebuilder lots could signify as important clues to a brewing bubble.

Adds Mr. French, ``The lot-buying homebuilders may be irrational, but they aren't yet exuberant. The National Association of Home Builders' housing-market index rose just 2 points to 17 in February — far below the bullish readings of 50 that haven't been seen since April 2006. But the 528 residential developers surveyed say that the tax credits being offered along with low mortgage rates are spurring some demand.” (bold highlights mine)

This seem to reconcile with our view that if we are correct, the record steepness in the yield curve will likely generate belated credit traction 2-3 after a recession [see What’s The Yield Curve Saying About Asia And The Bubble Cycle?]. We may probably see some signs of revitalization in the credit process of the US by the end of the year.

And what else could stoke the credit process than a new bubble!

Remember considering that homebuilder losses have been allowed to be offset via tax refunds, essentially, the carryover losses has been borne by the US government.

So there lies the issue of the moral hazard problem. What should stop these economic agents from resuming reckless and imprudent risks, when they know that Big Brother would backstop their activities?

Moreover, these homebuilders are only responding to the incentives set by the government: Government gives them money from which they employ based on inherent familiarity, and government provides the conditions-low interest rates and the moral hazard issue/risk free environment- for them to take a stab at new risks. Besides, government subsidies tend to immunize economic agents from the sentience of profits and losses.

So the US government’s approach to gradually disengage itself from the housing market appears to be to stir up a new bubble.

The US government is simply fundamentally following the dogma of sustaining the perpetuity of a quasi boom.

From John Maynard Keynes, ``The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.” A quasi boom kept as permanent policy would lead to a prolonged depression and a reduction of the nation’s living standard.

Also this should put into rigorous tests the effectiveness of the new set of tools, strategies or the new doctrines for the Federal Reserve to deal with its humongous excess reserves.

Where to bet our money? Against the success of the Federal Reserve, of course.