More Promises from ECB’s Mario Draghi and the US Federal Reserve

Central bankers continue to engage in talk therapy or jawboning the markets or manipulating the public's expectations in the hope that promises to inflate may be enough to rejuvenate the “animal spirits”.

From Bloomberg,

European Central Bank President Mario Draghi signaled the ECB intends to join forces with governments to buy bonds in sufficient quantities to ease the region’s debt crisis, while conceding that Germany’s Bundesbank has reservations about the plan.

ECB bond purchases would likely focus on shorter-term maturities, would be conducted in a way to soothe investors’ concerns about seniority, and wouldn’t breach European Union rules prohibiting the financing of government deficits, Draghi told reporters in Frankfurt today. ECB officials are working on the plan and details will be fleshed out in coming weeks, he said.

“Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner,” Draghi said at a press conference after keeping the benchmark interest rate on hold at 0.75 percent. “The euro is irreversible.” There is a “severe malfunctioning” in bond markets, he said.

This seems little different from the US Federal Reserve which has deferred from taking on more stimulus but gave a strong signal that such contingency would be used in case the economy deteriorates further.

From an earlier Bloomberg article,

The Federal Reserve said it will pump fresh stimulus if necessary into the weakening economic expansion to boost growth and reduce an unemployment rate that’s been stuck at 8 percent or higher for more than three years.

The Federal Open Market Committee “will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability,” it said today in a statement at the end of a two-day meeting in Washington. “Economic activity decelerated somewhat over the first half of this year.”

So far markets have held on well to such promises, although as I previously admonished, eventually markets will seek the real thing.

should markets continue to rise in ABSENCE of REAL actions from central bankers, we cannot rule out that the markets could fall like a house of cards (fat tail risks) or what I would call a Dr. Marc Faber event.

The market’s deep addiction to stimulus will eventually seek REAL stimulus more than just promises or in central bank lingo, signalling channel. Reversal of expectations can become violent.

Such opaqueness in policy directions only underscores the uncertainty of the financial marketplace which only amplifies the risks of sharp volatilities.

Be very careful out there.

More On The Krugman Inflation Spiel

In my earlier post where I argued that Paul Krugman appear to be conditioning his readers for a possible reversal in his ‘deflation’ stance, I forgot to put on some charts which Mr. Krugman has referred to.

I would like to reiterate, “Such shell game is happening NOW!”

Krugman says,

So we’re talking about a monetary base that rises 12 percent a month, or about 400 percent a year.

Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

Let’s do away with the %. Here is the state of the adjusted Monetary Base...

…which apparently is in a VERTICAL spike! (chart from St. Louis Federal Reserve)

Here is the composition of the Fed’s balance sheets...

This from the Wall Street Journal Blog, (bold highlights mine)

Assets on the Fed’s balance sheet expanded to around $2.566 trillion in the latest week from $2.403 trillion at the end of 2010. Nearly all the additions this year have come from new Treasury purchases — some $164 billion in the past three months. The Fed announced earlier last year that it will purchase an additional $600 billion of Treasurys through June in addition to previously announced purchases with money reinvested from its MBS portfolio.

Though the overall size of the balance sheet is continuing to increase, the makeup is moving back toward the long-term trend. The MBS and agency debt holdings have steadily declined as loans are paid off or mature. The Fed still holds nearly $1 trillion in MBS, but now owns more Treasurys — over $1.28 trillion.

And here is the Wall Street Journal on what’s driving inflation expectations.... (bold highlights mine)

Inflation, once believed dead, is showing a pulse. While price increases are unlikely to become rampant, consumers are lifting their inflation expectations, and more businesses are marking up their selling prices to recoup input costs.

Signs of life for inflation come at a time when the Federal Reserve has to weigh the potential impacts from the Japan tragedy and Middle East unrest.

To be sure, Thursday’s data on the consumer price index showed inflation remains well within the Fed’s preferred target of about 2%. Total prices, pushed up by higher food and energy, increased 2.1% over the year ended in February, while core inflation — which ignores food and fuel — was up a milder 1.1%.

Even so, higher commodity costs are starting to influence the outlook.

As earlier pointed out,

True, food prices signify a minor component in the household expenditure pie for developed economies. But that doesn’t mean that rising oil, food and commodity prices won’t spillover to the rest of the economy. Eventually they will!

Regular readers of this blog know that we have been pounding the table on this pathology known as inflationism—since 2008

Such as this

Our point is simple; if authorities today see the continuing defenselessness of the present economic and market conditions against deflationary forces, ultimately the only way to reduce the monstrous debt levels would be to activate the nuclear option or the Zimbabwe model.

And as repeatedly argued, the Zimbabwe model doesn’t need a functioning credit system because it can bypass the commercial system and print away its liabilities by expanding government bureaucracy explicitly designed to attain such political goal.

Or this (2010) and this and this (stages of inflation-2009) or my $200 oil forecast (2009) and many more also here and here

False religion eventually get to be exposed. The Emperor has no clothes.

Rising Inflation Expectations: Why Macro Economists Can’t See It Coming

This is an example why macro-models used by mainstream experts don’t get it.

From the Wall Street Journal Blog (bold emphasis mine)

The Federal Reserve expects higher price pressures to be “transitory.” But other economic players aren’t so sure.

A new survey of finance professionals done by J.P. Morgan shows core inflation expectations are rising around the world.

In the U.S. specifically, the mean response is that core inflation, as measured by the consumer price index excluding food and energy, will be running 1.8% a year from now. That is up from 1.4% when the survey was last done in November and up from February’s actual reading of 1.1%. The survey polled about 750 respondents, with about 40% from North America.

The report notes the recent jump in oil prices and the longer-running increase in commodity prices may be skewing responses. But the report notes core inflation rates have already been rising in the U.S. and the U.K.

Duh?!

Core inflation expectations have long been rising around the world! Don’t these experts see that the REVOLTS in the Middle East have partly been triggered by record food prices??!!!

Chart from Business Insider

Next, price pressures are “transitory”???!!!

The IMF even says that people should get used to high food prices for all other reasons except macroeconomic government policies. The IMF is part of mainstream macro.

From the Bloomberg,

Consumers should get used to paying more for food, after prices rose to a record, because farmers will take years to expand production enough to meet demand and drive down costs, the International Monetary Fund said.

People in developing countries are becoming richer and eating more meat and dairy, meaning more grain for livestock feed and land for grazing animals, Thomas Helbling, an adviser for the IMF’s research department, and economist Shaun Roache wrote in an article. Rising demand for biofuels and bad weather also tightened supply, they said.

“Rising food prices may be here to stay,” Helbling and Roache wrote in the article published in the agency’s Finance & Development magazine. “The main reasons for rising demand for food reflect structural changes in the global economy that will not be reversed.”

True, food prices signify a minor component in the household expenditure pie for developed economies. But that doesn’t mean that rising oil, food and commodity prices won’t spillover to the rest of the economy. Eventually they will!

Chart from Northern Trust

When models try to isolate variables from people’s action (like isolating food and energy from inflation index as shown above-right window), then experts tend to underestimate real social activities, like inflation.

People do not act based on one or two or select variables. Our actions are bundled, as I previously wrote

We cannot isolate one variable from the other. People’s actions are responses to an ever dynamic “bundled” environment shaped by laws, markets, culture, environment, etc...

Bottom line: macroeconomics tends to deal with superficial issues that are bottled up in laboratory environment models rather than lay blame on what truly causes CPI inflation—inflationism (low interest rates and money printing) and interventionism (price controls, subsidies and etc..).

Inflation Expectations: The Widening Chasm Between Households And Experts

Despite mainstream experts blabbering about deflation, we’ve been defiantly predicting for a long long long long time that inflation would be coming and would pose as the next real risk (everywhere).

That’s because it has been the instinctive/intuitive approach by central bankers to use their printing presses as antidote to perceived economic predicaments. (Despite years of experience people never learn and always find ways to perpetuate policies anchored upon acquiring “something from nothing”-which I would call “political greed”)

And reemergent “consumer price” inflation represents as the “unintended consequence” and “symptoms” from such persistent policies.

This report from the Wall Street Journal’s Blog, (bold emphasis original)

Consumers see more inflation ahead. That views puts them at odds with Federal Reserve officials and private sector economists.

According to Friday’s consumer sentiment survey released by Reuters/University of Michigan, inflation expectations have been rising since late summer. Back in September, U.S. consumers expected the inflation rate one year out to hit 2.2%. In early-February, the one-year expected inflation rate is up to 3.4%.

Contrast that rate with the tamer forecasts at the Fed and among private economists.

On Wednesday, Fed chairman Ben Bernanke told the House Budget Committee that “inflation is expected to persist below the levels that Federal Reserve policymakers have judged to be consistent over the longer term with our statutory mandate to foster maximum employment and price stability.”

In the US, it’s hardly true that mainstream private sector experts have been on the “inflation risk” camp, many, if not most, have sided with officials to claim inflation hasn’t been a threat mostly because of “output gap", “capacity utilization”, “unemployment” conditions and etc...an example of this outlook can be read here

Yet the “man on the street” sees things differently.

More from the same article, (bold highlights mine)

How can households be more hawkish about inflation than the Fed?

Much of the dichotomy reflects which prices are in focus. The Fed and economists tend to pay attention to core inflation, which ignores food and energy and which better reflects underlying economic conditions. Households pay more attention to the items most frequently bought, in particular gasoline and groceries.

See the difference?

The expert-official camp fundamentally relies on statistical data which isolates real world variables.

Meanwhile, households feel the pressure from relative price changes that affects their overall purchasing power based budgets.

The end result: A massive detachment between expert-official opinions and real events which shapes household’s expectation.

The use of statistical data can be manipulated to the extent that it will be (has been repeatedly) used to justify the imposition of ideologically based policies (mostly predicated on mathematical models).

Again to quote Mark Twain,

There are three kinds of lies: lies, damned lies and statistics

Eventually statistical chicanery backfires, as the above developments shows.

Ireland’s Woes Won’t Stop The Global Inflation Shindig

``When governments try to confer an advantage to their exporters through currency depreciation, they risk a war of debasement. In such a race to the bottom, none of the participants can gain a lasting competitive edge. The lasting result is simply weaker and weaker currencies against all goods and services — meaning higher and higher prices. Inflationary policies do not confer lasting advantages but instead make it more difficult to plan for the future. Stop-and-go inflationary policies actually reduce the benefits of using money in the first place.” Robert P. Murphy Currency Wars

For the mainstream, effects are usually confused with the cause to an event. And the misdiagnosis of the symptoms as the source of the disease frequently leads to the misreading of economic or financial picture which subsequently entails wrong policy prescriptions or erroneous predictions.

Yet many mainstream pundits, whom has had a poor batting average in predicting of the markets, have the impudence, premised on either their perceived moral high grounds or their technical knowledge, to prescribe reckless political policies that would have short term beneficial effects at the costs of long term pain with a much larger impact.

Take for instance currency values. Many pundits tend to draw upon “low” currency values as the principal means of attaining prosperity via the “export trade” route. As if low prices mechanically equates to strength in exports. And it is mainly this reason why these so called experts support government interventionism via currency devaluation.

Yet what is largely ignored is that in the real world most of the world’s largest exporters have currencies that are relatively “pricier”, and that most of the “cheap” currency economies tend to be laggards in trade—the latter mostly being closed economies.

In contrast to mainstream thinking, prosperity isn’t about the unwarranted fixation of currency values, but about societies that promotes competitiveness and capital accumulation.

As Ludwig von Mises once wrote[1], (bold emphasis mine)

The start that the peoples of the West have gained over the other peoples consists in the fact that they have long since created the political and institutional conditions required for a smooth and by and large uninterrupted progress of the process of larger-scale saving, capital accumulation, and investment.”

In other words, prosperity emanates from a society which respects the sanctity of property rights premised on the rule of law, which subsequently acts as the cornerstone or foundations of free trade and economic freedom that shapes the state of competitiveness of the economy.

The allure of the polemics of “cheap” currency is no less than “smoke and mirror” chicanery aimed at promoting the interests of a politically privileged class that does little or nothing to advance general welfare.

In short, what is being passed off or masqueraded as an expert economic opinion, is no less than a political propaganda.

Discipline As Basis For Bearishness?

And this applies as well to debt.

Many see the humongous debt load by developed nations as the kernel of the most recent economic crisis. They also use the debt argument as the main basis in projecting the path of economic and financial progress.

Yet debt serves NOT as the principal cause, but as a SYMPTOM of an underlying cause.

It is the collective monetary and administrative policies that have promoted debt financed consumption predicated on the presumed universal validity of AGGREGATE DEMAND that has been responsible for most of the present woes. This has largely been operating for the benefit the government-banking industry-central banking cartel worldwide[2]. Yet such irresponsible policies have spawned endless boom bust cycles and outsized government debts from repeated bailouts and various redistribution schemes which ultimately end in tears. Yet no lesson is enough to restrain these pundits from making nonsensical rationalizations of encouraging a repeat of the same mistakes.

The point is, redistribution has its limits, and we may be reaching the tipping point where the natural laws of economics will undo such false economic premises. And this would represent the grand failure of Keynesian economics from which today’s paper money standard has largely been anchored upon.

For instance the current woes in Ireland, which has not been about the imploding unwieldy social welfare programs yet, but has been about the BLANKET GUARANTEES issued by the Irish government to some of their major ‘too big to fail’ banks, have been used by perma bears to argue for the revival of the ‘deflation’ bogeyman.

While the Ireland debt crisis seem to share a similar characteristic to that of the experience of Iceland[3] in 2008, where the presumed ascendancy or infallibility of government “guarantees” crumbled in the face of economic laws, Ireland’s case is different in the sense that there appears to be political manoeuvring behind the pressure for the latter to comply with the proposed bailout.

Rumors have been rife that the proposed bailout of Ireland have been meant to raise Ireland’s exceptionally low 12.5% corporate tax rates, which has been an object of contention by European policymakers, most especially by the European Central Bank (ECB)

According to the Wall Street Journal[4],

``Brussels has always resented that Ireland transformed its economic fortunes by cutting corporate income taxes and marginal tax rates. At various times, the EU has sued Ireland to raise its rates, accused it of "social dumping" for having a 12.5% corporate income tax, and threatened to cut off European subsidies unless it hiked taxes. None of it worked, but now, with Ireland's banks teetering and its economy in its worse shape in a generation, Europe is moving in for the kill.”

And what better way to compel Ireland to accede to the whims of the bureaucrats in Brussels than to force a crisis from which Ireland would need to accept political conditionalities in exchange for a rescue!

Of course, politicians such as French President Nicolas Sarkozy had been quick to deny the political blackmail[5], saying that “But that’s not a demand or a condition, just an opinion.”

However the important point is that what is being misread by the mainstream as an economic predicament is actually a self inflicted mayhem arising from the political ruse meant at achieving certain political goals.

And unelected politicians have used the markets, largely conditioned to the moral hazard of bailouts and inflationism, to advance their negotiating leverage.

Another point I wish to make is that Euro bears have emphasized that the decision by some Eurozone members to assimilate fiscal austerity has been interpreted as a reason to be bearish on the Euro.

For this camp, the alleged political angst from imposing fiscal discipline would allegedly force the disintegration of the currency union. This is plain AGGREGATE DEMAND based hogwash.

How can it be bearish for individuals or nations (which comprises a community of individuals within defined territorial or geographical boundaries) to act on cleaning up their balance sheets? The excuse is that the lack of AGGREGATE DEMAND will pose as a drag to the economy undergoing the process of “develeraging” from which the government should takeover. What works for the individuals does NOT work for the nation.

Of course the distinction of the paradox can viewed based on time preferences: short term negative and long term positive. People who emphasize on the long term see the positive effects of the structural adjustments even amidst the necessary process of accepting short term pain. Like any therapeutic process, it takes time, regimented diet and regular exercise to recover. There is no short cut, but to observe and diligently work by the process.

On the other hand, there are those who cannot accept any form suffering, or the entitlement mentality. And this mindset characterises the advocates of short term policy fixes.

For politicians who depend on the electoral process to remain in office, any form of suffering represents a taboo as this would signify as loss of votes and consequently the loss of office. Thus, politicians have used short term premised Keynesian economics to justify their actions mostly via the magic of turning bread into stones—printing money.

For unelected bureaucrats the incentives are almost similar, the consequences of any imbalances must be kicked down the road and burden the next officeholder.

For academic or professional supporters, whom are employed in the industries that have privileged ties with the government or whose institutions are funded directly or indirectly by the government, they serve as mouthpieces for these interest groups by embellishing propaganda with expert opinion covered by mathematical models.

The point is this that the AGGREGATE DEMAND paradigm from debt based consumption is not only unsustainable but unrealistic. Yet mainstream experts purposely confuse interpreting the effects as the cause to advance vested interest or for blind belief from dogmatism.

Remaining Bullish On The Euro

And having to confuse effects with the cause is one way to take the wrong side of the markets.

Figure 1: Ireland Government’s Spending Binge

As we pointed out above it is not debt but the incentive by politicians to spend taxpayer money to the point of accruing heavy debt loads that has aggravated the present woes.

As Cato’s Dan Mitchell[6] points out in the case of Ireland,

``When the financial crisis hit a couple of years ago, tax revenues suddenly plummeted. Unfortunately, politicians continued to spend like drunken sailors. It’s only in the last year that they finally stepped on the brakes and began to rein in the burden of government spending. But that may be a case of too little, too late.”

And contrary to the outlook of the Euro bears, the incumbent low corporate taxes seem likely to attract many investors into Ireland.

According to the Economist[7],

IDA Ireland, the agency that targets such investors, says FDI in 2010 will be the best for seven years. A new generation of firms, including computer-gaming outfits like Activision Blizzard and Zynga, are joining the established operations of Intel and Google. Ireland’s workforce is young, skilled and adaptable. Rents are coming down even faster than wages.

So not limited to low taxes, Ireland’s less activist government has resulted to more market based responses in the economy that seems to have also been generating incentives for investors to react positively in spite of the ongoing crisis.

Euro bears are wrong for interpreting discipline and responsible housekeeping as a bearish sign, and equally mistaken for prescribing unsustainable policies that play by the book of mercantilists.

We must be reminded of Professor von Mises’ advise on assessing currency values where ``valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money”[8]

This means that in terms of relative policies between the US and the Eurozone, the policy of inflationism as administered by the US monetary authorities, seem to tilt the relationship between the quantity (via Euro austerity) and demand, in favour the Euro, whose rally we have rightly predicted[9] in mid of this year.

Alternatively this means that any dip should be considered as a short term countercyclical trend or must be considered a buying window.

Misunderstanding Deflation

Finally, those who continually obsess over the prospects of a deflation environment similar to that of the Great Depression are bound to be incorrigibly wrong.

The Great Depression wasn’t not only a result of contraction of money supply via collapsing banks, but likewise the curtailment of trade from rampant protectionism (Smoot Hawley) and obstructionist policies (regime uncertainty) that inhibited the incentive of the public to invest.

Left to its own devise and unobstructed by government, the marketplace would result to an optimal supply of money. This means for as long as globalization remains operational there won’t be “deflation”.

As another great Austrian Economist, Murray N. Rothbard explained[10],

But money is uniquely different. For money is never used up, in consumption or production, despite the fact that it is indispensable to the production and exchange of goods. Money is simply transferred from one person’s assets to another. Unlike consumer or capital goods, we cannot say that the more money in circulation the better. In fact, since money only performs an exchange function, we can assert with the Ricardians and with Ludwig von Mises that any supply of money will be equally optimal with any other. In short, it doesn’t matter what the money supply may be; every M will be just as good as any other for performing its cash balance exchange function.

If there is any deflation it won’t be from what the mainstream expects, because price deflation would emanate from productivity growth instead of debt deflation, Think mobile phones or computers.

And that’s the reason why perma bears have gotten it miserably wrong, even all the credit indicators previously paraded to argue their case based on the flawed AGGREGATE DEMAND have NOT materialized[11] and worked to their directions.

Now that these indicators either have bottomed out or have manifested signs of improvements, they have NOT been brandished as examples.

So perma bears have been desperately looking for scant real world evidence to support their views.

Bond Markets Reveal Upsurge In Inflation Expectations

IF there would be any ONE thing that would crush the ongoing liquidity party it would be a chain of interest rates increases that eventually would reach levels that would trigger many projects or speculative positions financed by leverage or debt as unprofitable. This would be the credit cycle as narrated by Hyman Minsky.

This means that a bubble fuelled by systemic leverage would be pricked by the proverbial interest rate pin that would unleash a cascade of asset unwinding. This has been a common feature of our paper money system which only shifts from certain asset markets to another.

The motion of rising interest rates would surface from a pick-up in credit demand, which may reflect on policy induced illusory economic growth, broad based consumer inflation as a consequence to sustained monetary inflation or a dearth of capital, which may be prompted for by a surge of protectionism, a collapse in the banking system or snowballing questions over the credit quality on major institutions, if not on claims on sovereign liabilities.

Figure 2: Municipal Bonds by Rising Yields Over The Long End

Despite the recent statistical reports of muted consumer price inflation which marked “the smallest increase since records started in 1957”[12], one must be reminded that consumer price indices represent a basket of goods, services and assets based on the construct of the US government. And these hardly reflect on the accuracy of the real rate of consumer price inflation because they are determined based on the interpretation of government technocrats on what they perceive constitutes as a meaningful measure of “inflation” based on the aggregate assumptions.

So even if food and oil prices have been rising (CCI index in figure 2) it appears that these increases have hardly filtered into the government’s statistical data.

Yet the contradiction appears to have been vented on the bond markets as US treasury yields surge across the long end of the curve as seen in the US 1 year yield (UST1Y) and the 10 year yields (TNX).

As we have been echoing the view of Austrian economists, the inflation which signifies as a political process, would have uneven effects on the economy.

As Professor von Mises wrote, (bold highlights mine)

``Changes in money prices never reach all commodities at the same time, and they do not affect the prices of the various goods to the same extent. Shifts in relationships between the demand for, and the quantity of, money for cash holdings generated by changes in the value of money from the money side do not appear simultaneously and uniformly throughout the entire economy. They must necessarily appear on the market at some definite point, affecting only one group in the economy at first, influencing only their judgments of value in the beginning and, as a result, only the prices of commodities these particular persons are demanding. Only gradually does the change in the purchasing power of the monetary unit make its way throughout the entire economy.

So yes the ‘definite point’ where the symptoms of inflation appear to emerge can be seen in emerging markets, commodities and commodity related industries, with the succession of growing inflation expectations permeating presently into the bond markets.

Remember, recently investors bought into US Treasury Inflation Protected Securities (TIPs) at negative interest rates[13] indicative of mounting expectations of the resurgence of inflation.

So pundits sarcastically questioning “inflation where” are misreading the gradualist dynamics of deepening and spreading inflation. They will instead show you employment data and output gap to argue for “no” inflation regardless of what the bond, stockmarket and commodity markets have been saying.

The other sins of omission by the mainstream has been to read present trends as tomorrow’s dynamics.

Now the tax free US municipal bond markets had likewise been slammed by the surging treasury yields (despite the Fed’s QE 2.0 aimed at keeping interest rates at artificially low levels). As long term US treasury yields have soared, so has these tax free yields.

Other reasons attributed[14] to the recent collapse in muni bond markets have been the expectations of more issuance from many revenue strained states and the potential abbreviation of issuance of Build American Bonds (BABs) given a gridlocked in the US House of Congress, which may have prompted for a deluge of offering in order beat the deadline.

In my view, all these other excuses appear to be secondary to the deepening trend of inflation expectations.

Of course rising interest rates would also put more pressure on the already strained recovery in the US housing markets which I believe has been the object of QE 2.0.

Yet earlier this year we have debunked claims by the government officials and the mainstream pundits supporting the notion of “exit strategies” which I labelled as Poker bluff[15]. (Yes we are once again validated)

And this means that further stress into the housing markets which would translate into balance sheet problems for the US banking system will be perceived by officialdom as requiring more QE’s. So you can expect the Federal Reserve to feed on more QEs as strains on the housing sector remain unresolved.

Another beneficiary of the QE has been the US Federal government. While government spending may be curtailed under the new US Congress, concerns by emerging markets over “currency wars” may lead to less appetite in financing of US debts. This implies that the US will likely resort to the age old ways of financing deficits-debase of the currency. In short, more QEs to come.

So what all these imply for the markets?

It’s still an inflation shindig ahead.

Of course considering the inflation process distorts the market mechanism, we should expect sharp swings in the upside as well as the downside, but with the upside trend becoming more dominant as US monetary authorities resort to more QEs which will be transmitted globally.

Nevertheless, the so-called “crack up boom” or the flight from paper money appears to be taking place worldwide as gold has been fervently rising against all currencies.

With markets expectations over inflation getting more widespread, stay long commodity or commodity related investments.

Lastly, avoid the confusion trap of misreading effects as causes.

---

[1] Mises, Ludwig von, Period of Production, Waiting Time, and Period of Provision, Chapter 18 Section 4, Human Action

[2] See QE 2.0: It’s All About The US Banking System, November 8, 2010

[3] See Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?, October 14, 2008

[4] Wall Street Journal Editorial Target: Ireland, October 5, 2010

[5] Bloomberg.com Ireland Aid From EU Won’t Require Tax Increase, Sarkozy Says, November 21, 2010

[6] Mitchell, Daniel J. Don’t Blame Ireland’s Mess on Low Corporate Tax Rates, November 18, 2010

[7] The Economist, Saving the euro, November 18, 2010

[8] Mises, Ludwig von Monetary Stabilization And Cyclical Policy (1928) The Causes Of The Economic Crisis, p.18

[9] See Buy The Peso And The Phisix On Prospects Of A Euro Rally June 14, 2010

[10] Rothbard, Murray N. Mystery of Banking, p. 34

[11] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[12] Reuters.com Dollar hampered by tame U.S. inflation data November 17, 2010

[13] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[14] Mousseau, John The Spike in Muni Yields - an Opportunity, cumber.com November 16, 2010

[15] See Poker Bluff: The Exit Strategy Theme For 2010, January 11, 2011

Just a short note on equity markets…

``There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.”- Peter L. Bernstein Insight: The flight of the long run

At the start of the year, we propounded the scenario where 2009 could likely manifest some divergences in the global equity markets.

Despite the continuous decline in the major US equity bellwethers, we seem to be seeing some marginal proof of such transitioning.

Figure 7: stockcharts.com: Emerging Divergences Among Global Equities?

Although pressures from the worsening recession in the US continues to weigh on most Emerging Market bourses, the degree of decline hasn’t been as steep or as deep, based from December 23^rd of 2008, as shown in figure 7.

Probably this could be because most EM bourses fell steeply more than US benchmarks in 2008. As discussed in Black Swan Problem: Not All Markets Are Down in 2008!, In 2008, the US fell 38.49%, Chile lost 22.13%, Brazil 41.22%, Malaysia 39.33%, Thailand 47.56%, Indonesia 50.64% and the Philippines 48.29%.

In fact, the current losses of the US bellwethers seem to match, if not exceed, the losses attained by some of these bourses at their lows.

Nonetheless we seem to be seeing some outperformers: Chile lost only 22.13% during the dramatic meltdown in 2008 but is already slightly up on a year to date basis. We also see Venezuela (growing signs of dictatorships gaining acceptance?) and Colombia among the other Latin American honor roll.

Across the ocean, we have Morocco and last year’s member of the 3 amazing bourses which defied the tide, Tunisia as another hotshot. This, despite the global economic woes affecting their exports and tourism revenues, aside from a sharp slowdown in the national economic growth.

To quote Marion Mühlberger of Deutsche Bank, ``So it looks as though Tunisia cannot decouple completely from the global financial crisis but is unlikely to suffer any major economic or banking crisis”. Probably not in terms of traditional economic metrics but certainly has “decoupled” in terms of financial markets performance in 2008.

Not that we believe that this is anything about “economic recovery”, but from the monetary viewpoint, the potential response stems from the impact from we believe as the liquidity spillover or our “spillage effect” from the collective attempts by central banks and governments to inflate asset markets and the economies. Governments are essentially driving the public to speculate and turbocharge asset inflation.

As we noted above, the losses have vacuumed most of the liquidity generated by global authorities, although last week’s surge in select commodities as oil (+11.82%) and copper (+7.7%) seem to validate our supposition of a prospective spillover. Albeit Gold’s (6%) decline could be indicative of an emerging rotation, or possibly, rebalancing of the Gold-oil ratio which has surged to record levels in favor of gold.

Figure 8: PSE: Sectoral Performances

Finally we seem to see the same signs of divergences even in the Philippine Stock Exchange (figure 8).

Based on sectoral performance on a year to date basis we see commercial industrial (pink-up 15.27%) and the mining sector (green up 11.75%) outperforming the rest of the field- Property blue (-9.47%), banking black (-10.79%), holding red (-1.51%), all maroon (+1.17%) and service orange (+1.34%).

The surge in the commercial industrial has been powered by energy stocks.

The Phisix (-.03% year to date) continues to drift sideways which implies a likely bottoming cycle, despite the October like performance in the US. This seems largely due to the diminished scale of foreign selling activities which may have validated our assessment of the deleterious impact of forcible selling or delevaraging to the local equity market, regardless of fundamentals.

Nonetheless, if we see a continued rise by the present market leaders, then this “inflationary driven” run may start to spread over to the broader market. And people may start to read market prices as “justification” of an economic “recovery” and pile on them; even when this may be due to sublime responses to monetary policies.

However, we will need to be further convinced with technical improvements on some key local and select benchmarks, aside from key commodity prices and similarly progress in domestic market internal activities.

Do Governments View Rising Gold Prices As An Ally Against Deflation?

``One day the price of gold will be higher than the Dow Jones.”-Dr. Marc Faber

As gold nears its all time high see figure 7, public awareness in gold seems to be snowballing.

Figure 7: World Gold Council: Two Remaining Currencies Where Gold Has Yet To Establish Record High

There are only two major currencies wherein gold trades below its record high; one is the US dollar and the other is the Japanese Yen.

The chart above courtesy of the World Gold Council was last updated February 13^th. But as of last Friday’s close, Gold in US dollar terms was seen nearly leveling on its previous high at 1,004.

When gold rises across all currencies, this is symptomatic of a systemic monetary disorder than just mere inflation. There appears to be an accelerating realization that paper currencies issued and guaranteed by the global governments are becoming less sacrosanct, or people have been exhibiting diminished “faith” on the present financial architecture or this has been reflective of paper money’s “race to the bottom” or the effect of the collective efforts by governments to debauch or even destroy their currencies.

Nonetheless, a recent article at the Financial Times had this unusual observation; it noted that rising gold prices seem to be operating under the auspices of governments.

This from Mr. Steve Ellis of RAB Gold Strategy at the FT.com,

``Speaking to central bankers, this is the first time I can recall them actually favouring a high gold price. Normally they see high gold prices as a lack of trust in the financial system (not to mention their ability as central bankers). Alan Greenspan, the former Fed chairman, for example used to target a gold price of around $400 to $500 an ounce.

``Recently, the central bankers have become more enamoured of higher gold prices as it would suggest that their attempts to stave off deflation were starting to work.

``Central bankers in favour of higher gold prices? Things really have changed.”

Gold’s moniker, the “barbaric metal” had been contrived by interventionists because it functioned as rabid nemesis to elastic currency or the ability of authorities to inflate the system to appease the political gods.

Thus, could central bankers truly see gold as an ally against their campaign deflation?

Three reasons why we think this is possible.

Inflation Expectations Needs To Be Reshaped

One, for central bankers, it’s all about signaling channels. This is usually known as the managing of inflation expectations, where the central bank communicates to the markets their policy intentions as to project stability.

In a recent speech, US Federal Reserve chair Ben Bernanke said, ``increased clarity about the FOMC’s views regarding longer-term inflation should help to better stabilize the public’s inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low.”

You see central bankers believe that inflation can function like a light switch that can be turned on or off, or like a genie that be called in and out of his lamp.

Unfortunately, this is an academic and bureaucratic delusion. In as much as authorities failed to predict the catastrophic consequences of a bursting bubble, they’ve nonetheless equally botched any attempt to rein its deflationary reaction. So they are now hoping that by unduly taking on the inflation risk, they can manage to steer it successfully once the crisis pasts. But like the recent activities, the inflation genie will most likely elude them, until the next crisis surfaces.

Yet by pushing and maintaining interest rates at near zero levels, and the policy shift to adopt the tactical measures of “quantitative easing”, most major central banks (US, Swiss, UK, Japan) appear to be communicating their desire to reignite inflation as means to restore the credit flow.

However, this hasn’t been the entire truth, as we have repeatedly pointed out- the colossal debt structures of the bursting bubble economies require governments to inflate away the real debt levels.

In addition, government’s use of the fiscal medicine to deal with national or domestic economic malaise serves as a parallel approach to stoke inflation in the economy regardless of how ineffectual such efforts are.

Nevertheless, we have almost every government in the world today rehabilitating their domestic economies by instituting inflationary policies. Thus, if gold’s rise should signify as resurgent “inflation” then governments are likely to reticently “cheer” on it.

Enhancement of the Balance Sheet of the US Federal Reserve

Two, if the aim of the US Federal Reserve is to enhance its balance sheet, a revaluation of gold reserves might be necessary.

Using the “backing theory”, which means that the currency’s worth is determined by the underlying assets and liabilities of the issuing agency (wikipedia.org), the Federal Reserve’s attempt to debase its currency is done by absorbing more toxic assets to its balance sheet.

According to Philipp Bagus and Markus H. Schiml, ``Since the crisis broke out, the Fed has continuously weakened the quality of the dollar by weakening its balance sheet. In fact, the assets the Federal Reserve holds have deteriorated tremendously. These assets back the liability side of the balance sheet, which mainly represents the monetary base of the dollar. The assets of the Fed, thereby, hold up the value of the dollar. At the end of the day, it is these assets that the Fed can use to defend the dollar's value externally and internally. Thus, for example, it could sell its foreign exchange reserves to buy back dollars, reducing the amount of dollars outstanding. From the point of view of the buyer of the foreign exchange reserves, this transaction is a de facto redemption.” (bold highlight mine)

Hence, under the backing theory, it isn’t just quantitative easing (printing of money) that determines the currency value but also the qualitative aspects (or what it buys for the asset side of its balance sheet).

Again from Mssrs Bagus and Schiml, ``Despite of all these efforts, credit markets still have not returned to normal. What will the Fed do next? Interest rates are already practically at zero. However, the dollar still has value that can be exploited to keep the experiment going. Bernanke's new tool is the so-called quantitative easing. Quantitative easing is when a central bank with interest rates already near zero continues to buy assets, thus injecting reserves into the banking system. In fact, quantitative easing is a subsection of qualitative easing. Qualitative easing can be defined as the sum of the policies that weaken the quality of a currency.”

Simply said, as the Federal Reserve increasingly digests poor quality of assets into its balance sheet, this effectively reduces its equity ratio from which would eventually translate to its insolvency.

Hence, this would leave the US Federal Reserve with only two options, according to Mssrs Bagus and Schiml, ``Only two things can save the Fed at this point. One is a bailout by the federal government. This recapitalization could be financed by taxes or by monetizing government debt in another blow to the value of the currency.”

``The other possibility is concealed in the hidden reserves of the Fed's gold position, which is only valued at $42.44 per troy ounce on the balance sheet. A revaluation of the gold reserves would boost the equity ratio of the Fed.”

High gold prices would eventually be required for gold to be revalued to enhance the balance sheet of the US Federal Reserve.

End To Gold Manipulation?

Lastly, the surging gold prices suggest an end to possible gold manipulation.

It has been long contended by groups like the GATA that central bank gold reserves has been unofficially “sold”, through lease, swaps and derivatives to the markets, hence gold stashed in the central bank books have simply been accounting entries.

Mr. Robert Blumen of Mises.org cites a report from where a broker endorsed the suspicion of gold manipulation; says Mr. Blumen, ``The major conclusion of the report is that the western central banks have sold a larger fraction of their gold reserves than they acknowledge in their official statements. The gold has entered the market through derivatives such as leases, swaps, the writing of call options against the gold. The sale of the gold is obscured in the central banks books through the representation of leased, swapped, and otherwise encumbered, aggregated together with actual physical gold held in vaults as a single asset on their books. An estimated 10,000-15,000 tons of gold has entered the market since 1996 (compared to an official number of 2,000-3,000) through these mechanisms, according to the report. The purpose of these covert gold sales is part of a larger effort to disable the functioning of inflation indicators, which operate to limit central bank credit expansion.”

Gold’s recent rise has been primarily investment demand driven, see figure 8.

Figure 8: gold.org: Surging Investment Demand

The implication of which is a shift in the public’s outlook of gold as merely a “commodity” (jewelry, and industrial usage) towards gold’s restitution as “store of value” function or as “money”.

The greater the investment demand, the stronger the bullmarket for gold.

If the estimated number of 10,000 to 15,000 tons, is anywhere close to being accurate, then this translates to 40-50% of world central bank gold reserves of 29,697.1 tonnes (gold.org as of December 2008) as having been “shorted”.

Therefore, “short” positions in a rampaging gold bullmarket will extrapolate to additional national balance sheet losses. This implies that world governments, whom are net short positions, will likely be net buyers in the near future.

Although I haven’t been totally convinced about the “gold manipulation theory”, I am, however, open to it, in the understanding of the political nature of central banking. Central bankers don’t want competition or interference from gold, thus, the odds that price controls may have attempted in the past.

The implication is that the bullmarket in gold will possibly be accelerating once governments’ covers open short positions. And if we see $100 dollar a day moves, perhaps this theory might be validated.

And since the gold market is an iota or about 6% or $5 trillion (165,000 tonnes of above ground gold) relative to the overall financial markets, this suggests that a bullmarket market will likewise spillover to important key commodities as silver, copper and oil.

Moreover, any panic into gold will likewise see a panic to own producers, which functions as proxy to gold by virtue of reserves.

For now, central bankers would likely to be “sleeping with the enemy”.