On Bailouts: Left Hand Doesn't Know What The Right Hand Is Doing; Asymmetric Market Signals

``Monetary policy, at bottom, is not independent of fiscal policy. While reckless fiscal policy invariably ends in attempts to “monetize” the government's debt by printing money instead of issuing bonds, inflation is ultimately always and everywhere a fiscal phenomenon. Money and bonds are essentially portfolio substitutes, and interest rates fluctuate in order to ensure that the existing quantities of both assets are held in equilibrium.”-John Hussman Ph.D., Hussman Funds

Anent the Bank of England’s bailout of Northrock: As we always insist, Bailouts or government interventions have always been a manifestation of the ETHICAL PROBLEM—political authorities’ preference for a “treatment based solution” instead of a preventive cure, aside from its INFLATIONARY CONSEQUENCES in light of the quest to preserve the health of the prime conduits of today’s functioning FIAT MONEY Standard.

The risks of inflation and the MORAL Hazard problem has always been used as the perpetual POLITICAL SLOGAN of which these institutions proclaim as their nemesis, but behind the scenes surreptitiously work to uphold…or a case of a “left hand doesn't know what the right hand is doing.”

Allow me to quote PIMCO’s Paul McCulley anew (highlight mine), ``Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation. The question is not whether the Fed Put exists, but where is its strike price?”

For instance, some would readily believe the propaganda that the FED’s utilization of its REPO tool constitutes only of a substitution of liquidity or does not translate to monetary inflationary. While on the surface, such arguments look plausible, on a deeper context, particularly viewed within the TIME VALUE of Money frame, REPO activities are evidently inflationary.

Minyanville.com Professor Succo or Mr. Practical has a trenchant explanation (highlight mine),

``But the main point is that it is not the Fed that creates liquidity in an economy; it is the commercial banking system. What the Fed (mostly) provides is the temporary liquidity for these banks to do so.

``Large money center banks lever their assets. They take deposits and CDs and REPOs as liabilities and lend money and buy securities as assets with it. Every time they take in money via a liability they earn a spread (taking risk). So first, the writer is not understanding the time value of money: those REPOs, even though they have to be paid back, earns spreads over their life. This is liquidity for banks. And that spread, once earned, gets levered – voila – 10 to 1 or more.”

``Here is the problem. All those risky securities the banks have been carrying and earning spreads on have fallen slightly in value. Because of the immense leverage, just this small mark down of assets had seized up the banks from lending more money as they have to keep more cash to finance the lower mark on the assets. The temporary REPOs by the Fed act to finance those mark downs. The banks are “hoping” that their value goes up during the duration of the REPO. If they do not, the Fed will have to roll them and that liquidity becomes more permanent. Few people realize just how little the value of those assets held at banks have to fall before all the world's banks' capital is wiped out.”

In today’s world of the fractional banking system, whose degree of leverage has been equally reflected outside the banking sphere, a marginal fall in asset prices owned by banks or other financial institutions could pose as sufficient risk enough to destabilize the entire financial system. Hence, monetary authorities being aware of these conditions have been quick to respond to any incidences of heightened volatility.

So to suggest an answer to Mr. McCulley, the strike price could be the 10% threshold in the US equity market which has recently been touched and correspondingly has sparked an outcry for political subsidies.

And as we have pointed out repeatedly in the past, the markets have already priced in a FED “bailout” or a rate cut even prior to the FED’s action which is slated this September 18^th, as shown in Figure 2. The argument today is the depth or degree of the whole process.

Figure 2: ChartoftheDay.com: Effective FED FUNDs RATE

So whatever gains we have recently seen has been CONCRETIZED on the foundations of such expectations.

Of course, there is always the “BLACK SWAN” risk that the FED might do otherwise. But such actions could unleash violent reactions in the financial markets with unseen magnitude and repercussions, which we think the Mr. Bernanke and Company would be unwilling to gamble with.

Besides, given the inherent predilections of the authorities, even exhibited by those across the Atlantic, this paints Mr. Bernanke to the corner.

Anyway, evidences have been escalating where signs of the credit crisis, once confined to the jurisdictions of Wall Street, have now started to take its toll at MAIN Street, see Figure 3. This should help justify Mr. Bernanke’s prospective action.

Figure 3: New York Times: Double Warning On Recession

When mainstream media broaches of a trend, it usually signifies either an accelerating momentum or it could also mark a peak of a deeply entrenched trend.

In this case we believe that it is the former, since the Recession chatter has hardly hit the mainstream airwaves, until last week.

Mr. Floyd Norris in an article entitled “Double Warning That a Recession May Be on the Way”, opens with (emphasis mine), ``THE employment statistics and the bond market are combining to send out a warning that has been heard only rarely in the past two decades: A recession is coming in the United States.”

Mr. Norris points to the bond market’s negative yield curve as a precursor, punctuated by the recent job numbers as potential harbinger of a US recession. Of course, the August retail figures likewise points to a meaningful softening of the US economy.

In addition, even inveterate bull as Larry Kudlow has raised his recession probability forecasts to 50%!

What we are trying to point out is that there is a SNOWBALLING trend from the fringes to the mainstream forecasting of a hard landing for the US.

While we do not adhere to sentiments of the consensus (none I think correctly predicted the US payroll losses last September 7^th) especially during MAJOR inflection points, we think that a good number of these forecasters are riding on the RECESSION bandwagon to use the occasion to apply PRESSURE on the authorities to do SOMETHING to save the markets.

Yes, US equity markets have impressively climbed above its downtrend line as depicted in Figure 4.

Figure 4: Stockcharts.com: VIX Still on an Uptrend

US benchmarks registered substantial gains this week, the Dow Jones Industrials up 2.5% (upper window) while the S&P 500 was higher 2.11% while the Nasdaq rose 1.42%.

Meanwhile, the volatility indicator as shown by the VIX index at the main window, still hovers above the 20 levels and most importantly reveals of an uptrend which implies that there could be further bouts of selling in the offing.

Technically while the US benchmarks have popped beyond some critical thresholds such as resistance levels, moving day averages and downtrend lines, they were accompanied by LOW and DECLINING volume, which makes as us skeptical of the recent recovery.

Further, most of the recent gains came at the near end of each of the sessions, which has fueled speculations of U.S. government’s handprints.

One must remember that bond markets and credit conditions are not within the ken of the public since these are usually transacted within the confines of the specialized institutions, whereas stocks have more a permeating psychological bearing to the public. So based on incentives alone, it wouldn’t a far fetched notion for US authorities to meddle with the futures market to fillip these benchmark indices.

So what we have here is an asymmetry of market signals; bond markets still suggesting for a marked slowdown, credit conditions remain extremely tight (hence the wide spreads), US dollar broke below the 80 level coupled with and rising commodities as RECORD WHEAT, RECORD OIL, and a BREAKOUT in gold indicative future inflation, while stock markets have been climbing on expected bailouts.

Such incongruence will be sorted sooner rather than later and will prove some of these markets wrong.

As for Asia, we are seeing a conspicuous recovery in the GMF SPDR S&P/Citigroup Emerging Asia Pacific index exhibited by the lower pane. Since the index contains publicly listed companies from the Asia Pacific Region as China, India, Indonesia, Malaysia, Pakistan, the Philippines Taiwan and Thailand. Our observation is that perhaps the outperformance had been due to dazzling gains of China and the remarkable recovery in Indian stocks, while all the rest remain sluggish as that of the Phisix (pane below main window).

Next week has some potentials for added volatility in US stocks as the earnings period sets in with several important brokers submitting disclosures, such as Lehman Brothers, Morgan Stanley, Bear Sterns and Goldman Sachs aside from the much awaited Fed’s September 18^th FOMC meeting.

It would be interesting to see how…

1. the market responds to the FED cuts (we are inclined to expect a “sell-on-news” if the FED drops by 25 basis points) and…

2. the credit crisis has affected the balance sheets and bottom lines of such financial institutions; and if their recent declines have been already discounted by the markets or if the markets will be rocked by surprises.