Central Bankers Whets Wall Street’s Fetish For Inflationism

In a fiat-money regime, however, increases in credit and money are not a one-off affair. As soon as signs of recession appear on the horizon, public opinion calls for countermeasures, and central banks try their best to "fight the crisis" by increasing the fiat-money supply through bank-circulation-credit expansion, thereby bringing interest rates to even lower levels. -Thorsten Polleit

At a recent speech Non-voting FOMC member and President of Federal Reserve Bank of Dallas Richard Fisher said that he was puzzled with Wall Street’s obsession with Quantitative Easing[1],

I am personally perplexed by the continued preoccupation, bordering upon fetish, that Wall Street exhibits regarding the potential for further monetary accommodation—the so-called QE3, or third round of quantitative easing.

Such a statement signifies a bizarre denial of the impact to people’s incentives of the policies implemented by the US Federal Reserve.

In response to this statement Dr. Ed Yardeni posted on his blog charts which exhibited the tight correlations between actions of the S&P 500 (as well as the TIPs) and the Fed’s bond market interventions called as the Quantitative Easing.

Writes Dr. Yardeni[2]

Let’s review the market’s medical chart to see how it responded to the injections and withdrawals of the Fed’s monetary medicine:

(1) The S&P 500 rose 36.4% during QE-1.0, which spanned from November 25, 2008 through the end of March 2010.

(2) The S&P 500 rose 10.2% during QE-2.0 from November 3, 2010 through the end of June 2011. It rose much more, by 24.1%, if we start the clock on August 27, 2010, when Fed Chairman Ben Bernanke first hinted that a second round of quantitative easing was on the way.

(3) Operation Twist was announced on September 21, 2011. Since then, the S&P 500 is up 15.9%.

(4) Between the end of QE-1.0 and Bernanke’s speech on August 27, 2010, the S&P 500 fell 9.0%. Between the end of QE-2.0 and the beginning of MEP, it fell 11.7%.

There is an even better correlation between the Fed’s QEs and expected inflation implied in the spread between the 10-year Treasury nominal and TIPS yields.

The relevance and relationship between monetary policies and financial markets has not been limited to the United States but to the global marketplace.

As I have been pointing out global stock markets have been on a tear on central bank steroids.

I plotted the Bloomberg charts of the Phisix [PCOMP:IND] along with major world’s major bourses as the US S&P 500 [SPX:IND], Japan’s Nikkei [NKY:IND] and Germany’s DAX [DAX:IND] as futher exhibit to this tight relationship.

Since the bottom in October of 2011, the wave-like motions or undulations of three bourses have almost been in identical. The difference can only be seen in the degree of gains (where Germany’s Dax has outperformed the pack).

A near synchronized motion can also be seen in the Phisix, but to a lesser scale than the developed economy peers.

The point of the above is that any perception that sees actions of specific markets as demonstrating “fundamentals” will signify as patent misimpression or a misread—that will be eventually exposed once the tide of monetary liquidity subsides.

And a further point is that I am dubious of the impact of Operation Twist to the recent market run up.

Operation Twist which was announced in September[3] during the heat of the Euro crisis was designed to manipulate the yield curve. Then the US Federal Reserve announced that their goal[4] was

to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve's portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities.

In other words, Operation Twist has been a modified QE with sterilization[5] functions (or the act of central banks to soak up new cash that would otherwise circulate in the economy).

Since sterilized monetary actions soak up freshly injected money, there won’t be similar narcotic effects on the markets as unsterilized interventions.

Instead I believe that other forms of interventions helped boosted global markets.

The US Federal Reserve opened foreign currency swap lines mainly targeted at the ECB and was also made accessible to many central banks at the end of November[6]. The announcement of the swap lines placed a floor on the plummeting S&P (as well as to major global markets) which at that time reeled from the eroding short term stimulant impact of the announcement of Operation Twist.

Also, the European Central Bank launched in December 22^nd of 2011, the first round of the massive rescue program by the infusion of €489 billion of credit[7] to the European banking system through the Long Term Refinancing Operation (LTRO) facility or repurchase auctions with expanded to maturity of 36 months[8] (typically during normal times LTROs had three month maturity[9]).

Both the Fed’s Swap Lines and the ECB’s LTRO operated like a 1-2 punch.

In addition, major interventions had been conducted during February of 2012, these had a follow through effect on the market’s speculative vim.

The Bank of Japan[10] along with the Bank of England[11] reengaged in more QE programs, while the ECB reopened the second round of LTROs which was met with record borrowings[12]. The second round of LTROs resulted to an expansion of the ECB’s balance sheets which has now topped the US Federal Reserve[13].

The asset purchasing program by developed central banks has been in conjunction with many major central banks slashing policy rates. This week India aggressively cut bank reserve requirements[14], while Brazil accelerated the reduction of policy rates[15].

This article has essentially captured today’s foundations which revolves around central banking actions

Reports the Dow Jones[16]

Central banking has become a global growth industry. But it is not just the size of balance sheets that's changed: so too have their composition. With rates close to zero, the U.S., U.K., Japanese and European central banks have pumped cash into the financial system. But each has chosen a different method - and will face different challenges when they try to shrink again. The growth in balance sheets has been startling: the combined assets of the four central banks will top $9 trillion by the end of March compared to $3.5 trillion five years ago, Deutsche Bank says. The European Central Bank's EUR3 trillion balance sheet is the biggest relative to the economy, at 32% of nominal euro-zone GDP, followed by the Bank of Japan with 24%, the Bank of England with 21% and the Federal Reserve with 19%. The BOE's balance sheet has expanded fastest in the crisis, more than tripling to GBP321 billion. But the change in composition and maturity profile of the balance sheets has been equally noteworthy. In January 2007, the Fed held $779 billion of U.S. Treasurys, of which 52% matured in under a year and only 19% in more than five years. Now, it holds $1.65 trillion of Treasurys, of which 57% mature in more than five years. Of the BOE’s GBP255 billion face value of gilts, 72% mature in more than five years, with 26% maturing in more than 20 years

Recently rumors of innovative QE via a reverse repo[17] have been floated. This is probably in designed as transition to the end of Operation Twist and could be part of the signaling channeled used by the Fed to see how the public would react.

Going back to the Wall Street’s fetish for QE, the answer is simple, the US Federal Reserve has been providing the narcotics and Wall Street became addicts. The inflationary dynamics has been accelerating because governments around the world has been working to protect an unsustainable welfare (and warfare) based political system that has been financed by debt and operates on the platform of cronyism.

As the great Ludwig von Mises wrote[18],

A government always finds itself obliged to resort to inflationary measures when it cannot negotiate loans and dare not levy taxes, because it has reason to fear that it will forfeit approval of the policy it is following if it reveals too soon the financial and general economic consequences of that policy. Thus inflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, i.e., of antidemocratic, policy, since by misleading public opinion it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them. That is the political function of inflation. It explains why inflation has always been an important resource of policies of war and revolution and why we also find it in the service of socialism. When governments do not think it necessary to accommodate their expenditure to their revenue and arrogate to themselves the right of making up the deficit by issuing notes, their ideology is merely a disguised absolutism.

And the politics of inflation requires piggybacking inflationism one after another until the whole structure self-implodes.

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[1] Fisher, Richard W. Not to Be Used Externally, but Also Harmful if Swallowed”: Projecting the Future of the Economy and Lessons Learned from Texas and Mexico Remarks before the Dallas Regional Chamber of Commerce Dallas, Texas March 5, 2012 Dallasfed.org

[2] Yardeni Ed Stocks & QE, March 8, 2011

[3] CNN Money Federal Reserve launches Operation Twist September 22, 2011

[4] Federal Reserve.gov What is the Federal Reserve's maturity extension program (referred to by some as "operation twist") and what is its purpose? September 21, 2011 Official statement FederalReserve.gov FOMC Press Release September 21, 2011

[5] Wikipedia.org Sterilization Capital account

[6] Wall Street Journal Real Times Economics Blog What Are Fed Swap Lines and What Do They Do? November 30, 2011

[7] Wikipedia.org Long Term Refinancing Operation (LTRO) European sovereign-debt crisis

[8] European Central Bank Press Release ECB announces measures to support bank lending and money market activity 8 December 2011

[9] European Central Bank, THE LONGER TERM REFINANCING OPERATIONS OF THE ECB, working paper series, May 2004

[10] See Bank of Japan Yields to Political Pressure, Adds $128 billion to QE February 14, 2012

[11] See Bank of England Adds 50 billion Pounds to Asset Buying Program (QE), February 9, 2012

[12] See Record Bank Borrowing from ECB’s Second Round LTRO March 1, 2012

[13] See ECB’s Record Balance Sheet Tops the US Federal Reserve March 7, 2012

[14] New York Times In India, Bank Moves To Stimulate Economy, March 9, 2012

[15] Bloomberg.com Brazil Accelerates Interest Rate Cuts Amid Signs of Lackluster Growth, March 8, 2011

[16] Dow Jones News Wires, Now, Sterilized QE? PrudentBear.com March 9, 2012

[17] Hilsenrath Jon 'Sterilized' Bond Buying an Option in Fed Arsenal March 7, 2012 Wall Street Journal

[18] Mises Ludwig von 3 Inflationism CHAPTER 13 Monetary Policy The Theory of Money and Credit, Mises.org

European Debt Crisis: Demand for US dollar Rises amidst Signs of Funding Stress

From Reuters,

A larger-than-expected take-up of dollars at a European Central Bank tender on Wednesday reflected euro zone banks' funding stresses but the fact banks were using the facility was seen as a positive.

Banks took more than $50 billion at a three-month operation, which was the first since the world's major central banks cut the cost of using dollar swap lines with the Federal Reserve last week to help institutions struggling with the fallout from the euro zone debt crisis.

That was well above the $10 billion median forecast in a Reuters poll of money market traders. Banks also took $1.6 billion in one-week funds.

But analysts said there was no reason to panic as dollar-funding stresses were widely acknowledged already.

"We view this as a positive first step -- it leads a string of potential policy actions as authorities attempt to break the negative feedback loop from the euro zone and limit contagion back to the U.S.," said George Goncalves, head of U.S. interest rates strategy at Nomura Securities International in New York.

Morgan Stanley estimated the take-up in the ECB tender was the most since December 2008, with banks able to borrow dollars for three months at 0.58 percent compared with around 1.45 percent before the coordinated central bank action to lower the cost.

So the US Federal Reserve may have reactivated QE operations via swap line funding to the ECB, as previously discussed here and here

And today’s EU summit may grant license to the ECB to conduct more asset purchases (QE).

Can the Phisix rise Amidst the Euro Crisis?

During the downturning segment of the cycle, the situation is such that credit for investment will be refused. With its supply of credit, the central bank will encounter a rejection of credit-taking by the economy. We have already given two reasons for this. On the one hand, the psychological conditions necessary for the investment of money into durable investments will not be present. There will be general unrest in the economy. On the other hand, the relationship of prices and the general tendency of price development will stand in the way of investment activity. The repudiation of credit will, however, not be general. Even in this stage of the cycle there is a very significant demand for credit, namely the demand by those who are forced to liquidate, to make emergency sales or to cease production due to a lack of capital—a demand for which any credit means at least the momentary avoidance of losses and perhaps even the potential for later improvements. However, satisfying this demand implies delaying the liquidation of the crisis, lengthening and strengthening it. For it is essential to this situation that a significant demand for credit by those who would like to work towards continuing the boom, that is, an “unhealthy” demand for credit, exists along with a significantly reduced demand for new sound investments- Richard Strigl, From Capital and Production (1934)

A local mainstream expert recently argued that for as long as the Euro crisis prevails, the Philippine Phisix won’t likely be able to carve out new highs. His argument has been mostly predicated on the deleveraging process being experienced by major developed economies, momentarily led by the Eurozone.

And given that the correlations of global markets has been intensifying as shown by the chart above[1], which means diversification among global markets have become a less appealing option to scrape for ‘Alpha’ returns, the Phisix will succumb to the same pressures being encountered by her contemporaries, and so it is held.

While part of such observation is true, as I have persistently maintained that an outright decoupling under financial globalization would be highly improbable, divergent outcomes would only become apparent under conditions where the risk of a global recession is low.

And most importantly, aggressive and sustained cumulative policies by global central banks to ease credit through zero bound rates and rampant injections of liquidity via asset purchases could defer the crisis from fully unwinding.

What You See Depends On Where You Stand: Charts

Many local mechanical chartists will see a foreboding road ahead with the bearish head and shoulder pattern looming over the Phisix (blue curves), aside from the extant death cross pattern[2]. Given this pattern searching impulse, these chartists would likely use the bleak events in the Eurozone as confirmation of their personal bias to argue for a pessimistic case.

US markets, as represented by the S&P 500, still trades significantly above the 2010 lows and whose present momentum could lead to an upside breakout above the 1,285 levels which would confirm her interim uptrend.

Moreover, both bellwethers of Europe (E1DOW) and Asia (P1DOW) seem to have bounced off the 2010 critical support levels. This could similarly be construed as either double or triple bottoms—a bullish pattern.

So even from the technical viewpoint, should the US, Europe and Asian equities continue to rebound from current levels then external pressures will imply for a rebound in local stocks more than what the Phisix chart patterns have been signaling.

In short, if global equity markets will retain the trend of high correlations, then external forces will likely influence activities in the local market. This will hold true unless there will be some dominant quirks in the local political economy that could influence the activities in the Philippine Stock Exchange, which thus far seems remote.

What You See Depends On Where You Stand: Liquidity Trap

On the other hand, mainstream economists, who premise their analysis on alleged ‘liquidity trap’, would say that ‘deleveraging’ would translate to a decline in ‘spending’, mainly seen through the credit channel and through consumers, which should translate to lower economic growth and subsequently lower asset prices.

Never mind if little of such assumptions have been proven to be accurately reflected by empirical data.

While US real personal consumption (lower window, red arrows) did fall along with credit conditions in 2008-2009 (upper window), consumer spending has recovered earlier and faster than the credit environment which presently treads at an all-time high.

Furthermore, US equity markets have been mixed year-to-date in spite of the European crisis.

As of Friday’s close, the Dow Industrial was up by 3.8%, the S&P 500 marginally down by 1.06% and the Nasdaq slightly down by .97%. These are hardly signs of deflation.

Moreover, deflationist arguments such as “Given the deflationary pressures that are the natural result of a recession and deleveraging/default, they can print a lot of money without igniting too much inflation[3]” is simply contorted and incorrect.

The excessive focus on the nominal yields of US government’s Treasuries, unemployment data and the CPI index used as basis to declare a supposedly deflationary environment blatantly ignores the composition of the CPI index[4] (which has been heavily weighted to housing), the manipulation of the yield curve via monetary policies and bank regulation, as well as the role of US dollar as the world’s premier reserve currency.

Of course “too much inflation” is a matter of semantics.

Nevertheless, even if US CPI index does not reflect on the actual state, US CPI inflation for October 3.5% has been higher than the 96 year average[5]. This applies to the Eurozone as well, where November’s inflation has been at 3%[6] vastly higher than the 19 year average at 2.24%[7]

Most importantly NONE of the crisis affected Eurozone crisis nations have shown disinflation. Only Greece’s inflation rate has shown some signs of decline, although the rate of growth has remained positive. Meanwhile Portugal, Spain and Italy’s inflation rate appear to be in an upswing in spite of the current crisis.

While it may be true that money supply has reportedly been contracting in Italy, the recent round of stepped up purchases by the ECB of Italian bonds are likely to offset this.

And given that inflation rates of the Eurozone and the US are above the average, this could be read as “too much inflation” in a relative sense.

No deflation here, move along.

And with gold prices drifting significantly above the $1,700 level and with oil prices at the $ 100 level, further inflationary actions by global central banks will imply for higher inflation figures ahead or that inflation rates will remain sturdily above their averages much to the contrary of the expectations of deflation proponents.

Lastly, the deflation perspective forgets that the deleveraging by the private sector are being substituted or offset by enormous increases in leveraging of major governments via their central banks. Yet all such actions will have consequences which most of them have been ignoring.

Misunderstanding Hyperinflation

Also those in the view that the “US is far from Zimbabwe” again represents deep denial based on the delusion the US can freely operate above or will be immune to the natural forces economics.

And importantly, these denials manifests blatant misunderstanding of the dynamics of inflation or the feedback loop mechanism between government controlled quantity of money and the public’s demand of money, as shaped by price influenced expectations, in the face of policies that leads to hyperinflation.

As a refresher let me quote the great Murray Rothbard[8] on how hyperinflation becomes a reality, (bold emphasis mine, italics original)

When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races.

Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.” A frantic rush ensues to get rid of money at all costs and to buy anything else. In Germany, this was called a “flight into real values.” The demand for money falls precipitously almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up boom.”

Episodes of hyperinflation can be seen similar to a hockey stick—serial, gradual and incremental increases of inflation rates for long periods that eventually transitions into a sudden explosion or exponential rates of increases.

The Germany’s Weimar experience[9] exhibits this hockey stick-like transition process from muted inflation towards hyperinflation.

It would further be foolish to assume that hyperinflation signifies as a desired policy outcome. Hyperinflation mostly represents an unintended consequence from repeated and intensifying doses of inflationism. This process eventually results to a critical mass or a tipping point where inflation morphs into hyperinflation. Yet again this will be decided by policymakers who control the money supply.

And stopping hyperinflation, says author of When Money Dies and witness to Weimar Germany’s hyperinflation, Adam Fergusson[10], would require

“the kind of courage that politicians cannot have”

As a caveat, I am not saying that a global hyperinflation is imminent, but hyperinflation could be one of the two possible major extreme outcomes that should NOT be written off.

Again all this would greatly depend on the underlying actions by the global political stewards.

Dollar Swaps, Lehman Comparison and Central Bank Activism

Overtime, a binge of debt defaults should be expected[11], although the political path or approach to such crisis has yet to be determined. And such defaults may be channeled anew through inflation (which risks hyperinflation) or restructuring (repudiation, e.g. Greece 50% haircut[12]) or a mixture of both. All of these aforementioned scenarios would bring about different sets of market outcomes, but assured volatility.

And given the way politicians have been loading up on taxpayer liabilities for the benefit of the bondholders and the banking class, aside from the massive interventions in the economy, growing out of the debt mess economically will be next to impossible.

Yet inflationism seems to be the de facto or preferred path as exhibited by the exhaustive policy efforts to prop up the asset markets.

This week’s joint or coordinated action by 5 major central banks have been targeted to ease credit conditions by lowering of interest rates on dollar swaps and by the creation of bilateral swaps[13]. Such actions has been complimented by China’s lowering of reserve requirements[14]—the first time in 3 years—appears to be symptomatic of major economy’s central banks in a panic mode.

But instead of a panicky market, global equity markets zoomed.

The essence of these swaps would be to facilitate funding flows, in case of a cataclysmic banking run or an abrupt capital flight from the Eurozone.

This week’s EU summit will be critical as they will be dealing with the prospects of treaty changes (that may possibly allow ECB), the proposed fiscal union and the committee’s proposal for Eurobonds[15].

As Professor Gary North incisively writes about the purpose of the swaps[16],

…this was an action preliminary to (1) Angela Merkel's December 2 speech to the German parliament, which is preliminary to (2) the next Eurozone summit, scheduled for the weekend of December 9, which is preliminary to (3) a coordinated violation of the two treaties that created the European Union, which is hoped will (4) pressure the European Central Bank to buy newly created Eurobonds issued illegally by the EU, in order to (5) raise enough euros fast enough to buy Italian government bonds before (6) the Italian government misses interest payments, which may (7) bankrupt the largest French banks, which could (8) trigger a worldwide financial panic.

In short, Bernanke and his peers are in a pre-panic panic.

And failure to reach an agreement may trigger such panic, which is probably why these major central banks led by the US Federal Reserve may have coordinated their actions to institute preventive measures against possible funding stops or a gridlock that may lead to sharp market fluctuations and to ensure accessibility of funds.

And given the state of interdependence of the global banking system, the worsening troubles for the Eurozone would severely hurt US the banking system, an event which the US Federal Reserve may see as urgent which requires their participations.

Writes the Economist[17],

According to data from the Bank for International Settlements, American banks had just $47 billion in exposure to Italian institutions (including the sovereign) as of June. That's a digestable amount. France, on the other hand, has $416 billion in exposure to Italy. That's very bad news for France, but it's also very bad news for America; American banks have a total exposure to France of some $271 billion. Trouble in Italy is manageable, from an American perspective. Trouble in France makes Americans nervous. But that's not where it ends. British banks have a total of $305 billion in total exposure to France. And American exposure to Britain is close to $800 billion.

There are more ties to worry about, of course. If France and Italy get into serious trouble, then German, Swiss, and Dutch banks will also be in very serious trouble, and British and American exposure to those countries is also enormous. And so the full scope of the danger begins to become clear. It was very important for the euro zone to limit trouble to Greece, Ireland, and Portugal. Europe could handle big losses on Greek, Irish, and Portuguese investments, but Italy is too-big-to-fail and, for everyone but the ECB, too-big-to-save. As far as Britain is concerned, trouble in Spain and Italy is worrisome, but problems in France are devastating. And in America, a sinking France is a big headache, but a crash in Germany and Britain is simply gutting.

And by backstopping the Eurozone, the US Federal Reserve will be conducting a global bailout through swaps as another form of quantitative easing most likely on a scale far larger than in 2008.

This chain of prospective bailout, like the footsteps of Germany and France, will likely drag the US deeper into the crisis which would further diminish her status as foreign reserve currency.

The likely difference will be a more liberal US Federal Reserve in terms of lending that could buy the affected parties some time, but would risk heightened inflation.

Nonetheless dealing with the unfolding Euro debt crisis has increasingly become dependent on central banks.

I would further add that comparing today’s dollar swap facility with that of 2008 would seem misleading.

The accounts where the foreign central bank dollar swaps with the US Federal Reserve did not prevent the US equity market from further deterioration in 2008 were true. But one must be reminded that conditions of 2008 has far been different than today.

Today has seen an unparalleled scale of the ramping up of major central banks’ balance sheets even prior to the dollar swap interest rate cuts.

The US Federal Reserve opened dollar swap access to specific central banks, namely the ECB and the SNB in March of 2008. The FED gradually expanded the amount involved as the US recession deepened.

However immediately after the Lehman bankruptcy, the US dollar swap facility was expanded to cover more central banks, which came along with increased amout of lending (see chart above from the New York Federal Reserve[18]).

As one would note, the first signs of the current EU crisis has already been manifested in 2008 where the ECB was the largest borrower. As I have been saying, today’s crisis has been a continuation of the 2007-2008 bust phase. This means most of what we see as “recovery” represents artificial boosters from the extensive use of the central bank’s balance sheets to shore up the financial system first and the economy second.

And seen from the actions of the US equity markets, the S&P 500’s trough in February 2009 coincided with the culmination of US dollar swap facility borrowings.

To reiterate, the difference then from today has been global central banks actively revving up on their asset purchases.

In fact, not only seen from asset purchasing perspective, today’s global interest rate environment has been the lowest since 2009[19]. In short, even emerging markets have joined the bandwagon of reflating the system through open market operations[20] which also employs asset purchasing.

At the end of the day, the understanding that the policy of inflationism via activist central banking remains as the dominant path in managing of the unfolding debt crisis is what sets our view apart from the mainstream.

Conclusion: Can the Phisix rise amidst the Euro crisis?

So going back to the original premise, can the Phisix rise amidst the Euro crisis?

Again this will critically depend on the feedback loop mechanism from the prospective political actions of global authorities in response to the unfolding conditions.

If global central bankers will inflate massively, far more than the market’s expectations from the adverse effects of the crisis then the answer should be a conditional “yes”. This week’s EU summit could serve as an implicit license for more asset purchases by the ECB.

And there can be no stronger evidence of the abovestated dynamic than the recent showing of ASEAN bourses.

DESPITE the crisis, the Phisix has been down by only about 5.75% from its August peak.

Yet on a year-to-date basis, the Phisix and the Indonesia’s JCI has been UP by about 2%, while Thailand’s SET and Malaysia’s KLSE has been marginally lower. ASEAN’s performance goes in contrast to the returns of major equity markets, whom are down or negative in the range of 10-25%, except for the United States.

True, past performance may not guarantee future outcome. However, for as long as global central banks remains on an inflationary path in support of the asset markets, then we should see divergent or relative price actions which are likely to benefit the Phisix and ASEAN bourses.

And even more, any hiatus from the perceived worsening of the EU crisis, which will likely be treated with the band-aid approach most likely emanating from massive ECB purchases and possibly from the US Federal Reserve, will likely lead to ASEAN bourses outperforming the region or the world.

This means that contra mechanical chartists and consistently wrong mainstream deflationists, my bet is for the Phisix to breach the August highs perhaps sometime within the first quarter of 2012. Again, all these are conditional or subject to the premise where global central banks will continue to unleash waves and waves of inflationism. Otherwise all bets are off.

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[1] US Global Investors Investor Alert - Are Stars Aligned for a Year-End Rally?, December 2, 2011

[2] See Phisix Should Outperform as Global Markets Improve, November 6, 2011

[3] Mauldin John Time to Bring Out the Howitzers December 3, 2011, HoweStreet.com

[4] See US CPI Inflation’s Smoke and Mirror Statistics, May 18, 2011

[5] Tradingeconomics.com United States Inflation Rate

[6] Reuters.com UPDATE 1-Euro zone inflation holds at 3 pct for third month, November 30, 2011

[7] Tradingeconomics.com Euro Area Inflation Rate

[8] Rothbard, Murray N. The Mystery of Banking, 2^nd Edition, p.71-72 Mises.org

[9] Nowandfutures.com Germany, during the Weimar Republic & the hyperinflation

[10] See Video: Adam Fergusson: Inflationism is Playing with Fire November 15, 2011

[11] See The Coming Global Government Debt Default Binge, June 20, 2011

[12] See Global Risk Environment: The Transition from Red Light to Yellow Light, October 30, 2011

[13] See Hot: Major Central Banks Coordinate Easing On Dollar Swaps, November 30, 2011

[14] Bloomberg.com China Reserve-Ratio Cut May Signal Slowdown December 1, 2011

[15] Guardian.co.uk Angela Merkel vows to create 'fiscal union' across Eurozone, December 2, 2011

[16] North Gary French Fried Banks, December 2, 2011 Lewrockwell.com

[17] R.A Run, run, run, The Economist, Free Exchange, December 1, 2011

[18] Goldberg Linda S., Kennedy Craig, Miu Jason Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs FRBNY Economic Policy Review / May 2011

[19] See Global Central Banks Ease the Most Since 2009, November 28, 2011

[20] Wikipedia.org Open market operations

Swap Facility Backdoor for Quantitative Easing

Writes PIMCO’s Tony Crescenzi at the CNBC… (bold emphasis original) [hat tip Bob Wenzel]

Keep in mind that any use of the Fed’s swap facility expands the Fed’s monetary base: all dollars, no matter where they are deposited, whether it be Kazakhstan, Japan, or Mexico, wind up back in an American bank. This means that any time a foreign central bank engages in a swap with the Federal Reserve, the Fed will create new money in order to make the swap. Use of the Fed’s liquidity swap line in late 2008 was the main cause of a surge in the Fed’s monetary base at that time. The peak for the swap line was about $600 billion in December 2008. Some observers will therefore say that the swap line is a backdoor way to engage in more quantitative easing .

So there you have it, the foundations of QE 3.0 has been put in place. QE 3.0 seems now a matter of formality.

Hot: Major Central Banks Coordinate Easing On Dollar Swaps

Wow. Now we are seeing some real heavy weightlifting! The world’s major central banks have embarked on a major coordinated credit easing operation.

This should be another "I told you so moment". As I earlier wrote

Global central banks and politicians have, in increasing signs of desperation, been intensifying the use of the nuclear option. Such concerted move is likely one of the many to come. Expect to see amplified market gyrations as consequence to the boom-bust policies of global central banks.

From Bloomberg, (bold emphasis mine)

The Federal Reserve cut the cost of emergency dollar funding for European banks as part of a globally coordinated central-bank response to the continent’s sovereign-debt crisis.

The interest rate has been reduced to the dollar overnight index swap rate plus 50 basis points, or half a percentage point, from 100 basis points, and the program was extended to Feb. 1, 2013, the Fed said in a statement in Washington. The Fed will coordinate with the European Central Bank in the program, which was also joined by the Bank of Canada, Bank of England, Bank of Japan (8301), and Swiss National Bank (SNBN) are involved in the coordinated action.

The move is aimed at easing strains in markets and boosting the central banks’ capacity to support the global financial system, the statement said. The cost for European banks to fund in dollars rose to the highest levels in three years today as concerns about a possible breakup of the euro area increased after leaders said they’d failed to boost the region’s bailout fund as much as planned….

The six central banks also agreed to create temporary bilateral swap programs so funding can be provided in any of the currencies “should market conditions so warrant.” Those swap lines were also authorized through Feb. 1, 2013.

The dollar swap lines were previously set to expire Aug. 1, 2012. The new pricing will be applied to operations starting on Dec. 5…

Separately, China two hours earlier cut the amount of cash that banks must set aside as reserves for the first time since 2008. The level for the biggest lenders falls to 21 percent from a record 21.5 percent, based on past statements.

The Frankfurt-based ECB, which says it is up to governments to stem the two-year-old debt crisis, unexpectedly cut its benchmark interest rate Nov. 3 as the turmoil threatens to drag the euro area into recession.

Refinancing Operation

Yesterday the ECB allotted the most to banks in its regular seven-day refinancing operation in more than two years, lending 265.5 billion euros. The ECB offers unlimited funding to euro- area banks against eligible collateral.

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity,” the statement said.

Under the dollar liquidity-swap program, the Fed lends dollars to the ECB and other central banks in exchange for currencies including euros. The central banks lend dollars to commercial banks in their jurisdictions through an auction process.

Well, central banks are defying Walter Bagehot’s rule of lending freely but at penalty rate. Major central banks have currently been lending freely and promoting moral hazard which eventually will backfire.

The Fed will essentially be printing money to support the Euro through the ECB, as well as other major central banks.

Again central bankers are dabbling with Pandora’s Box of inflationism

No wonder gold prices, European and US stocks have been surging as of this writing.

Again profit from folly.

Euro’s Bailout Deal: Rescue Fund Jumps to $1.4 Trillion and a 50% haircut on Greece bondholders

From Bloomberg (bold emphasis mine)

European leaders persuaded bondholders to take 50 percent losses on Greek debt and boosted the firepower of the rescue fund to 1 trillion euros ($1.4 trillion), responding to global pressure to step up the fight against the financial crisis.

Ten hours of brinkmanship at the second crisis summit in four days delivered a plan that the euro area’s stewards said points the way out of the debt quagmire, even if key details are lacking. Last-ditch talks with bank representatives led to the debt-relief accord, in an effort to quarantine Greece and prevent speculation against Italy and France from ravaging the euro zone and wreaking global economic havoc.

“The world’s attention was on these talks,” German Chancellor Angela Merkel told reporters in Brussels at about 4:15 a.m. today. “We Europeans showed tonight that we reached the right conclusions.”

Measures include recapitalization of European banks, a potentially bigger role for the International Monetary Fund, a commitment from Italy to do more to reduce its debt and a signal from leaders that the European Central Bank will maintain bond purchases in the secondary market.

So the money destruction from recapitalization of European banks will be offset by the ECB’s bond purchases.

In addition, the deal transforms the EFSF into an insurance fund. As I earlier noted

In the Eurozone, a proposal being floated to ring fence the region’s banking system will be through the conversion of the EFSF into an insurance like credit mechanism, where the EFSF will bear the first 20% of losses on sovereign debts, but allows the banks to lever up its firepower fivefold to € 2 trillion

Yet the lack of real resources, insufficient capital by the ECB, highly concentrated and the high default correlation of underlying investments could be possible factors that could undermine such grandiose plans. Besides, such plans appear to have been tailor fitted to reduce credit rating risks of France and Germany aside from allowing the ECB to monetize on these debts.

The Eurozone’s rescue will rely heavily on the ECB’s QE program.

The rest of the world will also participate in the Euro bailout via the IMF which should not only dampen global economic performance overtime, but would also reduce available resources when the next crisis arises.

And China is also being asked to contribute more.

From another Bloomberg article,

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster their debt-crisis fight, said a person familiar with the matter.

The investment vehicle was one of the options being considered by European leaders at a summit tonight to expand the reach of its 440 billion-euro ($612 billion) European Financial Stability Facility.

Sarkozy’s plea to his Chinese counterpart would come the day before a planned visit to Beijing by Klaus Regling, chief executive officer of the EFSF, to court investors.

Should China give in to the request to support the Euro, this means a weaker US dollar.

Nevertheless, current events in the Eurozone reveals how privileged the US and Euro banking class have been, who are supported by their domestic and regional political patrons, and indirectly the US through the US Federal Reserve whose swap lines to the Eurozone which have tallied $1.85 billion, and the world through the IMF.

Yet all these centralized rescue plans seem to be anchored on hope which only buys time before next episode of this continuing crisis resurfaces.

For the meantime, the QE starved financial markets will likely get another boost. Thus the boom bust cycles.

Demystifying the US Dollar’s Vitality

``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell

Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.

While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.

Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns

From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.

And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).

And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.

While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.

What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.

DEBT DEFLATION Dynamics In Progress

So what could be the forces behind such phenomenon?

``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.

How?

Figure 4: Bank of International Settlements: CDS and Foreign Exchange Derivatives Market

One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.

This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.

Figure 5: Investment Company Institute: World Mutual Fund

Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.

For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.

We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.

Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.

The US Dollar’s Hegemon and Threats To Its Dominion

Figure 6: Bill Gross: Going Nuclear

Lastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.

PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.

From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”

``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”

Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).

Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).

The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.

Figure 7: finance.yahoo.com: South Korea Won-US dollar

Understanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.

The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.

Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.

Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),

``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.

``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”

Conclusion

All these demonstrate the two basic factors on why US dollar has recently surged.

One, this reflects the US dollar’s principal function as international currency reserve and importantly,

Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).

We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.

Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.

Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.