BRICs Mulls Bailout of the Eurozone

From the Reuters,

BRIC major emerging markets are considering ramping up holdings of euro-denominated bonds in a bid to help European countries mired in a sovereign debt crisis, newspaper Valor Economico reported on Tuesday, citing a monetary official.

Valor reported a decision could be made at a Sept. 22 meeting of finance ministers and central bank presidents from Brazil, Russia, India, China and South Africa in Washington.

Brazil's central bank declined to comment on the story.

This comes on the heels of China’s proposed investment on Italy, yesterday.

From Bloomberg/Businessweek, (bold emphasis mine)

China’s status as the fastest- growing major economy and holder of the largest foreign-exchange reserves lured another bailout candidate as Italy struggles to avoid a collapse in investor confidence.

Italian officials held talks in the past few weeks with Chinese counterparts about potential investments in the country, an Italian government official said yesterday, adding that bonds weren’t the focus. Finance Minister Giulio Tremonti met with Chinese officials in Rome earlier this month, his spokesman Filippo Pepe said by phone today, declining to say exactly when the talks took place or what was discussed.

Foreign Ministry spokeswoman Jiang Yu, asked about buying Italian assets, said Europe is one of China’s main investment destinations, without specifically mentioning Italy.

Italy joins Spain, Greece, Portugal and investment bank Morgan Stanley among distressed borrowers that turned to China since the 2007 collapse in U.S. mortgage securities set off a crisis that widened to engulf euro-region sovereign debtors. Stocks rose on the potential Chinese investment in Italy even as previous commitments failed to have a lasting impact…

Any Chinese purchases of euro-region debt to date haven’t produced a lasting cut in yield premiums for Greece, Portugal or Spain…

Any Chinese purchases of euro-denominated debt may help it diversify its reserves away from dollars. The biggest foreign owner of U.S. government debt has doubled its holdings of Treasuries in the three years through June to about $1.17 trillion.

China is playing a “white knight” role in assisting Europe and buying itself goodwill that will enable it to purchase more sensitive European assets such as technology companies, according to Stamford, Connecticut-based Faros Trading in a June report. The European Union still has an arms embargo on China, imposed after the Tiananmen Square massacre in 1989.

My comments:

1. The above exhibits the bailout mentality prevalent among policymakers. It’s easy to spend money or resources that aren’t theirs, since the costs of the ensuing political actions are distributed or externalized or borne by taxpayers. Policymakers are essentially unaccountable for their actions.

2. This also demonstrates the implicit desire of global governments to preserve the status quo, again at the expense of local taxpayers.

3. The transfer of resources from productive to non productive entities will have temporary palliative effects. Over the long term, this weakens the productive capability of productive enterprises, as well as, heightens the risk environment of the global economic and financial system. Besides, such transfers distort price signals and resource distribution in the marketplace which only increases systemic fragility.

And since we are dealing with non-productive entities, i.e. governments, for BRIC political leaders, the above represents a choice between domestic or international ‘political’ expenditures.

Again go back to #1.

4. BRIC governments will be a part of the consortium that will rescue elite bankers of the Eurozone and the US. This only reveals how widespread the welfare government-banking-central banking cartel is.

5. For China, part of the incentive to conduct a bail out is to project her growing geopolitical influence; yet a very expensive way to signal success.

China will also use this opportunity to squeeze political deals with economic repercussions. Like any political concession, these would likely benefit the client cronies and the political patrons of the incumbent Chinese government.

6. Diversification of currency reserves out of the US dollars has been attributed as one of the motives for the rescue. But why the Euro, whom like the US suffers from the almost the same disease?

Notice that the current developments signifies as a continuing crisis since 2008. Despite repeated trillions of US dollars or Euro spent on a seemingly expanding breadth of bailouts, there are hardly any convincing signs that this crisis will be over anytime soon. Much of the present political actions have been meant to 'kick the can down the road', which means the likelihood of even larger crisis ahead.

None of the above shows that the BRIC's rescue will matter. Again the thumbprints gleaned from the above would likely be more inflationism.

The Policy Making Moral Hazard: The Bailout Mentality

To give you an example how the ‘Bernanke Put’ or the ‘Bernanke doctrine’ has worked to ingrain the psychology of moral hazard to the Financial industry, here is an example where Panic is seen as a buy, principally because of the political ‘need to do something’.

In short, the bailout mentality.

From analyst Martin Spring (bold emphasis mine)

If there is another major crisis – perhaps deadlock in Europe as voters in the North torpedo plans to implement a fiscal union and prevent issuance of bonds for the Eurozone as a whole, underpinned by the power of the German economy – or even just a general worsening in the global economy, with employment and/or property crisis in the US, then it’s very likely that that will panic policymakers.

-Central banks will go crazy with “printing” and otherwise unorthodox money-pumping policies;

-Despite growing public resistance to rising federal debt in America, and to “rescue” packages in Europe, governments will find ways to spend more to stimulate demand;

-In Asia, where sounder fundamentals allow policymakers more freedom of action, there could be a switch from fighting inflation to promoting domestic demand.

Of course, such changes could build up even greater problems for the future, such as the eventual threat of serious inflation facilitated by the money bubble. But the political imperative will be to do something… anything… immediately, to ward off disaster.

The equity markets will love such a panicky turnaround. The next couple of months at least … maybe longer… will be the time to use most of the cash that you should have realized and parked awaiting such an opportunity, to invest in shares.

Mr. Spring is right, a realization of this short term political patchwork would essentially translate to crisis begetting more crisis.

Nevertheless, political actions are almost always focused on short term (palliative) effects and directed at attempts to resolve problems of politically 'favored' sectors.

Quote of the Day: Path Dependency

From Professor Arnold Kling,

…most respectable people think that Bernanke and Paulson and TARP and such SAVED THE WORLD, and so that is now the model going forward for handling any situation involving shaky large banks.

D-Day for the US Federal Reserve’s QE 3.0

This is the day where the Fed will likely be announcing QE 3.0 or another asset purchasing program under a new format, template or name.

Wall Street has been bleeding profusely and the sentiment can be captured by this comment by Harvard’s Kenneth Rogoff

From Bloomberg,

Federal Reserve policy makers are likely to embark on a third round of large-scale asset purchases, moving “more decisively” to secure the U.S. recovery, said Harvard University economist Kenneth Rogoff.

“They certainly should do something right away,” said Rogoff, a former International Monetary Fund chief economist who attended graduate school with Fed Chairman Ben S. Bernanke. It’s “hard to know” if Bernanke would immediately be able to gain the support of Federal Open Market Committee members, Rogoff said in an interview today on Bloomberg Television.”

This validates what I earlier wrote

Besides, who would like to see a market crash with them on the helm, and not be seen as “doing something”? Today’s politics, embodied by the Emmanuel Rahm doctrine has mostly been about the need to be seen “doing something” even if such actions entail having adverse long term consequences. Actions by the ECB, SNB and BoJ have all revealed and exemplified such tendencies. Even the debt ceiling bill was forged from the need to do something to avert an Armageddon charade.

Danske Bank’s Research team also sees a FED QE today: (bold emphasis original)

Developments have moved significantly in the wrong direction for the US economy over the past months. We believe this will be enough for Fed to launch new stimulus measures at its meeting today. The main arguments are the following:

1. Growth will be significantly lower than Fed forecast in June.

2. Unemployment is very far from target and not coming down.

3. Fiscal tightening in coming years leaves Fed as the only entity to support growth

further and counter the significant drags on the US economy.

4. Action is needed to fight the current confidence crisis in the markets.

Of course, I see this as a setup meant to save the tripartite cartel of welfare state-central bank and banking system.

Now here is how I think the market’s possible reaction to a QE 3.0 (or its variety)

For the market to respond positively to the Fed’s QE 3.0, this will likely be another huge “shock and awe” delivery type. Otherwise, they may end up like the ECB’s sputtering Bazooka (perhaps they used the 2^nd world war type-L.O.L!) where the stock market fell hard despite actual bond purchases.

Today gold will most likely fall from its lofty record perch. Gold may fall because of profit taking from the "buy the rumor sell the news" dynamic, a smaller than expected QE delivery package or NO QE.

But the difference will be in the degree of decline. Profit taking off a significantly packaged QE will still be substantial perhaps back to the 1700 level, but this would come amidst a backdrop of sharply rebounding global equity markets. Some will misread this as eroding "fear premium". It isn't.

However a market perceived insufficient QE, or a “NO” QE would translate to bigger fall for gold prices along with another round of crashing equity markets.

As of this writing US futures are modestly up while Europe’s 3.5% decline has been reduced to less than 1%.

This is the day.

Here is a 1980s MTV 'This is the Day' from a band called The The.

The lyrics appear suited for the Wall Street cartel and the Bernanke Team,

THIS IS THE DAY -- Your life will surely change.
THIS IS THE DAY -- Your life will surely change.
You could've done anything -- if you'd wanted
And all your friends and family think that you're lucky.
But the side of you they'll never see
Is when you're left alone with the memories
That hold your life together like
Glue...

Again, it's time to profit from political folly.

G-7: More QEs Coming

From Bloomberg, (bold highlights mine)

Group of Seven nations sought to head off a collapse in global investor confidence after the U.S. sovereign-rating downgrade and a sell-off in Italian and Spanish debt intensified threats to the world economic recovery.

The G-7 will take “all necessary measures to support financial stability and growth,” the nations’ finance ministers and central bankers said in a statement today. Members will inject liquidity and act against disorderly currency moves as needed, they said.

QE 3.0 looks like a dead giveaway.

Falling Markets, QE 3.0 and Propaganda

The essence of the interventionist policy is to take from one group to give to another. It is confiscation and distribution.-Ludwig von Mises

Some say that falling markets won’t account for the imminence of QE 3.0.

That would signify a blatant misread.

For me, falling markets account as one of the two possible conditions for the re-institution of QE

As I previously wrote[1],

Although I expect that this extension won’t come automatically which I see as either tied to the US Congressional vote to raise debt limits or in reaction to growing pessimism in the some of the world’s economic environment due to a cyclical slowdown or to the accrued effects of signaling channels applied by governments or from mainstream’s addiction to inflationism. Besides if the debt ceiling will be raised this gives further excuse for the FED to activate QE 3.0.

Today’s financial markets have essentially been influenced by political forces more than economic developments. All the accounts of bailouts, rescues and assorted market interventions (quantitative easing, currency interventions, credit margin hikes on commodity markets) are part of the many examples. All these have effects on the marketplace[2].

Thereby, the state of the current sluggishness in the Philippine and global markets could likely be symptomatic of more of political design than merely reactions from economic forces.

Markets as Hostage to Politics

This week, we saw a political representative of China and one of the Fed officials jawbone on the possible adverse repercussions[3] from the palpable dabbling of a brief debt default by several Republican lawmakers as the debt ceiling is being deliberated.

This week, reports also say US President Obama pondered on using tax cuts as possible concession to the Republicans to reach a compromise[4].

Earlier both President Obama[5] and Treasury Secretary Tim Geithner[6] warned of a global recession if a settlement on raising the debt limits won’t be reached.

About a month ago a series of studies from the US Federal Reserve came out to state that commodity prices have not been tied with Quantitative Easing. Also during the same period commodity markets were slammed by the repeated increases of credit margins[7] of several commodities.

The point is the markets are seemingly being held hostage by politics. The idea is that markets can indeed go down, for the plain reason that the market is being used as leverage to secure political concessions.

Intervening and manipulating, directly or indirectly in the marketplace has been the du jour trend of today.

And what appears to be the imperative political tenet resonates in the famous statements of President Obama’s former Chief of Staff Rahm Emanuel[8]...

Never let a serious crisis go to waste. What I mean by that is it's an opportunity to do things you couldn't do before.

Don’t you see, the vehement aversion to crises has been the hallmark of today’s politicking?

This runs along with the prevailing economic ideology which guides on the directives of the political orthodoxy, where the prescription to supposed “market failures” would be through interventions channeled mainly through Keynesian concepts of ‘parting with liquidity’ (giving up liquid assets in exchange for employment-creating illiquid assets) ‘euthanizing the rentiers’ (low interest rates), and ‘socializing investment’ (public private partnership)[9].

Even Harvard Professor Carmen Reinhart along with her colleagues observes of the ongoing non-market features of today’s marketplace[10] characterizing an environment which they call as financial repression, (bold emphasis mine)

Undoubtedly, a critical factor explaining the high incidence of negative real interest rates was the aggressively expansive monetary policy (and, more broadly, official central bank intervention) in many advanced and emerging economies during the crisis. This raises the broad question of the extent to which current interest rates reflect the stance of official large players in financial markets rather than market conditions. A large role for nonmarket forces in interest rate determination is a key feature of financial repression.

In short, official players will likely manipulate markets to meet their ends.

Stoking Fear

And part of such tactical operations would probably mean instilling fear to paint an ambiance of urgency.

And speaking of fear, the current stock market declines seem to have twitched Wall Street’s fear measures higher.

Whether seen from original computation of volatility ($VXO), the current VIX ($VIX) and volatility applied to the CBOE S&P 500 3-Month ($VXV) signs of fear have emerged. The rallying US dollar appears to chime with such an environment.

This fear has been evident even seen Google Search trends (chart below).

Lately Google has shown increasing searches by the public for ‘double dip’. Meanwhile news and articles featuring double dip have also grown.

Given that Wall Street has been a politically privileged sector, with more fear comes the greater clamor for interventions.

Wall Street operates in an environment fostered by the moral hazard, which reveals on their sense of entitlement.

Rescues signify political events. Only in the pretext of growing risks of a crisis that would incur pernicious broad market and economy welfare implications will bailout measures be deemed as justifiable by politicians and the bureaucracy.

And along this line, it wouldn’t be farfetched to say today’s actions in the marketplace could be part of the effects of the conventional signaling channel tool used by central banks in preparation for the next set of rescue measures.

That’s why mainstream media seems to have misinterpreted Bernanke’s last comments as having ‘no QE 3.0’ when the fact is Bernanke’s statements prior to November 2010’s QE 2.0 resembled his latest comments[11].

In short, if there is no emergency, then there will be no rescue. Falling markets sow the seeds of alarmism, and thereby, setting in motion the conditions required for prospective rescues.

As previously noted, this has been the routine recourse by political leaders almost everywhere.

A Possible Growth Scare and Not a Crisis

Despite the recent signs of fear, credit markets in the US and in Euro seem to remain calm.

The above chart from Danske Bank[12] shows marginal signs of impact from the current equity-commodity downdraft on US bond markets and on interbank loans as represented by the LIBOR OIS spread.

But this has not been powerful enough to stir the proverbial hornet’s nest.

And the cyclical downturn of major economies following a vigorous upside could also be part of the story.

As the Danske Research writes[13],

Global leading indicators have suffered a setback recently, pointing to slower growth. The US ISM dropped considerably in May and European PMIs also fell faster than expected. China, on the other hand, seems to have stabilised, as the PMI dropped slightly in May and order-inventory bottomed.

The current declines could represent more of a growth scare instead of imminent risks of crisis or recession as presented by politicians.

Also, Danske Research[14] thinks that the dislocation from Japan’s recent disaster has partly been the culprit of the downturn of economies. But signs according to them are that Japan has been recovering fast.

The above evidences seem to show that the essence of fear being manifested by reports which highlights ‘double dip’ concerns may seem unwarranted.

A growth scare and not a crisis could be taking place.

Yet it is quite obvious that politics have been dominating feature of the marketplace.

---

[1] See ASEAN’s Equity Divergence, Foreign Fund Flows and Politically Driven Markets, June 5, 2011

[2] See Poker Bluff: No Quantitative Easing 3.0?, June 5, 2011

[3] See China Warns US on Debt Default as ‘Playing with Fire’, June 9, 2011

[4] See US President Obama Mulls Tax Cuts as Compromise for Raising Debt Limits June 9, 2011

[5] Huffington Post, Obama Debt Ceiling Warning: Raise Limit Or Risk Global Recession, April 15, 2011

[6] Wall Street Journal Geithner Issues Warning on Debt Ceiling, May 15, 2011

[7] See War on Commodities: Intervention Phase Worsens and Spreads With More Credit Margin Hikes! , May 14, 2011

[8] Wall Street Journal A 40-Year Wish List, January 28, 2009

[9] what-when-how.com SOCIALIZATION OF INVESTMENT

[10] Reinhart Carmen M., Kirkegaard Jacob F., Sbrancia M. Belen Financial Repression Redux, June 2011, IMF FINANCE & DEVELOPMENT

[11] See Bernanke’s Comments Mirror Those of Pre-QE 2.0 in 2010, June 8, 2011

[12] Danske Bank, Bad macro indicators and Greece weigh on market sentiment, Weekly Credit Market, June 10, 2011

[13] Danske Bank, Global: Business Cycle Monitor, June 6, 2011

[14] Danske Bank, ECB confirms July rate hike, Weekly Focus June 10, 2012

China Warns US on Debt Default as ‘Playing with Fire’

Here is another spectacle, China warns the US of ‘playing with fire’ by tinkering with the prospects of default.

From yahoo.com

Republican lawmakers are "playing with fire" by contemplating even a brief debt default as a means to force deeper government spending cuts, an adviser to China's central bank said on Wednesday.

The idea of a technical default -- essentially delaying interest payments for a few days -- has gained backing from a growing number of mainstream Republicans who see it as a price worth paying if it forces the White House to slash spending, Reuters reported on Tuesday.

But any form of default could destabilize the global economy and sour already tense relations with big U.S. creditors such as China, government officials and investors warn.

Li Daokui, an adviser to the People's Bank of China, said a default could undermine the U.S. dollar, and Beijing needed to dissuade Washington from pursuing this course of action.

"I think there is a risk that the U.S. debt default may happen," Li told reporters on the sidelines of a forum in Beijing. "The result will be very serious and I really hope that they would stop playing with fire."

China is the largest foreign creditor to the United States, holding more than $1 trillion in Treasury debt as of March, U.S. data shows, so its concerns carry considerable weight in Washington.

"I really worry about the risks of a U.S. debt default, which I think may lead to a decline in the dollar's value," Li said.

This just shows how governments have been addicted towards profligacy and inflationism as recourse to economic predicaments.

By advocating an increase of US debts, the US will genuinely be “playing with fire”.

Eventually this spending-deficit cycle will reach a point where the US economy won’t be able to pay her liabilities and will prompt her to an outright default or pursue hyperinflationary policies. So China is effectively asking the US to kick the can down the road.

However, these warnings do not just come from China, but also from the Fed’s James Bullard and one of the key credit rating agency, the Fitch Ratings

From the Reuters (hat tip Dr Antony Mueller)

A default would have severe reverberations in global markets, a top Federal Reserve official said just hours after Fitch Ratings warned it could slash credit ratings if the government misses bond payments.

St. Louis Federal Reserve Bank President James Bullard told Reuters on Wednesday "the U.S. fiscal situation, if not handled correctly, could turn into a global macro shock."

"The idea that the U.S. could threaten to default is a dangerous one," he said in an interview.

"The reverberations in those global markets would be very severe. That's where the real risk comes in," Bullard warned.

So the political pressure to raise debt limits has apparently been escalating.

Once the US Congress approves such actions, which I think they will, this gives the Fed another rational for QE 3.0: insurance against the risk of a bond auction failure as previously discussed here.

But while China warns of a default, the fact is that the US has already been partially defaulting on her debt via inflationism (QE 1.0 and 2.0)

Repeating what Murray Rothbard wrote,

Inflation, then, is an underhanded and terribly destructive way of indirectly repudiating the "public debt"; destructive because it ruins the currency unit, which individuals and businesses depend upon for calculating all their economic decisions.

So China prefers indirect default by inflation than an outright default.

Finally another paradox is that this warning of China comes amidst what appears to be her declining interest to finance the US.

True China owns lots of US debts (following charts from zero hedge)

But China has been buying less during the past months

Bottom line: Global policymakers appear to be averse at imposing fiscal discipline and would choose the inflationism route instead.

These actions manifest what I call path dependency or the bailout mentality via inflationism. Until the next crisis implodes such dogmatist approach simply won’t change.

EU’s Bailout Structure, Behind The Scene Role of the US

Speaking of the policy of bailouts (possibly financed by inflationism), here is nice graphic from the Economist.

The Economist writes,

PORTUGAL’S bail-out means another stage in Europe’s debt crisis and another call on non-European coffers. The total €865 billion ($1.2 trillion) pot available for euro-area rescues looks enormous, more than enough to cope with Greece, Ireland and Portugal’s anticipated needs besides. Almost half of that comes from the European Financial Stability Facility, a €440 billion euro-zone fund whose major contributors are Germany, France and Italy. But the EFSF’s effective lending capacity is only €250 billion, because only six of its 17 members have a AAA credit rating. European leaders have pledged to bring the fund’s actual firepower up to €440 billion by the summer but in the meantime the IMF has more cash on hand, at €280 billion. If all that money were used (a very big if), America would end up lending indebted euro-zone nations €50 billion.

Oops, the last statement shows why the US dollar will likely keep falling…the US appears to be bailing out the rest of the world! (this included Libya’s Gaddafi in 2009)

Symptoms of Crony Capitalism: Soaring US Financial Profits

This is exactly how crony capitalism looks like.

Following massive support from the US government, US financial firms posts huge profits.

From the Wall Street Journal, (bold highlights mine)

During the darkest days of the financial crisis, when Lehman Brothers and Washington Mutual went belly up and the U.S. government had to bail out other institutions, the finance sector reported an annualized loss of $65.2 billion in the fourth quarter of 2008. It was the only quarterly loss recorded in the government data.

Since then, the sector has come roaring back. The GDP report shows finance profits jumped to $426.5 billion. While profits haven’t returned to their high levels of 2006, the gain in finance profits last quarter more than offset a drop in profits posted by nonfinancial domestic industries.

After rising like the Phoenix, the financial industry now accounts for about 30% of all operating profits. That’s an amazing share given that the sector accounts for less than 10% of the value added in the economy.

Wall Street and banking critics have pointed out the finance industry enjoys government supports not given to other companies. That includes the low cost of funds from the Federal Reserve. As a result, critics say, the U.S. economy is overly skewed toward finance.

Aside from the bailouts and behest loans, the Federal Reserve’s QE programs have had a big influence on this swelling of corporate profits.

Writes Peter Schiff, (bold highlights mine)

But another very large chunk of Treasuries go to "primary dealers," the very large financial institutions that are designated middle men for Treasury bonds. In a late February auction, these dealers took down 46% of the entire $29 billion issue of seven year bonds. While this is hardly remarkable, it is shocking what happened next.

According to analysis that appeared in Zero Hedge, nearly 53% of those bonds were then sold to the Federal Reserve on March 8, under the rubric of the Fed's quantitative easing plan. While it's certainly hard to determine the profits that were made on this two week trade, it's virtually impossible to imagine that the private banks lost money. What's more, knowing that the Fed was sure to make a bid, the profits were made essentially risk free. It's good to be on the government's short list.

So what we essentially have is a redistribution of resources from the real economy to the financial sector.

This is rent-seeking.

The essence of which is, as explained by Alfred Nobel Prize winner Professor James M. Buchanan,

“it extends the idea of the profit motive from the economic sphere to the sphere of collective action. It presupposes that if there is value to be gained through politics, persons will invest resources in efforts to capture this value. It also demonstrates how this investment is wasteful in an aggregate-value sense.

Such is the essence of government interventions or the political distribution of resources via state capitalism. Winners are the politically endowed (concentrated) while losses are distributed throughout the system.

What To Expect In 2011

We humans, facing limits of knowledge, and things we do not observe, the unseen and the unknown, resolve the tension by squeezing life and the world into crisp commoditized ideas, reductive categories, specific vocabularies, and prepackaged narratives, which, on the occasion, has explosive consequences- Nassim Nicolas Taleb, The Bed Of Procrustes

It’s crystal ball peeking time.

Much of what we’ve been saying here isn’t likely to change for 2011, except to say that perhaps most of what we have been predicting may accelerate or escalate.

Here are the factors, which I perceive, constitute as the major drivers of the global asset markets (this includes the Philippines):

1. Monetary authorities of developed economies will fight to sustain low interest rates.

This comes even amidst pressures on the bond markets (see figure 1)

Figure 1: Economagic: US Treasury Yields leads Fed Fund Rate

Rising treasury yields (see green line) almost always leads Fed interest rates (red line). Said differently, markets influence policies than the other way around.

In addition, the Fed’s rates only reveal the path dependency or the penchant to artificially keep down interest rates until forced by hand by the markets.

Yet, rising interest rates do not automatically equate to financial markets turmoil, as suggested by some perma bears, who desperately keeps looking for all sorts of excuses to pray for the markets to go lower. The US S&P 500 index (blue) shows how US equities had surfed the rising interest tide over the years, until they have reached some pivotal point.

Nevertheless, it is important to determine the genuine dynamics of the interest rate movements[1] rather than to impute personal bias-based conclusions that are largely unfounded.

And as we earlier pointed out[2],

Rising interest rates presuppose one of the following drivers: increased demand for credit, concerns over credit quality, emerging scarcity of capital or the deepening inflation expectations.

Figure 2: Rising Yields A Global Phenomenon (charts courtesy of Cumberland Advisors[3] and Danske Bank[4])

Let me further point out scarcity of capital can be a consequence of perceived insecurities from political environment or protectionism.

Yet, the fact that rising interest rate appears to be a global phenomenon (see figure 2-upper window) suggest that the current interest dynamics has been less about credit quality concerns (despite the ongoing PIIGs crisis) but more about emerging inflation expectations, and secondarily, rising demand for credit.

Even China, whom sporadically applied some brakes over her system’s rapidly growing credit due to bubble concerns this year, has also been vacillating to implement a tight monetary environment despite posting inflation rates at 28-month high[5]. China reportedly plans to allow some 7 trillion yuan ($1.1 trillion) in new loans for 2011[6].

So like any conventional approach, when caught between the bind of choosing between the proverbial devil (the temporal benefits from inflationism) and the deep blue sea (prospects of having to suffer from economic rebalancing). Authorities as will most likely choose the former.

2. More Inflationism: Bailouts and QEs To Continue

In spite of the rhetoric on austerity, authorities of major developed economies will likely engage in more inflationism, stealthily coursed through central banks or in central banking vernacular “quantitative easing” or “credit easing”.

At the start of the year, policymakers blabbered about ‘exit strategies’ which we accurately debunked and exposed as poker bluff[7].

Even if the US had been declared out of recession by the National Bureau of Economic Research (NBER) in June of 2009[8], a non profit group in charge of ascertaining recession and business cycles, the Federal Reserve have stubbornly persisted on using the printing press option.

Incidentally and ironically, popular economic experts have again failed miserably with their misguided forecasts, such as Keynesian high priest Paul Krugman[9] and populist Nouriel Roubini[10] both whom had predicted of a large probability a double-dip recession, which apparently did NOT materialize this year.

Just how could these so called experts be so frequently awfully wrong, yet get so much the public’s attention?! As Nassim Taleb rightfully dissects, economics cannot digest the idea that the collective (and the aggregate) are disproportionately less predictable than individuals[11]. Of course Mr. Taleb refers to mainstream economics which fixates on mathematical-empirical formalism rather than the study of people’s actions or conduct (praxeology).

This also demonstrates that the public has hardly been concerned about accuracy or about dealing with reality. Instead the public have been indulging or assimilating dogmatic ideas that confirms to their beliefs or which runs along with their line of thinking, regardless if they work in the real world.

Nonetheless, we further argued that such inflationist policies had been actually directed at the banking system, which actually operates as some form of cartel under the aegis of central banks. Officials have only used the economy, particularly the employment figures, as cover[12] in order to continue with the redistributive process of ‘privatizing profits and socializing losses’ in order to buttress the banking sector.

To add, if higher treasury yields will translate to higher mortgage rates and thereby put renewed pressure on the housing markets, then we can expect more versions of QE to be activated. QE 2.0 has barely waded into the water and now Fed officials as Bernanke appear to be telegraphing or conditioning the public for a QE 3.0[13].

And this isn’t going to change anytime soon. Not unless consumer inflation runs berserk and consequently weigh on the political dimensions that would affect policymaking.

Yet while I am very pleased that Congressman Ron Paul will take over as the chairman of the Domestic Monetary Policy Subcommittee of the House Financial Services Committee[14], it remains uncertain whether Congressman Paul can successfully overhaul, or diminish the role of, or dismember the deeply entrenched interest groups that constitute the banking cartel, or at the least make a dent on the making the Federal Reserve transparent. Subjecting monetary policies to free market forces should salvage the system from self-disintegration (read: sell gold).

And the same dynamics appears to take hold whether in the Eurozone or Japan or the United Kingdom. Every perceived crisis would be met by the same approach.

My point is: bailouts and flooding the world with liquidity would remain instrumental in determining the direction of asset prices in 2011.

3. Effects of Divergent Monetary Policies

Divergent monetary policies will impact emerging markets and developed markets distinctly, with the former benefiting from the transmission effects from the latter’s policies.

While most economic experts will talk about interrelationships of the output gap, economic growth and trilemma of international finance or the impossible trinity[15] of fixed exchange rate, free capital movement and independent monetary policies-where only two of the three conditions can be attained, we see current coordinated policies as no more than designed to artificially promote growth by inflating bubbles.

Artificial low interest rates, which punish savers and rewards borrowers, have been the conventional or the orthodox policy treatment to modern financial and economic maladies. Thus, suppressed interest rates are likely to impact both domestic and international reallocation of resources applied to nations under the rubric of emerging markets and of nations classified as developed.

For nations whose banking and financial system have not been directly affected or impaired by the recent financial crisis, and for economies that had been relatively unscathed and whose financial system have been less leveraged and has been marked by high rate of savings, the impact from such interest rate policies have been dramatically magnified.

And this appears to be case for ASEAN bourses (see figure 3).

Figure 3: Policy Divergences And ASEAN Bourses

With the exception of Malaysia (green), the bellwethers of major ASEAN bourses, namely Philippines (yellow), Indonesia (Orange), and Thailand (red) has broken above the pre-crisis highs largely driven by the above stated dynamics.

Local investors will likely continue to ramp up speculations on asset prices (stocks, real estate[16] and private sector bonds) which should give some semblance of or will likely be interpreted as an ongoing economic boom, where in truth, many will account for misdirected investments.

And this will be amplified by portfolio flows from foreign funds, whose incentives to arbitrage on global markets have been driven by home policies of similar depressed interest rates and the deliberate debasement of their currency.

Add to that would be pressures from resurgent domestic inflation that would force up rates or the appreciation of the domestic currency or both, whose yield spreads would equally attract foreign arbitrage. Thus, in cognizance of the volatility of policy induced portfolio flows, some emerging markets have either been contemplating on capital controls[17] or have begun implementing them, albeit largely in a benign scale.

Yet one can’t discount the role of momentum or the herd mentality in the bidding up of asset prices, where psychology fuelled by circulating credit would lead to irrationality or extreme valuations which would be justified as “new paradigm”.

4. The Globalization Factor

Aside from globalization of monetary and administrative-fiscal policies, globalization of trade, migration and finance similarly plays a significant role in shaping asset prices.

While inflationism does play a role in the allocation of resources, so does globalization. So in one way globalization somewhat offsets the malinvestments from inflationism. However it remains to be seen how much of malinvestments can be muted by globalization.

Nevertheless, mainstream economics not only to tend misread the effects of globalization for political ‘mercantilist’ purposes, but likewise underestimate on the role it plays on the economy, as well as the rapidly changing dynamics behind these[18].

For instance many perma bears have mainly used “lack of aggregate demand” from developed economies as the principal reason to argue for “depression economics”.

But this is false for the simple reason that it oversimplifies and underestimates the impact of trade and of people’s action and likewise sees past performance as a static trend going forward!

And this is why high profile experts have entirely missed out predicting the recent rally or the recent improvements in the global economy

A good example of sicj underestimation is the dynamics of Asia’s domestic consumption (see figure 4).

Figure 4: DBS Research: Asia 2011 How Scissors Cut

According to the DBS Group Research[19],

Remember all that talk about global imbalances and the worry that if the US did not consume then Asia, which purportedly lived off the US, could not grow? Oops. Since 3Q08, US consumption has grown by 1%, or by paltry $27 bn. Asia’s consumption has grown by 22%, or by $225 bn. That’s an expansion 8x bigger than in the US. With new consumption running 8:1 in Asia’s favor, it’s simply no longer credible to claim that Asia’s growth depends on the US or that failure to fix some ‘imbalance’ puts global growth in peril. It doesn’t. US growth maybe in peril...but that’s another kettle of fish: one that everything to do with explosive leverage and abysmal risk management and nothing to do with current account surpluses or deficits.

So aside the mainstream missing out the improvement of Asia’s domestic consumption, the DBS Research group goes on to argue that the region’s growth has been spurred mostly by the private sector in spite of the safety nets applied (bottom window).

And as we have long argued, trade openness and economic freedom lubricates demand, which serves as the ultimate end of production. And demand isn’t constructed based on circular flows but on people’s changing subjective value preferences.

And for as long people are allowed to openly engage in free markets, depression-deflation economics, which stems largely from government bubble and protectionist policies that induces such systemic distortions, is no more than a figment of a mercantilists imagination. Under free markets, greater output translates to growth deflation that increases the public purchasing power.

Besides, the aggregate demand deflation camp also tends to underestimate the fundamental function of why central banks ever exist at all: they exist not only as a lender of last resort, but as financer of government liabilities or the financier of political goals of the political leaders.

To repeat, what generates market instability or what are called as “market failures” are fundamentally bubble policies and interventionism and not some random flux arisng from from the lack of confidence or “animal spirits”.

My Working Targets for 2011

So here is how I see 2011:

Unless inflation explodes to the upside and becomes totally unwieldy, overall, for ASEAN and for the Philippine Phisix we should see significant positive gains anywhere around 20-40% at the yearend of 2011 based on the close of 2010. Needless to say, the 5,000 level would seem like a highly achievable target. What the mainstream sees as an economic boom will signify a blossoming bubble cycle.

Of course my foremost barometer for the state of the global equity markets would be the price direction of gold, which I expect to continue to generate sustained gains and possibly clear out in a cinch the Roubini hurdle of $1,500[20].

To repeat, Gold hasn’t proven to be a deflation hedge as shown by its performance during the 2008 Lehman collapse. The performance of Gold during the Great Depression and today is different because gold served as a monetary anchor then. Today, gold prices act as a temperature that measures the conditions of the faith based paper money system.

In addition if inflation will become more widespread, then we should likewise see the oil jump above $100 per barrel and this will be accompanied by general increases in other commodity prices, particularly in food prices.

And in my opinion, while everyone likes to focus on what seems sensational, I’d focus on what I think is more important. I don’t expect the Euro to evaporate soon as some others suggest. I’d probably pay a closer look to China, whose yield curve appears to be flattening (see figure 5).

Figure 5 Asianbondsonline: China’s Flattening yield curve

And I will get to scream fire once the yield curve turns negative.

Finally, surging inflation may not be good for the stock market in the entirety but that would be conditional. It should be good for certain assets as commodities or real properties (see figure 6).

Figure 6: Stagflation’s Winners (courtesy of Dr. Marc Faber[21])

Based on a seemingly similar economic environment or during the stagflation days of 1970-1980, hard assets turned out to be the winner.

Of course, it would be a different picture once hyperinflation gets into play; equities became store of value in Weimar Germany (1921-1923) and in Zimbabwe (2000s-2009).

But this could be one of the two options that could likely happen once the next bubbles go bust. The other one is debt default.

For now, identifying the whereabouts of the bubble cycle is my primary concern. And it should be yours too.

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[1] see Rising US Treasury Yields: Credit Quality Concern or Symptoms of Bubble Cycles, December 14, 2010

[2] see Global Markets And The Phisix: New Year Rally Begins, December 6, 2010

[3] Kotok, David R. The Bond Herd, 6% and Gold, Financialsense.com December 16, 2010

[4] Danske Bank, Basel III impact study published, Fxstreet.com December 16, 2010

[5] BBC.co.uk China sees inflation jump to 5.1%, a 28-month high, December 11, 2010

[6] Bloomberg.com China Said to Aim for at Least 7 Trillion Yuan Loans, December 13, 2010

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

[8] Marketwatch.com U.S. recession ended June 2009, NBER finds September 10, 2010

[9] Bloomberg.com, Krugman Sees 30-40% Chance of U.S. Recession in 2010, January 4, 2010

[10] Reuters.com Roubini says U.S. economy may dip again next year, May 29, 2009, Roubini, Nouriel Beware Of A Double-Dip Recession, March 11, 2010 Forbes.com

[11] Taleb, Nassim Nicholas The Bed of Procrustes, Philosophical and Practical Aphorisms Random House

[12] See QE 2.0: It’s All About The US Banking System, November 18, 2010

[13] See QE 3.0: How Does Ben Bernanke Define Change, December 6, 2010

[14] Norris, Floyd, Ron Paul Appears Poised to Irk the Fed Chief, December 16, 2010

[15] Wikipedia.org Impossible trinity

[16] See The Upcoming Boom In The Philippine Property Sector, September 12, 2010

[17] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[18] See iPhone Shows Why Global Imbalances Will Remain, December 16, 2010

[19] DBS Research, Asia 2011: How Scissors Cut, Economics Markets Strategy, December 9, 2010

[20] In 2009 Jim Rogers and Nouriel Roubini went into a heated public debate, where celebrity guru Roubini predicted that gold won’t surpass $1,500. See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009

[21] Faber, Marc Tomorrow's Gold: Asia's Age of Discovery