Interest Rates As Key To Stock Market Trends

``Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.” Ludwig von Mises

As we have long reiterated, the main driver of the financial assets isn’t economic growth nor is it about earnings but mainly about monetary inflation and credit.

Well it appears that the prominent mainstream research company McKinsey Quarterly somewhat shares our view (see figure 3)

Figure 3 McKinsey Quarterly[1]: Watch For Credit Conditions

Tim Koller of McKinsey writes that the stock markets are not reliable economic indicators of the economy (left window), ``While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times.”

And importantly, Mr. Koller identifies credit conditions as the chief mover of the economy and of the financial markets: ``The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past to 40 years.” (see right window of chart)

And four common patterns of credit crisis cycles can be observed: yield curve inversion and the freezing up of the debt markets, marketplace illiquidity, bandwagon effect on the industry participants and enlarged risk appetite out of the expectations that governments will provide support (moral hazard problem).

And naturally the common symptoms of a blossoming bubble would be loose lending standards, unusually high leverage and what Mr. Koller calls as “transactions without value” or euphemism for outrageous valuations, which are rationalized as the new paradigm.

Interest Rate Manipulation Fuels Imbalances

In reality, credit conditions are hardly shaped by free markets, otherwise boom bust conditions would largely be limited in scale and in duration. Instead, as a major policy tool used by central banks, interest rates are mainly used to perpetuate boom conditions, mostly based on political considerations.

As the great Professor Ludwig von Mises described of the Business or Trade cycle fostered by central bank manipulation of interest rates[2],

``The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as "suppliers" of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated.”

In short, artificially tampering of interest rates leads to an unnecessary pile up in systemic leverage along with massive malinvestments which also drives up valuations of securities or assets to extreme levels.

Of course the market psychology here is to rationalize such actions as being warranted to the prevailing conditions, when they genuinely account for “flaws in perception” as billionaire George Soros rightly identifies[3], or a false sense of reality brought about by distorted incentives.

Yet in order to maintain these lofty levels would require constant infusion of fresh credit at far larger scale than the former.

Figure 4: Economic Slowdown and Quantitative Easing (chart from Danske Bank[4])

We seem to be seeing this episode playout today with renewed clamor[5] and the growing expectations by the mainstream for the US Federal Reserve to implement Quantitative Easing 2.0 on escalating fears of a global economic relapse (see figure 4 right window) by further pushing down interest rates.

Market expectations of the realization of the Federal Reserve’s QE 2.0 have thrashed the US dollar (left window), even as US treasury yields fall!

Even the resurgence of Ireland’s debt woes have failed to bolster the US dollar relative to the Euro. The rising Euro seems to validate our earlier prediction in contrast to mainstream expectations, but appears to have overshot our target[6].

So we have now a phenomenon outside or opposite to what had occurred in 2008, where a rally in US treasuries coincided with a rally in the US dollar.

And this should be a prime example of how past performances or patterns do NOT repeat.

Unravelling Of The Business Cycle

However, artificial suppressed rates can last only for so long.

Since resources are scarce and where interest rate manipulation essentially diverts massive amount of resources and labor into unproductive speculative activities, the increased demand for resources are eventually reflected on the price levels.

The current run-up in most prices of commodities[7] seem to be manifesting symptoms of the Austrian business cycle theory at work.

Eventually the whole artifice unravels with a bubble bust or with a destruction of the currency system if central banks persist to inflate.

Again Professor von Mises,

``This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money....

``If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of "profitability" created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to the artificial lowering of the interest rate, and which had been sustained thanks to the equally artificial increase of prices, no longer appear profitable. Some enterprises cut back their scale of operation, others close down or fail. Prices collapse; crisis and depression follow the boom. The crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit.

Therefore, it has been long contention of mine that the interest rates and market psychology working as a feedback loop mechanism ultimately sorts out the phases of the business cycle.

---

[1] Koller, Tim A better way to anticipate downturns, McKinsey Quarterly

[2] Mises, Ludwig von The Austrian Theory of the Trade Cycle

[3] Soros George, The Alchemy of Finance p.58

[4] Danske Bank, Currency Debate Heats Up, October 8, 2010

[5] Los Angeles Times Blog More Fed help for economy now just a matter of time October 8, 2010

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

[7] See Commodity Inflation, October 8, 2010

What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

``This pessimistic bias is a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.” Bryan Caplan The 4 Boneheaded Biases of Stupid Voters

What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

-The Pavlovian Response Stimulus Behavior
-Unlike The Bear Market Of 2007
-Posttraumatic Stress Disorder Revisited
-Economic Relativism And Zero Bound Rates
-Authorities Seem Clueless With Bubbles And Operate On Fear

Most of the global financial markets have ended the month mostly in the red. And with momentum appearing to falter, we are seeing marginally more price signal convergence than of a divergence over the past few weeks [both of the prospects we discussed in When Politics Ruled The Market: A Week Of Market Jitters]

By price signal convergence, I mean eerily somewhat similar shades that characterized the bear market of 2007-2008, namely, generally frail equity markets, feeble commodity markets, buoyant US dollar as foreign currencies fumble, lower treasury yields and rising credit default swap premiums, as shown in Figure 1, aside from a higher fear index.

Figure 1: Danske Bank: Negative Interest Rates In US and Resurgent CDS

US T-Bills turned negative for the first time since the Lehman episode in 2008 (left window). However, in spite of the spike in the credit default index of Europe’s most liquid investment grade companies, this has yet to even reach or top its most recent high in 2009 (about 75-right window).

The Pavlovian Response Stimulus Behavior

But does this mean a redux of bear market meltdown of 2007-2008? I don’t think so.

As we have earlier stated, markets appear to be acutely discordant or confused on what has truly been prompting for such apparent broad based weakness.

And as usual, media and mainstream analysts has repeatedly focused on any available current events to ascribe on the possible causal relations: the Chinese government enforcing a curb on bank credit, the Greece debt crisis and or the US proposed enhanced regulatory policies, aside from employment concerns.

Unfortunately, markets have not entirely been confirming such suppositions (see figure 2)

Figure 2: US Global Funds: S&P Weekly Performance

If read from the equity market activities in the US, aside from the Materials and Energy Index, which could be extrapolated as having been influenced by the China factor, it isn’t financials but the Info Tech index that has suffered the worst beating after the China factors this week.

Financials, consumer staples and consumer discretionary, or “economic sensitive” sectors declined marginally relative to its other contemporaries as the US economy registered a faster than expected 5.7% growth mainly due to inventory build up.

Yet following the outperformance of the Nasdaq (44%) and by the S&P 500 info tech (53%) in 2009, it should be natural that any correction should impact the biggest gainers most. The same force appears to have earlier influenced the financial sector, which accounted for last week’s biggest loser but this week’s least affected.

In other words, what we may have been witnessing could be an intrasector rotational profit taking process more than a rerun of the bear market.

And if we are to assess market sentiment (see figure 3) using the Fear index, following 3 successive weeks of decline, the financial markets doesn’t appear to be as apprehensive similar to the 2007-2008 experience…yet.

Figure 3: Fear Index: Not As Fearful

The Fear index has been on a relative downtrend compared to the 2007-2008 patterns where we saw massive contiguous spikes (blue ellipses).

While the surges in 2007 had little impact on the US dollar (USD) which then continued to decline, the recent upswing in the Fear index seems to somewhat replicate on the post Lehman syndrome October 2008 climatic drama, wherein the stock markets collapsed, the US dollar skyrocketed, US treasuries soared and commodities crumbled.

Like the famous experiment known as Pavlov’s dogs, where Nobel Laureate awardee Ivan Petrovich Pavlov successfully proved that dog’s behavior could be shaped by stimulus (ringing of bells)-response (bell ringing means food!), the markets appear to have assumed the same behavior by cognitively anchoring on the post Lehman syndrome as template for any correction: When the US dollar started edging up (or the perceived stimulus), markets have thus interpreted these as signals for “carry trade unwinds” and has equally responded by selling off in almost the same pattern as in the 2008.

In short, a morbid fear from the 2008 meltdown still seems fresh and deeply entrenched into the market’s mind. Yet with fear deeply-rooted into the market’s mindset (even policymakers are fretful of these), it is thus unlikely that the market should experience another bust, until complacency and overconfidence rules anew.

Of course, alternatively, a bust may occur only if the 2006 US housing mortgage crisis meltdown is seen as a continuous process extending until today, where the recent improvements in the markets and economies signify as merely bear market rallies or countercyclical trends.

Well our argument is if this should apply to the US then why should it also plague Asia or the rest of the world? Because the US is the world’s ONLY consumer and Asia is the world’s manufacturer? What nonsense.

Unless the global markets are inferred as sooooo hopelessly and incorrigibly stupid, static and rigid enough to fail to respond to the drastic and dramatic changes in the economic sphere, then this scenario should apply.

But in reality, the only thing rigid is NOT the market but the economic dogma espoused by mainstream analysts whose idée fixee is to resurrect past models and whose prisms of reality is as prisoners of the past. This month we discussed some of these subtle but highly material changes: Asia Goes For Free Trade, Asian Companies Go For Value Added Risk Ventures, Global Science and R&D: Asia Chips Away At US Edge, and Japan Exporters Rediscovers Evolving Market Realities.

The intense fixation on aggregates and on quantitative models which simultaneously ignores the human dimension to adapt to changes and respond to stimulus is the basic flaw for analysts who presuppose omniscience.

Unlike The Bear Market Of 2007

Well, sorry, but it’s not entirely like 2007-2008. Going back to the VIX and the European iTraxx index, both of the current surges haven’t undermined the dominant downtrend trends, and could reflect instead on normal countertrend cycles.

Moreover, while short term yields have admittedly shown some strains, these have not been reflected on the broad yield curve spectrum in the US and abroad.

Figure 4: stockcharts.com: US Yield Curve

The short term rates have indeed been falling but long term rates have held ground in spite of the recent pressures in the market. In short, it seems hardly like the 2007-8 chapter where yields have synchronically fallen.

True, the massive interventions of the US government has helped, but over the past 3 weeks the Federal Reserve has offloaded US treasuries in what some experts see as an experiment to rollback liquidity, aside from some FED activities that may have resulted to negative adjustments in November-December in US money supply (M1) and Adjusted Monetary Base.

But from our standpoint these actions could also be construed as insurance Ben Bernanke underwrote to extend his term [as discussed in Federal Reserve Tightening: Exit Experiment or Bernanke's Confirmation Insurance?].

Think of it, a market meltdown amidst the wrangling over Bernanke’s extended mandate would likely influence positively lawmakers to approve of his stay. That’s because the recent ‘successful’ market actions (money printing) have been correctly attributed to him. Yes, policymakers are not transcendental entities and are also human beings whom are subject to cognitive biases.

Yet, Mr. Bernanke epitomizes the public’s desire for inflationism, as Ludwig von Mises has been validated anew, ``In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

So in effect, the US yield curve appears to have steepened and should incentivize the maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).

In addition, Asian sovereign yields have not substantially appreciated amidst the recent turmoil. In 2008, except for US treasuries all assets including sovereign debt yields of Asia fell.

Posttraumatic Stress Disorder Revisited

It would also be similarly foolish to assume that following a bust cycle or a recession, especially in the aftermath of a banking crisis, markets would automatically respond to a renewed borrowing spree or rapid revival of confidence, even if they have been supported by governments. (On the contrary, government support could even be the cause of uncertainty, since expectations would have been built on the continual dependency of the markets from government crutches)

Blind believers of the theory that markets operate on “animal spirits” think that this can happen, we don’t. It would take a bevy of spirits to bodily possess a significant segment of the population to enable these to happen. Unfortunately, the concept of animal spirits escapes the fact that people react based on incentives and NOT on some senseless randomness or mood based decisions.

So aside from the hackneyed arguments of overleveraged consumers and capital scarce banking system, the credit markets is likewise subject to Pavlov’s doggy experiment; children burned from touching a hot stove will refuse to touch it anew. Again it is a stimulus-response dynamic.

Airplane traffic fell (response) post 9/11 (stimulus) as people opted to travel in cars even if the latter mode of transportation has been statistically proven to be more fatal. In short, a person traumatized by a specific action (e.g. flying or swimming) due to a certain set of circumstances will most likely refrain from engaging the same activity, even if the circumstances that generated the trauma is absent.

Since markets are primarily psychologically driven then obviously prices reflects on human action based on people’s varied expectations.

So unless people buy or sell financial securities because their “dream” or a “fairy godmother” or their nanny instructs them to get ‘confident’ and buy up the market, we expect people to act on the markets with the expectations to profit or to hedge or to get entertained or to study or to get some needs or wants to be fulfilled from rationally related goals.

We have said this before and we’re saying it again-it’s called Posttraumatic Stress Disorder syndrome (PSTD). [we brought this up last February and has been validated, it’s time to refresh on the idea What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis]

Figure 5: IMF GFSR: Bank Credit to Private Sector In OECD and Emerging Markets

So it would be natural for markets to react negatively to the credit process, in the aftermath of a bust, which had been preceded by an inflationary boom, because the environment turned into a “proverbial hot stove”.

Let’s get some clues from the IMF on its latest Global Financial Stability Report on the state of bank credit to developed economies, ``Bank credit growth has yet to recover in mature markets, despite the recent improvement in the economic outlook. Bank lending officer surveys show that lending conditions continue to tighten in the euro area and the United States, though the extent of tightening has moderated substantially. Although credit supply factors play a role, presently weak credit demand appears to be the main factor in constraining overall lending activity.” (emphasis added)

Again the IMF on Emerging Markets, ``Outside of China, credit growth in many emerging markets has yet to recover appreciably. This suggests that leverage is not yet a key driver of the rise in asset prices. That said, policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.” (emphasis added)

We see TWO very important messages from the IMF outlook: one Asset Markets have NOT been supported by credit growth and most importantly FEAR.

This brings to my mind some questions:

If global asset prices haven’t been pushed up by the global credit expansion then how can asset prices materially fall (assuming they’ve been pushed up by savings)? Or how can a bust happen when there has been no preceding boom? Unless the global stock markets are ALL being manipulated by developed governments, which have taken most of the balance sheet expansion these days!

Another way to look at this is from the time delayed impact of the steep global yield curve which obviously hasn’t taken a footing yet.

As we have argued in What’s The Yield Curve Saying About Asia And The Bubble Cycle?, it takes some 2-3 years as in the case of 2003 to generate traction in the credit markets.

``Credit growth can be a powerful accelerator in expansions and usually kicks in strongly in later phases of upswing, but it rarely leads markets or real economy on the way up. Put simply, we do not need a pickup in bank lending to see an economic recovery or pickup in asset prices” comments Morgan Stanley’s Joachim Fels and Manoj Pradhan.

In short, the focus on credit, which is predicated on mainstream ideology, is actually a lagging indicator. Credit lags and not lead the economic cycle. This is perhaps due to the median expectations to see more concrete signs of stability, since everyone’s risk profile isn’t the same.

So while mainstream seems unduly focuses on the state of credit, little attention has been given to market’s ability to adjust based on existing the stock of savings, aside from the repercussions of money printing to the asset markets.

Hence if we go by the feedback mechanism from the previous credit cycle (2002-2006) then a more meaningful improvement could probably be expected by late this year and well into 2011. Yet the impact will be dissimilar.

Economic Relativism And Zero Bound Rates

But the mainstream would object, how about the overindebted consumers and the overleveraged banking and financial system, will they not affect the credit process?

Again the problem is to engage in heuristics or parse from angle of aggregates or oversimplifying problems or issues. For even in the economies that have seen the absorption of extraordinary or excessive leverage, debt assumption is largely a relative sectoral issue. Not all the industries have over expanded by taking up too much debt.

In the US, the technology and communications sectors bore the brunt of the dot.com boom bust cycle during the new millennium which spent the entire decade cleaning up their mess. The recent US boom bust phenomenon was largely a banking-real estate crisis and would likely spend years doing the same, unless government continues to socialize the losses, whereby taxpayers will shoulder the burden.

A similar relative effect should apply to the US households or even on the highly politicized issue of employment (By the way, the employment issue is being politicized as a way to shore up lost political capital following the electoral setbacks by the President and his party. On the other hand the pandering to the masses could also mean a diversionary strategy from a beleaguered political party whose goal is to secure the Senate majority this year).

Yet even if unemployment rate is at 10% or 17% on a broader scale last September, then still some 90% and 83% are presently employed and could possibly take up some form of credit but maybe to a lesser degree.

So the issue of absolutism is totally out of whack. So we may yet see some credit improvements in the future from the current levels (see chart again above) even if they are muted relative to the height of the previous boom.

The same dynamics should be applied to the world, where only some nations engorged on excessive credit. Many haven’t, such as Asians and the BRICs.

Figure 6: CLSA/Zero Hedge: Asia’s Loan To Deposit Ratio

In most of East and Southeast Asia bank loan to deposit ratios are under 100% which translates to generally underleverage in the system (more deposits than lending) except for Korea, Australia and India whose ratios are marginally above 100%.

Thus it would be foolhardy to argue that these economies won’t generate credit improvements when there is low systemic leverage, high savings rate, unimpaired banking system, current account surpluses, a trend towards deepening regionalization and integration with the world economy.

So the low leverage figures as shown by the IMF in figure 5 will likely see major improvements for as long as current policies are skewed towards favoring debtors at the expense of creditors.

Moreover I just can’t foresee a market meltdown given interest rates have been zero bound in major economies.

Figure 7: Japan’s Interest Rate and the Nikkei 225

Japan is a favorite for the mainstream peddling the deflation theme (which implies that money printing has no effect on consumer prices or the ‘liquidity trap’ which is disputed by the Austrian school as the money is neutral fallacy).

Although we believe that present conditions DON’T MEET anywhere near a Japan scenario, there seems no example of markets operating on near ZERO rates for comparison. So even if it is an apples to oranges comparison the point is to prove that a meltdown is unlikely at Zero bound, at current levels.

As you can see in figure 7, Japan’s stock market has basically shadowed the actions of its interest rate. In 2003, Japan’s zero bound rates hit the lowest level which apparently had been in coordination with the US, and these has been followed by a stock market rally. Interest rates then chimed, it moved higher. Today, Japan’s rates remain at near the lowest or near zero even while the Nikkei has modestly advanced. The interest rate chart in the lower window is only until 2005.

In other words, interest rates are pivotal factors in determining relative asset pricing, resource distribution and risk considerations.

In a bubble cycle, a credit boom will force interest rate higher as demand for resources will be artificially buttressed as investors compete with each other to invest in projects with long time horizon and also with consumers, whose consumption patterns will focus on the present. This hasn’t been the case yet.

Hence, ZERO bound interest rates amidst comparable yet depressed treasury yields or even cash will likely favor riskier assets as stocks and commodities.

In addition, major economies have been growing national leverage as the crisis erupted. National leverage comes in the form of government spending. And government spending has been backed by the issuance of these sovereign paper receipts, from which spending results to relative scarcity of goods and services. Hence the relative abundance of government paper receipts over goods and services implies prospective inflation.

And an upsurge of inflation likewise implies that given the loftily priced levels of sovereign instruments or paper receipts, risks appears titled more towards “risk free” instruments, particularly from nations which PIMCO’s Bill Gross calls the Ring of Fire [see Bill Gross: Beware The Ring Of (DEBT) Fire!]

So the risk reward tradeoff should benefit equity and commodity assets more than the conventional “risk free” instruments.

Authorities Seem Clueless With Bubbles And Operate On Fear

The second most important message conveyed by the IMF is Fear.

Again according to the IMF on emerging markets, ``policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.”

Even if the stock and commodity markets have gone substantially up, as we earlier pointed out, fear remains a dominant feature in the landscape.

Again the PTSD and or the Pavlov’s stimulus response behavior exhibits that not only many investors but most officials and policymakers have bubbles chronically embedded on their mindsets. The wound is apparently still fresh.

Yet this is one of a policy paradox, policymakers create bubbles by artificially lowering rates in order to boost the credit cycle, aside from other policies as manipulating the treasury and mortgage market via quantitative easing or providing assorted Fed as THE market via an alphabet soup of programs and other forms of fiscal or government spending.

Another implied goal is to see higher asset prices with the implicit aim to recharge confidence or the “animal spirits”.

However, rising asset prices is likewise seen as a bogeyman arising from the previous experience (anchoring) where such officials have excruciatingly learned that a bust follows a boom, ergo a bubble.

Yet, we’re quite sure authorities won’t be able to determine how to distinguish when high prices redound to a bubble. Why? Based on what metric? Who determines when it is a bubble? Since prices are subjective they will always arguable or debatable by some other officials. Besides market based politics will likely influence policymakers. Regulatory capture anyone?

We are seeing signs of such ambiguity or confusion today.

Here is International Monetary Fund chief Dominique Strauss-Kahn who recently warned against ``easing their stimulus programs "too early" before private demand becomes strong enough.”

From the Japan Times, ``"If countries exit too early (from stimulus), and if we have a new downturn in growth, then really I don't know what we can do," the IMF managing director said at the Foreign Correspondents' Club of Japan.

``Although the IMF does not forecast a double-dip recession, he said, "You never know. It may happen."

So the IMF chief wants easy policy to remain, while their GSFR is cautioning against higher asset prices (implying an intervention is required). Are they simply pretending caution? Or are they merely playing safe by offering a contingent clause?

Here is another contradiction, this time from a Chinese official who rebukes US authorities for low interest rates which he believes risks exacerbating a US dollar carry trade bubble. This was when the US dollar was falling last November.

From Marketnews.com ``Liu Mingkang, the director of the China Banking Regulatory Commission, warned a forum here at the weekend that a falling dollar and low U.S. interest rates are providing a vehicle for speculation worldwide, and are exposing risks for the emerging markets in particular as asset prices soar.

"The carry trade in U.S. dollars is huge because of U.S. dollar depreciation and the U.S. government's policy to keep interest rates unchanged and that has had a big impact on global asset prices, encouraging speculation in stock and property markets," he said. (emphasis added)

With the US dollar apparently rising today and where outflows from China’s swooning stock market reached an 18-week high, we see a reversal of sentiment.

From the Telegraph, ``China's deputy central bank chief Zhu Min warned that tighter US monetary policy could spark a sudden outflow of capital from emerging markets, evoking the 1990s Asian financial crisis.”

So China initially smacks the US for low interest rates, easy policies and a weak dollar policy and then currently China censures the US for tightening, which is which?

Have authorities been seeing their shadows (policies) as if it have been chasing them (boom bust cycles)? Or is it a case of a tail (policy errors) that wags the dog (unintended consequences vented on the marketplaces)?

Given the prevailing undertones which reflect on the heightened apprehensions of policymakers, it is doubtful if true tightening would ever take place in the near future. Instead, what would force up interest rates would be the same dynamics that haunt China now, market based inflation from a boom bust process.

At present, global stock markets don’t seem to clearly manifest signals on these yet. Moreover, the dissonance or the incoherence of the opinions of the experts appear to demonstrate a market undergoing a reprieve more than one suffering from a bout of depression based meltdown as alleged by some grizzly bears.

As we have been saying it’s seems mostly about poker bluffing.

Dramatic Improvements In Global Country Default Risks (CDS)

The following is an updated table of country default risk courtesy of Bespoke Invest
According to Bespoke Invest, (all bold highlights mine)

``The CDS prices represent the cost per year to insure $10,000 of debt for 5 years. The US CDS price is quoted in Euros. The list is sorted by year-to-date change, and as shown, default risk in Russia and Australia is down the most in 2009 at -77%. US default risk is down 68.1%, which is the most of any G-7 country. Japan is the only country that has seen default risk actually rise in 2009, but it also had the lowest CDS price of any country at the start of the year. Overall, while CDS prices are down sharply in 2009, they remain well above where they were at the start of 2008, so there's still plenty of recovery work to do."

Additional comments:

Falling cost of insurance on global sovereign debt papers seems consistent with today's general climate where there has been a significant reduction in risk aversion, mainly due to massive and concerted liquidity injections.

This fires up the self reinforcing collateral-lending feedback loop mechanism where rising collateral values prompts for more lending, and more lending increases collateral values.

This seem to also filter into sovereign instruments too. For example, the Philippines has taken advantage of today's yield searching landscape to book its third dollar denominated debt this year. This comes amidst record bond issuance in parts of the globe.

While this paints an impression of stability, stability becomes future instability as the credit cycle expands on a pyramid structure, otherwise known as the Ponzi finance.

Bespoke rightly points out that most countries have seen their CDS levels STILL significantly higher when compared to the last column or the start of 2008, in spite of the general improvements.

This is a noteworthy reference point. Only Lebanon has seen its CDS rates today lower than the start of 2008.

Moreover the Philippines, startlingly, could be reckoned as the second best performer where its CDS levels are back to the start of 2008! Perhaps this could be one reason she has easily raised a third round of debt issuance this year.

Lastly Indonesia and Brazil are among the closest to recovering the start of the 2008 levels.

Again the marked improvements of credit risks could serve as a staging point for massive levered risk taking-ergo a new bubble.

2009: The Year of Surprises?

``A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. In contrast to a sharp and typically short-lived recession, when, after the rupture, business as usual can go on, the restructuring of a distorted capital structure will require time to play out. Rebalancing the distorted capital structure of an economy requires enduring nitty-gritty entrepreneurial piecemeal work. This can only be done under the guidance of the discovery process of competition, as it is inherent in the workings of the price system of the unhampered market.”-Antony Mueller, founder of Continental Economics Institute, What's Behind the Financial Market Crisis?

2009 will surely be an exciting year.

How can it not be?

After markets got beaten black and blue in 2008, the world in terms of government policy actions have been responding in an unprecendented breadth and scale, using up all possible and known tools, to prevent the financial meltdown or debt deflation from filtering or spreading to the real economy on a global dimension.

Given the alarmist response of policymakers, fear appears to have given way to outright panic. This suggests that at worst, we could be at risk of walking the tightrope between a depression and a collapse of the world’s monetary standard. At best, this could signal a monumental shift to a new financial and economic world order.

Undue Panic? First, global central bankers of major economies have collectively been lowering rates at a frenzied pace. A few economies like such as the US Federal Reserve Bank, Bank of Japan and Swiss National Bank have now embarked on a Zero Interest Rate Policy (ZIRP) regime. Others are expected to play catch up.

Next, the same authorities have been taking up the manifold role of last resorts as lender, guarantor, liquidity provider, market maker, financiers and investor, all within the doctrinal confines of the monetarist approach led by the illustrious late Milton Friedman.

Third, global policymakers have been doing a John Maynard Keynes in adopting massive fiscal stimulus programs. This seems to be the largest D-Day like operations to ever take hold where national economies would be coughing up trillions of dollars to replace “lost” aggregate demand with government spending.

Meanwhile, some central bankers have now been resorting to the crudest of all central banking tools; the printing press. Under the technical label of “Quantitative Easing” some central banks would be intervening directly in the marketplace mostly bypassing the commercial banking system-by providing loans directly to end users or by buying assets directly (mostly bonds to possibly even stocks) with the goal to reduce interest rate gap arbitrage, buoy asset prices and forcibly pry open the banking system to “normalize” lending or by intervening in the currency market with the tacit goal of “depreciating” the currency-without sterilizing or mopping these up.

Essentially today’s primary practitioner of the printing press, a signature approach of Zimbabwe’s central bank governor Dr. Gideon Gono will in essence be given a boost, as central bankers of major economies will likewise be utilizing these as the NUCLEAR option.

Politics and Inflation As Drivers, Overcapacity Balderdash

As anyone should notice, to gloss over the political dimension as drivers of markets and of economies in 2009, when governments have arbitrarily bestowed upon themselves the divine privilege of administering life or death to which industries or companies it would deem as qualified or otherwise, would be a monumental mistake!

For instance, in the US, given the approval of General Motors’ financing affiliate, the GMAC, to upgrade its status into a bank holding company, which essentially grants license for it to access government loans, has used this extraordinary privilege to aggressively launch a market pricing offensive (how about predatory pricing?) by offering 0% financing to the public at the expense of other automakers as Ford, Toyota or others that have not availed of government loans and rescues programs. In short, the competitive edge seems shifting in favor of those closest to Washington.

And it is no wonder why political lobbying has now transformed as the de facto booming Industry in the US and elsewhere as governments rediscover their clout in the economic horizon.

And it would be no different when applied to any country, such as the Philippines which has slated to undertake its own P 300 billion stimulus program for 2009 (abs-cbn). Political pandering will mean beneficiaries of such inflationary policies would get a boost over and at the expense of the rest. It would be a heyday for politicos, cronies, the bureaucracy and those affiliated with them.

Altogether, a few trillions of US dollars will be earmarked to “stimulate” national economies around the world.

And this “political variable as determinant of economic and market output” will not be confined to the premises of domestic politics but one of geopolitics too.

Policies implemented by one country could have economic and political repercussions which could force a policy response elsewhere. For example, fearing the loss of its domestic automakers industry as consequence to the recent bailout extended by the US to its domestic auto industry, Canada had been compelled to match with its own bailout program.

The obvious risk from the rampaging streak of overregulation and excessive market intervention is to raise the level of protectionist sentiment at a time when global economies appear fragile and reeling from the deleterious contagion impact of the financial meltdown.

Moreover, the general deterioration of the economic landscape could also translate to a snowballing of public security risks. Growing societal discontent could translate to rising incidences of public disturbances or social upheavals. For example, this financial crisis has claimed its first victim in the Belgian government which had its third leader for 2008.

Then there have been emerging incidences of global financial crisis instigated rioting in Greece, Russia and in China.

In other words, increasing signs of political instability at home is likely to induce policies that are “nationally” oriented than from a “global” perspective.

Thus, experts advocating for the “great rebalancing” of the global balance of payments asymmetries are like operating in the field of dreams- inapplicable under the realities of the US dollar standard system, (see The Myth of the Great Rebalancing), aside from the ongoing dynamics in the geopolitical sphere.

Aside, such “noble intentions that don’t square with reality arguments” seem to justify Black Swan Guru Nassim Taleb’s denunciation of the economic industry’s ‘intelligent nonsense’, this time for playing up the pious hype of using “exporting overcapacity” as rationale for compelling policymakers to be seek globally oriented interventions to correct current account imbalances.

A lucid example to debunk such theories comes from empirical evidence accounted for by a report in the New York Times, ``Through August, steel production was actually up slightly for the year. The decline came slowly at first, and then with a rush in November and December. By late December, output was down to 1.02 million tons a week from 2.1 million tons on Aug. 30, the American Iron and Steel Institute reported. The price of a ton of steel is also down by half since late summer.

``“We are making our steel at four mills instead of six,” said John Armstrong, a spokesman for the United States Steel Corporation, adding that two mills were recently idled and the four still operating are running at less than full capacity…

``Foreign producers no longer have an advantage over the refurbished American companies. Indeed, imports, which represent about 30 percent of all steel sales in the United States, also are hurting as customers disappear.” (underscore mine)

The point is unless the economic agents driving the supposed "overcapacity" is the government itself, the reality is that if private businesses can't get enough orders or not enough demand, then they simply will have to reduce output or suffer accrued losses, or at worst, fold up as in the account of the US Steel industry’s woes. Even when supported with indirect incentives as “exports subsidies, subsidized financing, import tariffs or currency devaluation”, if demand falls enough to render businesses unviable then the supply side will need to adjust.

It isn’t overcapacity as the problem but excess supply. Yet falling prices around the world seems to account for the market clearing adjustment process of such surpluses.

Moreover, excess capacity in a world of scarcity is a misnomer. We simply don’t have enough of anything. And that’s why a pricing system exists for goods or services. And that’s why poverty still exists. Excess capacity thrives only in a relative sense, and is mainly due to government interventions designed to prop up certain industries.

Finally, geopolitical tensions have likewise been apparently increasing, possibly aggravated by the present global financial and economic conditions. Some recent examples include:

-The mounting tensions between India and Pakistan. Following the terrorist attack in Mumbai India, which India has pinned the responsibility to Pakistan, the latter’s reaction had been a remobilization of troops along the Indian border. This raises the risk of another outbreak of military conflict from which the belligerent South Asian neighbors had suffered 3 wars over the past 70 years (1947-48, 1965 and 1971).

-Russia’s arbitrary shut down of gas supplies to Ukraine came amidst an acute financial crisis in the region. Russia supplies 25% of Europe’s energy requirement with about 80% of natural gas imports coursed through Ukraine. Given the recent military victory of Russia over Georgia, Russia’s exploits could be deemed as another attempt to reassert geopolitical control over the crisis stricken Eastern Europe (Ukraine recently secured $16.4 billion in loans from the IMF). On the other hand, given Russia’s domestic crisis, the Ukraine gas supply episode may be construed as an attempt to deflect the public’s attention towards regional concerns. Nonetheless, an acrimonious environment could again raise the specter of another war conflagration.

-The recent spate of bombing by Israel of the Hamas controlled Gaza strip and its possible escalation have also added to geopolitical jitters.

Political Motives Allude To INFLATION As Resolution To Ongoing Debt Deflation

Over $30 trillion of market capitalization have vanished last year as a result of the 2008 meltdown while write downs from financial firms have been estimated to have topped $1 trillion (IHT). With $8.6 trillion of US taxpayer money pledged to guarantee and support the financial system, possibly plus another $1 trillion for the inaugural stimulus package for incoming US President Barack Obama many have been optimistic about a quick turnaround in the US economy.

For us, it is highly unlikely that a “normalized” credit recovery would happen the same way as it did in the recent past.

In a credit cycle the relationship of lending and collateral values becomes a self-reinforcing feedback loop. In a boom phase, increases in lending prompts for higher collateral values which fosters even more lending or gains beget even more gains, until such trends tips over to the inflection point. And when debt deflation ensues, the decrease in lending prompts for a similar reduction in collateral values which further impels for a decline in lending activities, thus, losses fuel even more losses.

This means that “normalization” should extrapolate to a “resurrection” of the previous 20-1, 30-1 or 50-1 leveraging seen in the securitization –derivatives market and the over $10 trillion shadow banking system! Unfortunately, with roughly 20% of US banking now owned by the US government, we won’t see the same degree of leverage, unless the US government and other governments will assume such a role.

Yet the US government has so far absorbed or cushioned much of the losses in collateral values but has been unable to push prices higher in order to spur the release of the huge stash of bank reserves in the system (see figure 1)

Figure 1: St. Louis Fed: Spike in Adjusted Monetary Base

Ironically too, while the US government has been trying to reignite the borrowing lending or credit cycle in the banking system with a gigantic infusion of funds into the system, calls for tighter regulation in the financial system is apparently offsetting all these efforts. In short, what the right hand is doing, the left hand is taking away.

For us, what seems most likely to occur is a back to basics lending template than a sudden reinvigoration of the credit system which is hardly going to successfully reverse the debt deflation process.

In addition, today’s housing and securitization bubble bust has been transforming the American psyche to a cash building deflation psychology (a.k.a. Keynesian term: slowing monetary velocity). In other words, US savings which has been nearly zero over the recent years will be improving as households and the financial sector repair their respective balance sheets. There would have to be an immense force strong enough to reverse such psychological trend.

This brings us to the basics: the fundamental problem of the US economy is simply having too much debt. Or debt levels more than the economy can afford, with most of these unsustainable liabilities tacked into the balance sheets of the financial industry and the US households. Today’s losses have reduced some of the imbalances but have not been enough to normalize credit flows with or without government interference. And the obvious solution is to bring debt levels down to where the economy can be able to sustain them.

Unfortunately given the severity of the situation the alternative solutions to the problem we could see are: Default, Debt forgiveness and or market based deflation or inflation.

As we have noted before default isn’t likely to be a favored option because it would entail a severe geopolitical backlash:

-The most probable response to the US government debt repudiation would be an outright collapse of the US dollar standard and the US banking system as every creditor nation would possibly disown or seize the US dollar and US dollar based assets when available.

-Protectionist walls will rise everywhere which would lead to the modern day great depression and possibly a world at war.

-given the US sensitivity to import dependence, the severance of trade will create extreme shortages in the economy.

On the other hand, market based debt deflation is representative of today’s meltdown.

Market based debt deflation seems an anathema to the existence of global central bankers, or seen alternatively, for debt deflation to succeed means the loss of justification for the existence of modern central banking. Thus, central bankers will likely exhaust all possible means to prevent deflation from succeeding with every available or known tool as we have been witnessing today.

Again this leaves us with two likely alternative paths:

In an inflation dependent economy (see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?), structural economic growth requires the sustained acceleration of money and credit expansion similar to a pyramiding structure. This means that with the private sectors hands tied, only government can take its place by massively inflating the system from which they can implement through the banking system or outside the banking system (see Welcome To The Mises Moment)

In addition, the only possible way to reverse a deepening transition to a cash building deflation mindset is to debase the currency enough to incite people to seek an alternative “store of value” (as example see The Origin of Money and Today's Mackarel and Animal Farm Currencies).

Next, while the promulgated political incentives will be targeted to (hopefully) resuscitate the economy, the tacit incentives for authorities like US Federal Chair Ben Bernanke (and other central bankers who seem stooges for the Bernanke Doctrine) could be to erode the real value of existing liabilities echoing the calls of Harvard Professor and former IMF economist Ken Rogoff (see Kenneth Rogoff: Inflate Our Debts Away!) or simply to defeat inflation by all costs to validate Bernanke’s thesis as the “qualified” expert of the great depression (plain vanilla hubris).

Finally, central bankers have this notion that once they unleash the inflation genie out of the proverbial lamp, having to use it according to their desires, they can easily control, recapture and return it.

Yet the Federal Reserve could be overestimating their powers, according to Robert Higgs at the independent.org, ``So much potential new money is now impounded in the commercial banks’ holdings of excess reserves that it is difficult to see how the Fed will be able to stem the flood once the banks begin to transform those excess reserves into normal loans and investments. If the Fed attempts to sell enough government securities to soak up the growing money stock, it will drive down the prices of Treasury bonds and hence drive up their yield, increasing the government’s cost of borrowing to finance the huge budget deficits the government will be running because of its various bailout commitments and so-called stimulus programs. This scenario holds the potential for a complete monetary crackup.”

This implies that perhaps the risks that the markets or global economies could be faced with in 2009 will be tilted towards GREATER inflation if not HYPERINFLATION.

And for those who expect such a risk transition to be in a gradual phase, we just might get flummoxed. Let us take a clue from Murray Rothbard on 1923 Weimar Germany’s experience in his Mystery of Banking,

``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.” (bold highlight mine, italics-Rothbard)

When governments decide that the risks to the real economy would require a dramatic reduction of debt levels then they may resort to massive devaluation which independently may lead to a currency war, hyperinflation, severance of the dollar links or dollar pegs, and a disorderly unraveling of the US dollar standard.

However, if global central bankers decide to resolve this problem collectively they may opt for “debt forgiveness” which may entail a reconfiguration of the world’s monetary architecture similar to one floated in yesterday’s Wall Street Journal Editorial over the seeming success of the Euro as a model, ``the lessons point to the eventual need for a single global currency. That may be a political leap too far. But the world could still harness the benefits of exchange-rate stability if its political and economic leaders began to discuss how better to coordinate monetary policy.” Not that we support such theme but our intention is to depict of the growing recognition of the cracks in the present monetary system by the mainstream.

Nonetheless, any new monetary architecture will effectively translate to a diminished role of the US dollar as the world’s currency reserve or the world’s economic and financial hegemon. So 2009 could be the advent for a new world order.