Chart of the Day: Bernanke’s 2014 Taper

Presented without further comment the yield of the 10 year US Treasury from US Fed Chair Bernanke’s 2014 taper.

Phisix Meltdown: A Reality Check on the Bullish Dogma

Life is not about self-satisfaction but the satisfaction of a sense of duty. It is all or nothing.--Nassim Nicolas Taleb

The Reality Check

Except for the US, this week had been a gory one for global stock markets.

The Philippine benchmark the Phisix nosedived by 4.56%. Such loss was the second biggest in Asia, after Japan’s Nikkei. Except for Vietnam, Pakistan and Bangladesh, Asian markets hemorrhaged.

In two weeks, the Phisix surrendered 7.96%. From the highest weekly close during May 17^th at 7,279.87, year-to-date gains crumbled from 25.2%, nearly a month back, to just 15.3%. 

In almost a snap of finger, confidence evaporated. What seemed as the impregnable and infallible trade has been exposed, in just two weeks, as vulnerable and fragile.

Who would have thought that the conventional wisdom of the “rising star of Asia”, “no property bubble”, or “stunning growth” could produce such a bloody outcome?

What used to be mainstream heresy now represents as a reality check.

Just a few months back, mainstream experts pontificated that the Philippine stock markets have become more resilient from external events. They implied of “decoupling”. These experts cited many reasons such as the alleged low debt levels, huge foreign currency reserves or robust statistical economic growth among many others, mostly cherry picking of data sets.

In what seems as a turnaround, the same experts now attributes today’s market weakness to “global” factors. Such implied admission uncovers the myth of decoupling as consequence to the current meltdown.

Imagine today’s meltdown comes with no debt crisis yet. How much more if a debt crisis becomes a fact?

The susceptibility to exogenous dynamics is just one factor. The more important one is the massive buildup of internal imbalances as a result of quasi permanent boom monetary and fiscal policies. In short, domestic bubbles.

Should the onslaught of the global bond market vigilantes intensify, such imbalances will unravel. This would represent the “periphery-to-the-core” syndrome of the bubble cycle.

Yet most of mainstream experts appear to be in denial. They say that this episode is temporary, represents shopping for bargains and is tradeable.

They could be right. But if they are wrong, yield chasing could metastasize into concerns over return OF capital. Denials will morph into depression.

The context of “tradeablity” depends on two things: market timing, or in specific, the chance of catching a bottom and of the degree of rally.

These are factors nobody can predict with consistent accuracy. Not charts, not statistics. These will largely depend on lady luck.

If bull markets can have extended upside actions, panics extrapolate to a mirror image. This means that if markets continue to fall then what is seen as “bargain hunting” may mutate into “catching of falling knives”. 

Two examples: Anyone who tried to bargain hunt the mining sector (left window) from the early part of this year would have been thoroughly bludgeoned.

On the other hand, in 2007 the initial selloff on the Phisix produced a tradeable bull trap: Those who bought during the August bottom and sold at the peak of October would have ideally profited from such ideal lady luck guided trade. But for those who bought into the late “false positive” rally, they would have all lost significant amount of money, unless they cut their position.

Let me be clear: For now, I am not saying that the bear market is here. What I am saying is that unless the upheavals in global bond markets stabilize, there is a huge risk of market shock that may push risk assets into bear markets.

Bottom line: Current markets seem as in crossroads; if political actions will be able to soothe the mercurial bond markets, then current conditions represents an interim bottom.

If not, or if the conditions of the bond markets deteriorates further, then the imminence of a bear market on risk assets.

This represents an “if, then” conditionality and not a linear based prediction.

The Return of Bond Vigilantes: “All These Trades Start To Fail Massively”

The above chart represents the changing dynamics of the risk ON-risk OFF environment.

From 2009 until 2011 (chart is abbreviated from 2010), the risk ON landscape produced a synchronized bull market in every asset class (blue arrows), particularly, the bond market (UST-US 10 year treasury price), the US stock markets (as measured by the SPX or the S&P 500), gold-commodities (Gold) and emerging market equities (MSCI Emerging markets- MSEMF). In other words, the 2009-2011 bull markets exhibited convergence and tight correlations.

But such relationship began to diverge in mid-2011 (green arrows). Emerging markets took the initial hit; then this spread to the gold-commodities market and, now to the bond markets. 

This leaves the US equity markets as the only major asset class remaining on the upside as global stock markets have recently been slammed. [Amidst today’s selloffs are booming frontier markets]

US 10 year Treasury Prices appears to have topped exactly the same period last year and has been in a constant decline. Bond prices exhibit opposite relations to the yield[1]. 

The US Federal Reserve (FED) announced of the expanded unlimited QE 3.0 in September of 2012[2] the objective of which has been to “put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”

Ironically, the FED’s QE program appears to be producing the opposite effect: an upward pressure on longer-term interest rates!

As of Friday’s close, US 10 year bonds are at critical support level or that yields are at crucial resistance level. A breakout of such thresholds will likely intensify the pace of the interest rate increases.

In contradiction to mainstream media’s post hoc narratives that the FED has been spooking the US Treasury markets, chart actions shows of a reverse causation: Rising interest rates have been compelling FED officials to make chatters about “tapering”. Or rising rates have prompted FED officials to realign their views with the market actions in order to maintain their so-called credibility.

The failed QE policies appear as being ventilated on the bond markets.

The returns based Dow Jones Corporate Bonds Index[3] (DJCBP) has recently collapsed as yields have significantly risen. 

Even as the US stock markets have been performing strongly, REIT stocks (real estate investment trusts) represented by the Dow Jones US Mortgage REITs Index has also been plunging[4].

Meanwhile increasing rates has spilled over to the US housing seen via the Mortgage Backed Securities of government sponsored enterprises such as Fannie Mae[5] (FNMAM).

Media has been awash with the adverse ramifications of the rioting bond markets. High yields funds has posted the biggest record outflows[6], US credit default swaps rises to a two month high along with deepening losses from junk-bond exchange-traded funds[7] and carry trades endures from deepening losses.

This is noteworthy quote from the Economic Times[8] depicts of the aura of the current milieu

"Carry works as long as things don't change, and what really changed in our mind a few weeks ago was the message from the Fed," Rajiv Setia, the head of US rates research at Barclays in New York, said in a May 30 phone interview. "Once you start worrying about hikes, all these trades start to fail massively."

An improvement in the growth outlook induces confidence and henceforth should reflect on improvements on credit standing and credit quality.

But as the chart above shows[9], rising yields and increasing prices of credit default swaps[10] (or insurance premium on debt) have been indicative instead of market concerns over credit quality, or simply put, growing default risks.

Crashing global stock and bond markets, aside from sluggish commodity markets amidst rising interest rates demonstrates that bearish forces has been at margins spreading and outflanking the bulls.

Such likewise suggest of monetary tightening which has been seen through increasing signs of liquidations and deleveraging mainly on the credit markets.

If unlimited QE 3.0 has been putting pressure on interest rates, more QE will likely add to such pressure, and less QE also compounds on the interest rate risks woes.

The FED’s QE, like Abenomics, seems in a trap, where they are in a “damned if you do and damned if you don’t” predicament.

The very important difference between today’s bubble conditions from the US Lehman bubble days is that in the recent past, the bond markets specifically government bonds benefited from the bubble crash. Thus, governments from crisis stricken nations substantially channelled the rescue of financial institutions and of the political economy via the bond markets, thus the ballooning of government bonds[11] (upper window).

Today, the likely epicenter for a black swan event will be on government bonds first, and also on financial companies[12] exposed to government bonds as well as to asset bubbles. 

This also translates to increasing risks of a bond bubble crash or a debt crisis.

This also signifies as a backlash or the unintended consequences from previous government “bailout” policies.

These factors are hardly bullish for stocks.

As a side note, asset bubbles and statistical improvements in the US hardly suggest of a “goldilocks economy”[13], not too hot or not too cold economy which US media tries to sell.

Instead they signify as the “periphery-to-the-core dynamics” of bubble cycles and the Wile E. Coyote syndrome: inflating asset bubbles on increased leverage amidst rising interest rates—such lethal mix are ingredients for a financial “all these trades start to fail massively” accident.

Foreign Money: the PSE’s 800 Pound Gorilla

I read one so-called expert say that last week’s bloodbath had some signs of what is known as a “sudden stop”.

Sudden stops[14] which represent a slowdown or reversal of private capital flows into emerging market economies usually occur to nations suffering from large current account deficits. Sudden stops are in truth symptoms of the unwinding of internal emerging market bubbles.

But this hasn’t been the reality with regards to the latest ASEAN selloff yet. While trade deficits have indeed been swelling, ASEAN’s current account balance[15] remains a surplus, albeit in a decline.

In today’s tightly connected global financial markets, contagions can occur even without a bubble bust. The Philippines Phisix suffered a collapse in 2007-8 even when the economy continued to post positive growth, and corporate earnings were just off the record highs[16]. In short, a parallel universe or a huge disconnect emerged between actions in the financial markets and real events.

Yet such developments are hardly accepted by the mainstream intelligentsia who continues to peddle unrealistic conventional methodologies to the unwitting and gullible public.

If bubbles in ASEAN’s real economy continue to inflate, which will get reflected on trade and current account balance, then eventually a “sudden stop” may become a reality.

Last week’s meltdown has basically been foreign driven. Emerging market bond markets and stock markets registered substantial outflows[17] and so with Asia ex-Japan Equity Funds, which according to Livemint[18], were triggered by a further dip in sentiment towards China.

The Philippine Stock Exchange posted a net weekly selling of Php 8.43 billion (US$ 200.65 million) the largest since October 2012.

It is important to point out the biggest driver of the latest rally in the Philippine financial markets has been foreign money.

Foreign investors according to the BSP[19] were net buyers of P110.0 billion worth of stocks in 2012, more than double the P50.0 billion net purchases recorded in 2011.

And foreign money has also underpinned the yield chasing rally of ASEAN’s local currency (LCY) denominated government bonds[20].

I found no updated data for the Philippines but I will apply deductive logic instead. Considering the general trend exhibiting significant increases of foreign money on our neighbors’ bond markets plus the recent credit upgrades, these factors should imply at least a similar pace of foreign money placements on Peso denominated bonds.

Yet if bond vigilantes continue to wreak havoc on the financial markets, then current inflows to bond and stock markets may reverse, as this week has shown.

We understand that an estimated 83% of the market cap held by the politically privileged economic elites.

If foreign money turns sour on emerging markets including the Philippines, it seems wishful thinking to be bullish on the Phisix in the knowledge of the disproportionate or lopsided balance in favor of foreign investors (15-16%) vis-à-vis local participants (about 1%).

Should a significant number of foreigners head for the exit doors, similar to 2008 as shown in the previous BSP chart, such would be enough to push the Phisix into a deep bear market.

We cannot expect local investors to absorb the massive wave of foreign exodus for mainly the same reasons as the low penetration level of household (estimated at 21 out of 100) access to bank accounts, the informal system can hardly migrate to the formal system due to regulatory obstacles such as “Anti Money Laundering Act”, and of the inadequate understanding of finances.

Besides, even those with access to the banking system appear to be risk averse, they are most likely invested in government papers.

Sovereign papers (bills and bonds) accounts for 87% of the Php 4 trillion (US $99 billion) Philippine Peso bond markets, according to the ADB.

But again if bond vigilantes persist to unsettle financial markets, even these sovereign paper holders in the local banking system will endure losses.

And this also will apply to the government. The Philippine government has $40.3 billion of US treasury holdings as of March 2013 according US treasury[21]. This accounts for 42% of the BSP’s total assets[22] or about half 49.6% of the BSP’s Gross International Reserve, as of November 2012. A bear market in US treasuries would shrink the vaunted GIR, as well as, impose losses on the BSP.

It would take the resources of the entrenched families of economic elite to help cushion any decline.

Again this is an “if then” proposition.

The Myth of the Yen Targeting Redux

The mainstream has been fixated with the yen rather than the JGBs from which the Bank of Japan’s policies has been directed to.

Some have come to mistakenly believe that the BoJ targets the yen. This is arrant nonsense. Look at the chart of Japan’s Nikkei and the USD-Yen exchange rate[23]. Do you think that the BoJ designed both the boom and the latest collapse of the Nikkei and the USD-yen?

Last Friday, the Nikkei has touched or encroached on the 20% threshold levels which demarcates of a bear market.

While I would say that previous boom of the Nikkei and the weakening of the yen has been a desired outcome by political authorities, they are coincidental. The ongoing reversal hardly represents a policy agenda.

One of the supposed three arrows of Abenomics is the doubling of monetary base via the BoJ’s asset purchasing program. And since the announcement last April[24], the BoJ directly bought into JGBs (6.58%) and commercial papers (30.86%) and a scanty 1.33% of foreign currency assets as of May 31.

It is important to point out that JGBs account for 77.55% of BoJ’s balance sheets, while commercial paper and foreign currency assets represent 1% and 2.76% share respectively. So a 6.58% increase is substantial for 77% of BoJ’s assets.

Notice that the JGBs have traded rangebound from a high of nearly 1% to a low of .8% (left window).

The BoJ appears to have set an implicit target at .9% and thus the range which comes at the cost of a boom-bust cycle.

Since the announcement of the boldest experiment in modern central banking history, the BoJ’s JGB purchases allowed JGB sellers to use the proceeds to bid up on the asset markets. Along with the explicit inflation target of 2% which provided a boost to inflation expectations, direct interventions increased the monetary base from which the yen responded with a corollary sharp selloff.

The Nikkei and yen became tightly correlated arising from the feedback loop from such dynamics. Unfortunately the Nikkei punters came to realize that this was not sustainable. Ben Bernanke’s tapering talk provided the trigger for the tipping point.

Since, the yen has firmed along with a collapsing Nikkei.

Again boom bust cycles have not been the desired outcome but represents as the unintended consequence from aggressive inflationist policies.

Common sense or basic logic tells us that given the immense interest rate sensitivity from the gargantuan nearly ¥ 1 quadrillion of JGBs the BoJ will prioritize targeting JGBs rather than the yen.

Japan has nearly 250% debt to gdp, and as I pointed out last week[25],

The Japanese government’s tax revenues have been estimated by the Ministry of Finance at ¥ 43.1 trillion for 2013. National debt service accounts for ¥ 22.241 trillion which accounts for 24% of the general account budget or 51.4% of tax and stamp revenues. This may have been computed using perhaps less than 1%, if based on the yields of 10 year bonds. Thus a spike of interest rates to 2% will most likely wipe out the Japanese government’s ability and capacity to pay her obligations.

In targeting the yen, this would risks setting loose the bond vigilantes that would devastate on the JGB markets and bring about immediately a debt crisis.

Yen targeting will be like Godzilla running amuck and razing Tokyo.

Why would the Japanese government target the yen when merchandise trade as % gdp[26] accounts for only 28.59% (left window) in 2011 while exports constitutes[27] just 15.2% of gdp (right window) over the same period?

Such notion that the government will risk a debt crisis in order to pump up exports reeks of rank foolishness and is devoid of common sense.

Nonetheless crashing Japanese stock market has prompted Japan’s PM Shinzo Abe to use political suasion to convince their largest public pension fund, Government Pension Investment Fund (GPIF), to invest in risk assets as I recently noted. The GPIF has announced that they will comply by selling a fraction of JGBs and shifting 1% to domestic stocks and 3% a piece to foreign stocks and bonds. This announcement lifted the Nikkei from bear market territory to close with marginal losses.

Such a shift may provide a temporary boost or relief to Japan’s oversold stock markets and some of the world’s stock and bond markets which the GPIF will acquire.

But then consequences over the clashing goals of stoking price inflation and of low interest rates remains as the proverbial sword of Damocles which hangs over the head of Japan’s financial markets, and of the potential contagion risks particularly to Asia.

While JGBs appears to have stabilized at the costs of a volatility surge in the Nikkei and the yen, Japan’s credit default swap has been revealing of increasing stress via rising credit default swaps[28]. The Japanese government appears to be fighting the mythical hydra, where cutting of one of the monster’s many head would grow two more.

Finally the huge rally in Wall Street will likely provide a relief rally in the Nikkei and from the battered world markets. However, rising US markets and falling bond markets will eventually prove incompatible.

The Nikkei is expected to open strong as Nikkei futures suggest of a ‘gap up’ gain of 2.5%. Yet given the fantastic intraday swings during the past week, the question is will this hold?

Inflationistas are hoping that George Soros’ repositioning on Japan’s stock markets[29] would provide support to their cause.

In my view, if interest rates as expressed via the bond markets continue to rise across the world, any relief rally would be short-lived.

Everything now seems to depend on whether bond vigilantes will remain on a blitzkrieg or will be contained by forthcoming political actions.

Since we are at crossroads, where risks are extraordinarily high, do trade with extreme caution.

---

[1] Investopedia.com Advanced Bond Concepts: Yield and Bond Price

[2] CNN Money Federal Reserve launches QE3 September 13, 2012

[3] S&P Dow Jones Indices Dow Jones Equal Weight U.S. Issued Corporate Bond Index The Dow Jones Equal Weight U.S. Issued Corporate Bond Index is an equally weighted basket of 96 recently issued investment-grade corporate bonds with laddered maturities. The index intends to measure the return of readily tradable, high-grade U.S. corporate bonds. It is priced daily.

[4] S&P Dow Jones Indices Dow Jones U.S. Mortgage REITs Index The proprietary classification system described at www.djindexes.com defines the Mortgage REITs Subsector as real estate investment trusts or corporations (REITs) or listed property trusts (LPTs) that are directly involved in lending money to real estate owner

[5] Wikipedia.org Fannie Mae

[6] Bloomberg.com High-Yield Funds Post Record $4.8 Billion Outflow, BofA Says June 8, 2013

[7] Bloomberg.com Credit Swaps in U.S. Rise as Investors Search for Stimulus Clues June 7, 2013

[8] The Economic Times Carry traders lose on Federal Reserve’s talk of tapering QE June 5, 2013

[9] Zero Hedge It's Not Growth 'Hopes' That Has Backed Up Rates June 4, 2013

[10] Investopedia.com Credit Default Swap - CDS

[11] BBC News Is UK government debt really that high? December 22, 2009

[12] Branimir Gruić Philip Wooldridge Enhancements to the BIS debt securities statistics Bank of International Settlements December 2012

[13] Investopedia.com Goldilocks Economy

[14] Wikipedia.org Sudden Stop

[15] IMF.org Figure 1.10. Asia: Current Account Balances

[16] See Dealing With Financial Market Information February 27, 2011

[17] Reuters.com Outflows from bond funds hit record in latest week -EPFR June 7, 2013

[18] Livemint,com Emerging markets see highest fund outflow since 2011 December quarter June 8, 2013

[19] Bangko Sentral ng Pilipinas 2012 Annual Report

[20] ADB, Emerging East Asian Local Currency Bond Markets: A Regional Update Asian Bonds Online June 2013

[21] US Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[22] Bangko Sentral ng Pilipinas Economic and Financial Statistics

[23] Danske Bank Europe delivers the good news Weekly Focus, June 7, 2013

[24] See Video: Kyle Bass on Kuroda’s Doubling of Monetary Base; Japan’s Debt Trap

[25] See Abenomics: Will Japan Face a Debt Crisis Soon? June 3, 2013

[26] World Bank Merchandise trade as % of gdp Google public data

[27] World Bank Exports of goods and services (% of GDP)

[28] Tokyo Stock Exchange Credit Risk (CDS Indices)

[29] CNBC.com Investors Dump Japan, but Soros May Be Buying Again June 7, 2013

Phisix and the SET: Why Talking Up the Embattled Stock Markets Won’t Work

Desperate stock market authorities from the Philippines and Thailand gave an advice today to panicking stock markets: CHILL.

From Bloomberg:

Stock exchanges in the Philippines and Thailand have moved to soothe investors after speculation the U.S. Federal Reserve may scale back bond purchases prompted selloffs by overseas investors.

Stock Exchange of Thailand President Charamporn Jotikasthira today urged investors not to panic, saying economic and corporate earnings growth in Southeast Asia’s second-biggest economy remains strong. The benchmark SET Index dropped to two-month low. Philippine Stock Exchange President Hans Sicat described the selloff as an “extreme overreaction.”

The Philippines benchmark index has slumped 11 percent and the Thai gauge 8.4 percent since May 22, when Fed Chairman Ben S. Bernanke said policy makers could consider reducing the pace of monetary stimulus if the nation’s labor market improves. Overseas investors have sold a net $414 million of Thai stocks and $147 million of Philippine shares this month.

“Foreign net selling is an extreme overreaction to Bernanke’s” outlook on possible stimulus cuts, Sicat said in a televised interview with ABS-CBN News today. “Technical corrections tend to be buying opportunities for others who are more conservative.”

Authorities from both former sizzling hot stock markets hardly provided sufficient explanations as to the relationship between the so-called proposed Bernanke’s stimulus cuts vis-à-vis the meltdown, and why the current market paroxysm has not been justified. 

A reduction of stimulus, and not a cessation, simply means of a partial tightening of monetary environment. This could be suggestive of the advent of high interest rate regime. 

And the brutal market reactions reveals of the extent of sensitivity to interest rate changes due to the degree of leverage employed and established around the Fed’s and local central banking "stimulus".

Simply said, financial markets have been deeply addicted to central banking steroids. Thus the recent stock market rout may be analogized as "withdrawal syndromes"

While it may be a coincidence that the emerging markets, represented by the Philippines (PCOMP-yellow) and Thailand (SET-green), turned the corner (dark blue vertical line) as shown in the above chart from Bloomberg since the May 22nd Bernanke spiel, in reality interest rates as impliedly measured by the US 10 year yields (USGG10YR-orange)  has already been in a sharp ascent since the early days of May. This means that Bernanke's babbles seem as trying to realign their policies to match or to reflect on the actions of the bond markets. 

Of course when authorities talk about strong “economic and corporate earnings” they are referring to the recent past events which blossomed under a low interest rate environment. The prospects of higher interest rates essentially changes this, which has been the reason for such violent response.

Finally, words of appeasement from authorities like the above sends shivers down my spine. That’s because they resonate with the responses made by authorities during a somewhat similar crash environment 

Here is a some quotes from the October 29, 1929 stock market “Black Tuesday” crash that ushered in the Great Depression:

Sept. 1929: "There is no cause to worry. The high tide of prosperity will continue." Andrew W. Mellon, Secretary of the Treasury

Oct. 14, 1929: "Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board". New York Times

January 21, 1930: "Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said that reports to the Cabinet showed the tide of employment had changed in the right direction." News dispatch from Washington

May 1, 1930: "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States-that is prosperity." President Hoover

June 29, 1930: "The worst is over without a doubt." James J. Davis Secretary of Labor.

Sept. 12, 1930: "We have hit bottom and are on the upswing" James J. Davis Secretary of Labor.

What I am saying is that markets ultimately determine whether the interim trend and price levels are justified or not. 

Media’s appeal to authority and the subsequent denials made by authorities will hardly wish away any perceived problems the markets sees, which are currently being ventilated through the vehement feedback as expressed via steep price declines.

Following successive sessions of severe drubbing, the vastly oversold Phisix turned from a 164 point intraday opening decline to close higher by .78% or 58.21 points today (chart from technistock.com ).

The sharp rebound has little to do with pitching up of the marketplace, but about knee jerk responses to extreme technical conditions. 

Thailand’s SET slumped 2.13% today.

Video: Former Fed Governor on Bernanke’s QE: Unproven Experiment , Risks of Exit have to be Higher

Former Federal Reserve governor Kevin Warsh in this CNBC interview elucidates of the potential risks from Bernanke’s Open Ended QE

Here are some key points:

Ben Bernanke is a “modest man” with “an immodest move”

Yesterdays move was an “aggressive move”…which means that “They are really worried with the state of the economy”….part of it could be that “They must be dealing with some of the Tail Risk Europe is in an early innings of a recession” while Asia has been “weakening too”

For Mr. Warsh “Exit is a four letter world” where “exiting from a monetary policy is technically difficult”. He sees the benefits from QE as “incontestably small and that the risks are unknown”…He further notes that “This is an unproven experiment so risks of exit have to be higher”

So the FED’s hands are essentially tied and risks are magnified rather than suppressed.

Mr. Warsh also talks about the moral hazard risks by open ended QE on Washington where

“The risk in Washington is real too. I don’t mean political risks. What I mean is if the Federal Reserve is now in a business of private pullout, “rabbit out of hat” everytime the economy loses control, then the rest of Washington can say there is not much we can do or need to do because Bernanke has got my back. I do not think that is his intent”.

The implied incentive provided by QE to Washington is to rely on more inflationism.

Mr. Warsh adds that in reality the US state of the economy has been struggling “We’re not in a panic we are in a lousy recovery”

Short term oriented “informercial” policies have also been amplifying risks, yet this has been the framework guiding Fed and Washington policies

“For 4-5 years…Washington has been in the business of solving the next quarter, solving for the next election $5 trillion trying to turbocharge the economy we’ve been running stimulus program after stimulus program and GDP can look a little better next quarter but we’ve been running this program like it’s an infomercial…this time of short term policy has not served as well. I don’t they served the politicians well. We need to fundamentally change what our time horizon is”

Real recovery must come through improving competitiveness

“The private sector has much better at asset allocation than the government”

And that central planning has been hobbled by the knowledge problem

“There is lots of talent there, but they do not know which direction capital should go”

Mr. Warsh delineates what central banks can and cannot do

“Central banks are in the business of buying time…until the economy gets into the groove. But what we heard yesterday was that we will be buying time for a very long time”

He also notes that

“Policy makers should be humble”

Most importantly Mr. Warsh sees the market as I see it

“If you continue to look at the markets right now, where asset prices continue to melt up where asset prices are driven less by fundamentals in particular companies and more by speeches and policies come out of Washington you are taking this risks. Risk are highest in the economy when measures of risk ARE lowest, when I look at the VIX at this level and you compare that to the headlines you guys read every morning they certainly do not seem in sync that’s when shocks happen”

Shocks happen because inflationism has obscured the market price signals.

Why Deflationists Are Most Likely Wrong Again

“After the crisis arrives and the depression begins, various secondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation — a contraction in the supply of money. The deflation causes a further decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit contraction by the banks — and this is almost always the case — this will have the beneficial effect of speeding up the depression-adjustment process.” Murray N. Rothbard

I find it bizarre for many mainstream experts, if not nearly all, would try to interpret government’s policy actions as means to support the economy (read: property markets) and NOT the politics (read: the banking system).

And these are the same set of people who appear to impassionedly invoke the reprehensible deities of deflation in order for the government to apply more inflationism.

Figure 1: Mark Perry[1]: Relative Bank Failures/St. Louis Fred: M2 annual change

It doesn’t really matter whether the US government put in line an estimated $23.7 billion in bailouts[2], and the countless alphabet soup of stop-gap measures or programs in terms guarantees, swaps, and the various functionality of last resorts, all of which had been applied to ensure the untrammelled flow of liquidity into the financial system.

What seem to only matter to them is that “deleveraging” and the attendant alleged price contraction on every level will be due to loss of “aggregate demand” which ensures a deflationary outcome. As if these “deleveraging” is straightforwardly corollary with “price decline” regardless of the validity and strength of causation linkages.

Yet it’s been nearly two years since deflationists have brandished charts similar to the M2 in figure 1 (right window) to call for the unsustainability of the current economic recovery, and now, since the deflationary spiral hasn’t still happen, they invoke new references such as low interest rates to try to argue their case based on a preconceived bias.

Equally, they now junk this piece of evidence since it has now gone against their argument. So selective perception dominate the mainstream’s reasoning to argue for their rabid fear of deflation.

It doesn’t really matter too, that today’s banking failure hardly matches EVEN the savings and loans meltdown during the 90s and remains a fraction to the domino effect of bank collapses during the GREAT Depression of the 1930s (left window). Yes this includes the 110^th bank in Illinois[3], which failed August 13^th.

Gustave Le Bon appear to be correct[4] anew when dealing with crowd perception, “A crowd thinks in images, and the image itself immediately calls up a series of other images, having no logical connection with the first.”

These people fail to acknowledge that the deflation mess of 1930s wasn’t only due to banking collapses which paved way for the monetary contraction but importantly had also been due to the massive waves of regulations imposed that inhibited trade (Smoot-Hawley Act) and the necessary adjustments in the price levels within the system (New Deal Programs)[5].

Blindness Stems From Political and Economic Religion

The difference why many pundits can’t seem to see is because the monetary contraction they’ve hoped for, out of their predetermined bias, had been offset by an expansion of free trade worldwide.

Thus whatever contraction in US based credit from the banking system had clearly been offset by a surge in globalization[6]and the attendant boom of credit elsewhere. And this is why despite the incremental improvement in the traditional credit system, there has been a boom ongoing in US corporate bonds[7].

Some have argued that corporate bond market are meant to fall, due to the possibility of a double dip, but which is chicken and which is the egg? Given their logic, bonds markets should have never rebounded on the first place.

Besides, there is also the uneven impact from convergent rescue policies applied by respective governments. Given the idiosyncratic nature of each economy, the impact has clearly been asymmetric. And German’s stunning 2^nd quarter outperformance in economic growth seems to be an example[8].

So far, this has been what the Fed has accomplished: By preventing the collapse in the US banking system, which incidentally still remains as the de facto reserve currency of the world, it has managed to keep afloat the payments and settlements function that has allowed the trade mechanism to flourish in spite of signs of credit contraction at home.

This represents as Pyrrhic ‘battle’ (meaning short term) victory at astounding cost to the US taxpayers to sustain the her stature as the world’s currency reserve standard, with the big possibility of a huge unintended payback in the future. That payback, from our perspective will be in the form of higher inflation, bear market in US treasuries or an overall stagflationary environment.

The point is by preventing a collapse in the banking system the Fed has effectively staved off deflation in the 1930 context.

In addition, I don’t see Japan’s lost decade[9] as the path for America in the way the mainstream bears paints her to be. So it’s hardly a paradigm for adequate comparison.

The second and most important point is, the reason why monetary contraction hasn’t impacted the US the way mainstream foresees it is because they ignore that trade by itself, is first and foremost the liquidity provider.

How?

As Murray N. Rothbard explained[10],

“We come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines.” (italics original)

Since money’s purchasing power will naturally adjust to the level of existing stock, then there won’t be any required money level in a free market regime. Thus, the persistence of trade is enough to assure the continuity of liquidity and the avoidance of deflation. This applies even if the Fed would remain non-activist.

Even the popular Harvard duo Carmen Reinhart and Kenneth Rogoff whom has made extensive reviews of the historical relationship of debt, inflation and economic growth during every banking and property crisis worldwide, can’t pinpoint out the definite critical offsetting threshold on how debt and economic growth balance.

Figure 2: VoxEu.org: Reinhart-Rogoff: 90% Debt As Threshold?

This comes with the exception when debt levels have reached or exceeded 90% of GDP (see figure 1), they write, “relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP” and “no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the US, have experienced higher inflation when debt/GDP is high)”.

It’s truly difficult to try and compare with past episodes because there is simply NO two similar situations, one can only make estimates and hope that the performances will fall within the ambit of models. However, their implicit point is, this addiction to debt has got to stop. And this is what truly plagues the mainstream mindset.

The third important point is that we have been validated anew.

US authorities on fear of a slowdown that may transform into a double-dip at a time nearing national elections, where the ruling incumbents seem at the risks of being politically dethroned, has called on our poker bluff.

Here is what I wrote at the start of the year[11],

``Many have used the strong showing of 2009 to advert that 2010 would be the year of “exits”. I don't buy it.

``As in the game of poker, I’d call this equivalent to a policymaker’s Poker bluff.”

The FOMC has changed tunes about adapting an exit strategy and will maintain their bloated balance sheets.

Here is the Danske Research team[12], (emphasis added)

``The FOMC revised downward the near-term growth outlook and decided to reinvest the principal payments from the Fed’s portfolio of Agency and MBS holdings in longer-term Treasuries. This implies that the balance sheet will be held constant and effectively puts the exit strategy on hold. While the amount of treasuries to be bought is insignificant, the decision sends a strong signal to markets. It provides a clear indication that rate hikes remain in the indefinite future and that the central bank is prepared for another round of quantitative easing if necessary.”

In short, the Fed’s action is a direct communication to the market that the policy spigot towards Quantitative Easing 2 is being recalibrated as insurance for any material economic growth slowdown.

So there you go—path dependency, economic ideology and the morbid fear emanating from wrong perspectives and analytics will drive the Fed to pump the next wave of liquidity into the system.

For the mainstream, anything that goes down is DEFLATION. There never seems to be within the context of their vocabulary the terms as moderation, slowdown and reprieve. Everything has got to go like Superman, up up up and away!

I’m quite sure, even if statistics would prove to be a false alarm the Fed, would be quick-handed to initiate the trigger.

Let me guess, politics will dictate such action. The Democrats don’t want go without a fight and the Fed will supposedly provide the backdrop for a benign outlook with the slowdown as pretext. It has never really been about economics but the politics of control. Yet the mainstream obstinately refuses to see this.

Of course, there are many other aspects that could debunk the deflation outlook, such actions in commodities markets, the yield curve, exploding emerging bonds and some EM equity markets.

But it really doesn’t matter, because for the mainstream these markets are out of the ambit of “aggregates”. Unfortunately, as F. A. Hayek[13], “aggregates conceal the most fundamental mechanisms of change”.

Phisix: No Decoupling, Only Outperformance

Also this is just a reminder to our Filipino colleagues and audiences where today’s market action is seen or interpreted by some as in some semblance of decoupling.

I’m glad that the ASEAN markets have been showing a steady outperformance, but the case for a decoupling hasn’t clearly been established (see figure 3).

Thus, it would be a darned big mistake to be presumptive of a “decoupling” in the event of another turbulent episode such as US recession which I don’t think will leave the Philippines or ASEAN markets unscathed.

One must be reminded that decoupling and outperformance are two different dynamics.

Figure 3: Tradingeconomics.com[14]: US and Philippine GDP

What ASEAN markets seem to imply is that the US isn’t headed for a double dip as the US mainstream bears suggests.

By the way, the definition of a Double dip recession[15] is a backslide to a recession (negative growth) following one or two quarters of positive growth. Based on semantics, the window for a double dip is fast closing—the end of third quarter of 2010 as per definition (if January of 2010 is the starting point of the recovery based on chart).

For me, if there would any immediate real risk worth monitoring this would possibly emanate from China[16] (yes she is slowing down).

That’s because she has engaged in massive credit expansion to immunize herself from a global growth slowdown in 2008 and many of these loans have channelled via shell companies[17] and lent to government projects that likewise got involved in real estate speculation which is hardly part of their core businesses. And such expansion usually creates alot of malinvestments and would likely result to capital consumption, when the imbalances are forced by the natural laws of economics to reveal themselves.

One thing going for China is that she is replete still with savings. There is as much as 9.3 trillion yuan ($1.4 trillion) of hidden assets or undeclared assets according to Yahoo News[18].

Nevertheless, I think signs are pointing to a soft landing more than a hard landing.

The problem anew for the bears is that following a slowdown and prospective stabilization, a renewed reacceleration will likely spur another episode of serious lift-off for ASEAN and many emerging markets, whom depend on China for trade and investments. And this should also help boost the US and the Eurozone too.

And another thing, for as long as the US won’t fall into a recession, the expressed policy by the Fed to indefinitely postpone the ‘exit strategy’, and reemergent possibility to engage in QE version 2 is also likely to serve as another tremendous boost for Asia.

For instance, Hong Kong is already having a difficult time fighting her internal bubbles recently having to impose a “60% limit on the loan to value for property purchases worth more than $1.55 million”[19], given her peg to the US dollar which basically makes her import Fed policies. The transmission mechanism will just get magnified by the ensuing policy divergences.

So bears will continue to fumble from one mistake after another, until the broken clock finally strikes twice a day and claim victory. How bizarre.

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[1] Perry, Mark 106 Bank Failures in Perspective, Enterprise Blog

[2] See $23.7 Trillion Worth Of Bailouts?

[3] Thestreet.com Another Illinois Bank Fail, August 14, 2010

[4] Le Bon Gustave, ibid p. 23

[5] See Financial Reform Bill And Regime Uncertainty

[6] See How Free Trade Saved The World From Depression

[7] See US and Global Economy: Pieces Of The Jigsaw Puzzles All Falling In Place

[8] Marketwatch.com German GDP grows 2.2% in second quarter, August 13, 2010

[9] See Japan’s Lost Decade Wasn’t Due To Deflation But Stagnation From Massive Interventionis

[10] Rothbard Murray N. What Government Has Done To Our Money p.29

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

[12] Danske Weekly, Fear of a slump August 13, 2010

[13] Hayek, Friedrich August von Reflections on the Pure Theory of Money of Mr. J.M. Keynes, Mises.org

[14] Tradingeconomics.com

[15] Investopedia.com, Double-dip recession

[16] See China’s State Driven Bubble

[17] FinanceAsia.com, China's endless moral hazard, May 6, 2010

[18] Yahoonews.com Hidden trillions widen China's wealth gap: study, August 11, 2010

[19] Wall Street Journal Blog, Hong Kong Forced to Fight Fed Again, August 13, 2010